JPMorgan European Smaller Companies Trust — Building on long-term positive track record

Exhibit 2 (left-hand side) shows the performance of indices, in sterling terms, over the last five years. In aggregate, shares have performed particularly strongly since early 2016, due to robust corporate earnings growth and a positive revaluation of equities. Small-cap European stocks have significantly outperformed both global and UK equities over this period. On a forward P/E multiple basis, small-cap European stocks are more expensive than global equities, although they offer a modestly higher dividend yield. Compared to UK companies, smaller European firms are less attractively valued based on earnings multiples, and offer a significantly lower yield. While there are plenty of investment opportunities available in individual smaller European stocks, investors may wish to consider a fund that invests in quality, undervalued companies, and which has a solid long-term performance track record.

JESC was launched in April 1990. It aims to generate long-term capital growth from a diversified portfolio of European ex-UK small-cap equities. The trust is managed by Francesco Conte (since 1998) and Edward Greaves (since 2016), who are able to draw on the broad resources (c 40 professionals) of J.P. Morgan Asset Management’s European equity team. Former manager (since 1995) Jim Campbell has returned from personal leave and assumed another role within J.P. Morgan Asset Management. Jack Featherby was hired as an analyst in January 2018 to work alongside Conte and Greaves. The trust is benchmarked against the EMIX Smaller Europe ex-UK Index, which at end-FY18 contained c 1,000 companies with market caps up to £5.3bn, spread across 14 countries. At the time of investment, a maximum 5% of the portfolio is permitted in a single stock and no more than 15% may be invested outside of the benchmark. Currency exposure is not hedged. JESC may gear up to 20% or run up to a 20% net cash position; as at 9 July 2018, the trust had a net cash position of 1.4%. The trust has a strong performance track record – over the last 20 years to end-FY18, JESC’s NAV has achieved annualised total returns (net of fees) of 13.4%, 4.4pp per annum ahead of the benchmark’s annual total return.

We met with the managers in May 2018, and they explained that earlier in the year investors were bullish on the outlook for European equities. Conte and Greaves were less optimistic given the unusually low levels of stock market volatility in 2017; during the year, the maximum stock market pullback was just 4%. Investor sentiment changed in February 2018, driven by a number of factors: a higher than expected inflation number out of the US, which led to concerns about central bank tightening; fears of an economic slowdown; and concerns about global trade, following comments from President Trump. These events led to a stock market drawdown in March but, due to its focus on quality companies, JESC outperformed its benchmark during this period. The managers believe that the market pullback was a mid-cycle correction and has not signalled the end of the bull run. Overall, they remain fundamentally positive.

While the momentum in global purchasing managers’ indices (PMIs) has slowed, they remain above 50, which indicates economic expansion. The managers note that more than 50% of European company revenues are generated outside the region, and that economies in the European area also continue to improve. They believe that normalising inflation is positive, and there are factors that will ensure inflation will not get out of hand, which could otherwise lead to excessive monetary tightening and a subsequent recession. For example, the internet brings pricing transparency, and advances in automation are helping to curtail cost inflation.

The managers say that European equity valuations are not excessive, running broadly in line with long-term averages. While the European stock market has rallied strongly since early 2016 (along with global equities), it is supported by robust corporate earnings. Consensus estimates are for c 10% growth in both 2018 and 2019, following on from above average growth of c 20% in 2017.

JESC’s managers continue to focus on technological change across a broad range of sectors, aiming to identify the companies that will benefit, and avoid those that will be negatively affected. In an environment of more normal stock market volatility, they note there are outsized share price moves for companies that are beating or missing consensus earnings estimates, movements that can be exacerbated by algorithmic trading. The managers are keen to exploit what they view as pricing anomalies, taking advantage of individual company share price weakness as a result of transitory factors such as currency moves. They are able to employ gearing to increase exposure to high-conviction positions, rather than having to raise cash by selling an existing position. Earlier in 2018, the managers increased their position in Italian company Datalogic, a global leader in the automatic data capture and process automation markets. They believed the market overreacted to a temporary slowdown in the company’s growth; they consider the firm is well-positioned to benefit from long-term growth in its core products, which include bar code readers and sensors.

The managers aim to generate long-term capital growth from a diversified portfolio (50-75 holdings) of small-cap, European ex-UK equities. They use a proprietary multi-factor model to screen the potential universe, which is made up of c 1,500 small-cap European stocks. Companies passing the screen undergo thorough fundamental analysis. The managers seek high-quality companies, with good business momentum, that are trading on reasonable valuations.

Holdings tend to fall into three ‘buckets’: companies that can grow organically regardless of the economic backdrop; those offering a niche product or service; or turnaround situations. The exposure to each ‘bucket’ may vary depending on general market conditions. Position size is determined by the managers’ level of conviction and a company’s share liquidity. New positions are typically c 1% of the portfolio and are generally trimmed when they reach c 3%. Reasons for selling a holding are: due to a fundamental deterioration in business conditions; if the company has grown too large; on valuation grounds; or if there is a better investment opportunity available. Portfolio turnover is currently running at c 70%, which is broadly in line with historical averages.

JESC’s geographic exposure is shown in Exhibit 3. The trust’s largest overweight is now the Netherlands (+11.7pp), and it continues to have no exposure to Spain (-7.4pp) as the managers are unable to find attractive companies trading on reasonable valuations.

On a sector basis (Exhibit 4), JESC’s largest increases in exposure over the past 12 months are healthcare (+7.0pp) and energy (+6.1pp), while the largest decrease is consumer discretionary
(-13.1pp). The trust now has double the index weighting in technology, and has no exposure to the real estate and telecom sectors, which together make up more than 10% of the index.

The managers highlight one of JESC’s holdings – Tomra Systems, which is a Norwegian company manufacturing ‘reverse vending machines’ for recycling solutions. It has a 70-80% global share and the managers consider that the company has very favourable attributes: structural growth, technology leadership (its machines are very complex), and a highly conservative management team. They were able to initiate a position at an attractive valuation. Relatively recent new positions in the portfolio include Arcadis (Netherlands), an infrastructure consultant, which has undergone management changes and strengthened its formerly weak balance sheet; Atea (Norway), which offers value-added services using sensor technology to optimise a customer’s logistical network; Royal Vopak (Netherlands), the world’s leading independent tank storage company, which is expected to experience an earnings inflexion following a period of high capex; and Rubis (France), which is somewhat like a private equity company, in that it buys non-core, unconnected assets from energy companies and improves their efficiency.

In FY18 (ending 31 March), JESC’s NAV and share price total returns of +14.4% and +21.6% were significantly ahead of the benchmark’s +10.0% total return. The outperformance was primarily due to stock selection rather than asset allocation. The board is particularly pleased with the trust’s results, acknowledging that it was a difficult period for individual stock picking, and there were wide divergences between individual sector performances.

Over the last 12 months to end-June, JESC’s NAV and share price total returns of +12.7% and +10.7% respectively are again meaningfully ahead of the benchmark’s +6.9% total return (Exhibit 5). Significant contributors to performance include Interpump Group (high-pressure piston pumps); Jungheinrich (forklift trucks and warehouse systems); Stabilus (gas springs and dampers); and Trigano (camper vans and camping equipment).

JESC’s relative returns are shown in Exhibit 6. It has outperformed the benchmark over one, three, five and 10 years in both NAV and share price terms. The trust has also performed considerably better than both large-cap European and UK equities over these periods.

Over the last three years, JESC’s widest discount was 18.4%, which occurred in mid-November 2016. Since then the discount has narrowed meaningfully. The current 11.0% share price discount to cum-income NAV compares with the averages for the last one, three, five and 10 years of 8.8%, 10.8%, 11.3% and 14.1% respectively.

JESC is a conventional investment trust with one class of share; there are currently 160.0m ordinary shares in issue. The trust has a €105m lending facility with Scotiabank, at a cost of Libor +72.5bp, which expires on 17 January 2020. JESC is permitted to run between a 20% net cash and a 20% geared position; at 9 July 2018, the trust had a net cash position of 1.4%. During FY18, gearing varied between 3.6% net cash and 9.4% geared.

In recent years, JESC’s management fee has been coming down. Prior to 1 April 2015 it was 1.3% of net assets, which was then reduced to 1.0%. On 23 February 2017 it was announced that the fee structure would be reduced further. Effective from 1 April 2017, the management fee is 1.00% of net assets up to £400m and 0.85% of net assets above £400m. In FY18, ongoing charges were 1.04%, which was 9bp lower than in FY17.

While JESC aims to generate long-term capital growth, the board’s distribution policy is to pay out the majority of annual revenue, meaning that total annual dividends will vary from year to year. Interims, when paid, are in January, and finals, when paid, are in July. In FY18, the total distribution of 6.7p was significantly higher than the annual dividends paid in recent years; +43% versus FY17 and +109% versus FY16. This was a function of higher dividend receipts and exchange rate movements. Based on its current share price, JESC has a dividend yield of 1.7%.

JESC is the largest of four trusts in the AIC European Smaller Companies sector. Its NAV total returns are above average over all periods shown, ranking first over 10 years and second over one, three and five years. Its discount and ongoing charge are broadly average and, in common with most of the peers, no performance fee is payable. JESC’s dividend yield is the second highest in the group, where the average is skewed by European Assets Trust, which pays out an annual distribution of 6% of its year-end NAV.

There are five directors on JESC’s board, all of whom are non-executive and independent of the manager. The chairman is Carolan Dobson, who was appointed to the board in September 2010 and assumed her current role in 2013. The other directors and their dates of appointment are: Stephen White (April 2012), Ashok Gupta (January 2013), Nicholas Smith (May 2015) and Marc Van Gelder (August 2016).