European Assets Trust — Update 11 May 2016

World equity markets took a dive at the start of 2015 but staged something of a recovery in March and April this year. As shown in Exhibit 2 below (left-hand chart), European markets had lagged the world index over much of the past five years, partly as a result of a series of sovereign debt and banking crises in the eurozone, and partly because the US, which dominates the world index, had enjoyed a strong run of performance. For much of this period European smaller companies had underperformed their larger brethren, but since converging in mid-2014, small-caps (as measured by the Euromoney Smaller Europe ex-UK index) have pulled ahead of large-caps (measured by the FTSE AW Europe ex-UK index) to catch up with the five-year total return of the FTSE World index.

A side effect of this recovery has been that on a range of valuation metrics (right-hand chart), small caps arguably look less attractive at this point. Volatility is likely to continue in the face of the UK’s EU referendum, cooling global growth, fears of a hard landing in China and continued divergences in global monetary policy. In light of this, investors may be wary of committing to equity markets, particularly as the summer months (often characterised by thin trading volumes) approach. However, we believe an approach that seeks well-financed, growing companies at sensible valuations may help to overcome some of the likely pitfalls in such a market environment.

EAT began as a Dutch company in 1972 and is listed on the London and Amsterdam stock exchanges. It invests in small- and mid-cap companies in Europe, with the aim of achieving capital appreciation from this faster-growing segment of the market. It has been managed by the same firm since launch, though the manager has been through several name changes and is now BMO Global Asset Management (formerly F&C). The portfolio manager, Sam Cosh, (who is assisted by Lucy Morris and the BMO GAM European equities team) has been in the post since 2011.

While the European small- and mid-cap sector is not a high-yielding part of the market, the fund adopted a high distribution policy in 2001, initially as a way of distributing its reserves in a tax-efficient manner following a rule change in the Netherlands. Each year on 1 January a distribution is declared, calculated at 6% of the euro-denominated NAV at 31 December (the year-end). Depending on performance during the year, this may be funded from capital as well as income. The high yield has led to strong demand for EAT’s shares in an environment of low interest rates, and the fund has consistently traded at a premium to NAV, issuing £183.5m of new shares since 2013 to meet demand.

EAT’s manager Sam Cosh and his team have been taking advantage of recent market volatility to add to quality names that had become too expensive in the momentum-driven markets of 2015, although he notes that in aggregate, quality growth continues to present a challenge in terms of valuation. While March and April saw something of a recovery from the sharp falls in January and February, Cosh argues that volatility is set to continue in the near term, with fears over the impact of the UK’s EU referendum on the rest of Europe adding to the already present worries over slowing global economic growth, a hard landing in China and divergences in monetary policy.

One sector in the portfolio that has suffered in recent months is financials. However, Cosh says that EAT’s Italian financial stocks are likely to be less directly affected in the long term by current fears over the impact of non-performing loans (NPLs) on the country’s banking sector. The one Italian bank in the portfolio – Credito Emiliano – is a quality bank with conservative lending criteria, and its NPLs have been consistently low.

While the outlook for corporate earnings in Europe has deteriorated, Cosh says that broadly the portfolio has held up well in the recent earnings season, with many stocks producing results in line with or better than the market’s expectations. However, lower aggregate earnings forecasts are causing market volatility driven by investor risk aversion, and the manager argues that for Europe to look really attractive, there needs to be more evidence of a sustainable profits recovery.

With quality stocks (see Investment process, below) looking expensive, Cosh says he continues to believe that a balanced portfolio is the right way forward, with exposure to out-of-favour companies and sectors (such as financials) adding greater potential for reward alongside those where growth looks sustainable but is likely to be slower.

The small- and mid-cap market in Europe is large and diverse, with c 2,000 quoted companies, while EAT’s portfolio is a concentrated list of c 40-50 stocks. To arrive at his final selections, EAT’s manager Sam Cosh works with the European equities team at BMO Global Asset Management (formerly F&C) to analyse the universe. The portfolio managers and analysts in the team all undertake company meetings and research. Ideas may come from the team’s sector knowledge, quantitative screens or suggestions from brokers, with company meetings often the first stage in deciding whether to undertake more detailed fundamental research. The output of this research is a report following a standardised format; these are debated at twice-weekly team meetings and a qualitative score is assigned to each stock. EAT seeks a margin of safety in valuations and favoured stocks may go on to what the manager calls a ‘patient fishermen’ list if the team feels the current share price is too high. Several recent purchases have come from this list after the market correction brought them to more favourable levels.

The EAT portfolio is organised into four broad categories or (carrying on the fishing analogy) ‘buckets’. These are defined as follows:

In broad terms, the managers see companies in the first two categories as ‘quality’ stocks, and those in the latter two as ‘value’ stocks.

Holdings are monitored against price targets and a review process is triggered when they reach those targets, or if the share price has risen or fallen by more than 25% relative to the benchmark. Stocks may also be sold if developments occur that call the original investment thesis into question.

At 31 March EAT had 43 holdings, the shortest stock list in its peer group. The top 10 stocks made up 35.5% of the total, up from 32.6% a year previously. This is also more concentrated than the peer-group average. In spite of the concentrated portfolio, EAT is geographically diversified, with holdings spread across more than 12 countries in Europe. The biggest change to country weightings over the past 12 months is a 4.8 percentage point fall in exposure to Switzerland, caused partly by the sale of financial services stock Partners Group after its valuation began to look stretched, but also by a difficult period for structured financial products specialist Leonteq.

The sale of Partners Group and poor performance from a number of holdings has also contributed to the largest change in sector weightings, an 11.5 percentage point drop in exposure to financials. There has been a 7.9 percentage point increase in the industrials weighting to make it the largest sector exposure at 31 March 2016. Part of the increase in industrials was the purchase of wooden window manufacturer Inwido, a Swedish company that operates in markets across Europe. As the European market leader, Inwido benefits from economies of scale and is highly cash-generative. The manager began building a position in the stock in October 2015 and was able to add more during the sell-off in January and February; it is now just outside the top 10 holdings.

Other recent additions to the industrial side of the portfolio include Dutch chemical distributor IMCD, Italian specialist food distributor MARR, and another Italian company, IMA, which makes packaging machinery for the food and pharmaceutical industries.

The manager notes that with quality growth stocks looking expensive and much of the recent recovery focused on bombed-out commodity stocks with unfavourable fundamentals, he and the team will continue to focus on finding cash-generative companies with a margin of safety in their valuations.

EAT has a strong longer-term performance record, outperforming the Euromoney Smaller Europe ex-UK index in both share price and NAV terms over three, five and 10 years (Exhibit 4, right-hand chart), and the large-cap FTSE AW Europe ex-UK and the FTSE All-Share over all the periods shown in Exhibit 5 except the past three months. Recent performance, while positive in absolute terms over most periods, has lagged the benchmark (Exhibit 4, left-hand chart), with the bulk of the underperformance occurring since the turn of the year. This is principally because of poor performance from the financials sector, where EAT had an overweight position versus the benchmark. March saw the beginning of a recovery in the European small-cap market, which sold off heavily at the start of 2016, and while EAT suffered something of a reversal in both absolute and relative terms during April, Exhibit 6 shows that periods of relative underperformance have historically been fairly short lived.

A combination of strong performance and the high yield on offer has kept demand for EAT’s shares robust even in periods when investors have been fearful over Europe. Over the past 12 months to 9 May it has traded in a range between a 1.3% discount and a 3.7% premium, with a 12-month average premium of 1.1% (0.2% over three years). The premium to NAV at 9 May was 1.4%. EAT will issue shares in response to investor demand and has been active in this regard in the past 12 months, issuing 7.6m shares and raising £82.5m, of which 1.1m shares raising £11.8m have been issued so far in 2016. In July 2015, EAT issued a prospectus to give it the flexibility to allot up to a further 9m shares in the 12 months to July 2016.

EAT has one class of share, with 32.95m shares in issue at 9 May 2016. In response to strong demand from investors, 10m shares were issued in 2015, raising £109m. This has reduced the ongoing charges on the fund from 1.3% at FY14 to 1.1% at FY15 as a result of spreading fixed costs over a larger asset base. During 2015, EAT was granted the authority to increase the authorised share capital from 30m to 50m shares, and a prospectus was published in July 2015 to enable the issuance of 9m shares in excess of the 10% allotments allowed annually.

FCA Management BV (the Dutch management board) is paid an annual fee (€103,975 for FY15) and F&C Investment Business (the investment manager, a subsidiary of BMO Global Asset Management) receives a quarterly management fee of 0.2% of funds under management, equating to 0.8% annually. EAT has a €45m loan facility with Kas Bank, increased from €25m during 2015. At 31 December, the facility was undrawn, although gearing had varied from -2.2% (a net cash position) to 2.9% geared during the year and stood at 1.3% on 31 March 2016.

Although its primary objective is to achieve capital growth, EAT adopted a high distribution policy in 2001. Under this policy it pays a distribution equal to 6% of the NAV on 1 January (calculated in euros). The dividend is paid in three instalments, in January, May and August, and for UK shareholders the exact amount paid will depend on the sterling/euro exchange rate at the time. Shareholders may also choose to receive their dividend in the form of further shares (a ‘scrip’ dividend). Because the distribution is paid as a fixed percentage of NAV it will vary from one year to the next. For 2016 a distribution of €0.912 per share was declared. The first instalment of this was paid on 29 January, at €0.304 or 23.4p per share in sterling. If the exchange rate were to remain constant for the remaining two distributions the total sterling dividend would amount to 70.2p per share, which represents a dividend yield of 6.5% based on the 9 May share price of 1,072.5p.

EAT is a member of the AIC European Smaller Companies peer group, a small sector of four investment companies. While absolute returns have been positive over one, three and five years, EAT’s NAV total return is behind the peer group over one and three years. Over five years it is comfortably in first place, however. Risk-adjusted performance as measured by the Sharpe ratio is in line with the average over three years and behind over one year. Charges are broadly average, as is the level of gearing. As a result of its 6% annual distribution policy, EAT’s yield is the highest by some margin. This makes the shares attractive to income-seeking investors, boosting demand and leading to a small premium to net asset value, while the rest of the peer group trades at a discount.

As a Netherlands-incorporated company, EAT has a two-tier board structure. The management board has a single director, FCA Management BV, which is represented by Wilbert van Twuijver and Tim Koster. The supervisory board is similar to the board of directors for a UK investment trust. It currently has four non-executive directors: chairman Jack Perry (a board member since 2014 and chairman since 2015), Professor Robert van der Meer, Julia Bond and Laurence Jacquot. A fifth director, Martin Breuer, has been proposed for election at the May 2016 shareholders’ meeting. Neville Cook and former chairman Sir John Ward both stood down from the board in 2015.