European Assets Trust — European small-cap specialist

As shown in Exhibit 2 (left-hand side), small-cap European equities (ex-UK) have outperformed large-cap European and global equities over the past five years. A dip in late 2016 was largely attributable to the run up to the US elections and an increase in political uncertainty for Europe given a series of forthcoming elections. Political risk has since abated allowing markets to refocus on fundamentals, which have been increasingly favourable. European GDP growth has outpaced that of the US in four of the past five quarters while leading indicators, including purchasing managers indices above 50, suggest a positive outlook. Eurozone consumer confidence is at the highest levels since 2007 and unemployment continues to fall. Combined with a decent backdrop for global growth, economic conditions are favourable for European small-cap equities. Valuations, however, are now less attractive than a year ago. As shown in Exhibit 2 (right-hand side), European small-cap equities are now more expensive on a forward P/E valuation basis than Europe large-cap and global equities. Excluding Germany, however, European earnings have not recovered from recession lows and valuations reflecting normalised earnings are much more attractive. For investors looking for exposure to European small-caps, a fund with a rigorous bottom-up approach and solid long-term track record may be of interest.

EAT was launched as a Dutch company in 1972, is listed on the London and Amsterdam stock exchanges, and is a member of the Association of Investment Companies. Its objective is to achieve long-term growth in capital through investment in listed small and medium-sized companies in Europe (excluding the UK). The investment approach is fundamental, bottom-up and benchmark agnostic, to build a relatively concentrated portfolio across diverse sectors. Key attributes for portfolio companies are strong balance sheets, healthy cash flows and high and sustainable returns on capital. As at end-June 2017, over 75% of the portfolio was held in stocks with a market cap of between €250m to €3bn. Sam Cosh has been the lead manager since 2011 and is supported by David Moss and Lucy Morris. EAT’s board has adopted a high dividend distribution policy of 6% of year-end NAV in euro terms. Its current yield of 5.2% is significantly higher than that of peers.

This year, political risk in Europe has receded and markets have responded to increasingly favourable economic and earnings data, which has left valuations at levels that are not obviously attractive. The manager, however, believes traditional valuation measures to be blunt instruments and that the real picture is more interesting and nuanced.

Europe is not a homogenous region and since the recession, only Germany has staged a meaningful economic recovery, led by exports, while the rest of Europe and domestically-oriented industries have lagged. Current economic conditions should now be more supportive for a recovery to extend beyond exporters. These include positive leading indicators, improving consumer sentiment and falling unemployment. The manager notes that Q117 earnings were better than expected and positive earnings revisions are picking up pace. Should Europe stage a broader earnings recovery, valuations would look much more attractive, particularly against US equities. European cycle-adjusted P/E valuations relative to the US are now at historic lows (since 1980).

Furthermore, current economic conditions particularly favour smaller-cap stocks, which by their nature are more cyclical and domestically oriented. Cosh cautions, however, that quality stocks across the board are expensive. In response, the team has been looking at smaller companies and relatively newer listed companies, which are generally not yet on the radar of investors. These include two recent additions to the portfolio: Nordic Waterproofing, a construction supplies company; and Coor, a Scandinavian facilities management company.

The universe of European small and mid-cap companies consists of c 2,000-2,500 names, from which the manager builds a portfolio of around 40 to 60 stocks. The manager works with the European equities team at BMO Global Asset Management to screen and analyse the universe. Around 150 companies pass the screening process and are subject to rigorous fundamental analysis with particular focus on the areas of quality, management and valuation. Meeting managements of companies is an important part of this process. The team produce standardised proprietary research on its candidate companies, which include valuation targets and triggers for selling a stock. These help facilitate debate and discussion at the team’s twice-weekly meetings. Attractive companies that do not meet the valuation criteria, are put on reserve (referred to as the ‘patient fishermen’ list), to await an appropriate purchase opportunity.

EAT’s portfolio companies fall into four broad categories as follows:

In broad terms, the first two categories of companies are what investors would view as ‘quality’ stocks while the latter are ‘value’ stocks.

Portfolio holdings are closely monitored and a sell discipline is part of the investment process. A stock will be reviewed for sale when: it has reached the target valuation; its share price has moved by more than 25% (plus or minus) relative to the benchmark; and the sell triggers materialise.

As at end-May, EAT’s portfolio held 40 stocks across 12 countries and seven sectors. As shown in Exhibit 3, the largest country exposure continues to be Germany at 19.8%. In the year to end-May 2017, the most significant geographic change is a 4.3pp decline in the Ireland weight to 14.2% where recent recoveries in share prices prompted profit-taking and Permanent TSB was sold.

Industrials continue to be EAT’s largest sector and this has increased by 4.9pp to 34.3%. Recent purchases in the industrials sector include Dometic (Sweden), a market leader in appliances for recreational vehicles (RVs). Drivers include a cyclical economic improvement in Europe, but also structural trends in favour of outdoor recreation and an aging population; the traditional customer base for RVs. Increasing high margin aftermarket sales can also help improve profitability.

Vidrala (Spain) is a glass bottle manufacturer located in the Rioja region, where it has a high market share. Its proximity to local wine producers is a natural ‘moat’ against competition and furthermore, by regulation, Spanish wine must be bottled in Spain. The company has made acquisitions in Europe and is well-placed to be a consolidator in this industry.

Nordic Waterproofing (Sweden) is a recently listed manufacturer of water-proofing products, such as bitumen and rubber-based products, for the building and infrastructure industries. It is one of two pan-Nordic suppliers. With a fragmented customer base and improvement in the region’s construction sector, there is scope for both revenues and margins to expand.

Financials have declined 4.6pp in weight to 15.2% following several sales including Permanent TSB and Leonteq, both due to weaker than originally assessed investment cases. Topdanmark was divested on valuation grounds following a takeover by Sampo. C&C was sold on a share price rally as the manager deemed its competitive position no longer sustainable. This sale contributed to the fall in the consumer services weighting to 10.7% of the portfolio.

EAT’s share price and NAV total return performance relative to its benchmark has been positive over three, five and 10 years. Over the same periods, performance has been significantly better compared to benchmarks for large-cap European equities and global equities (as illustrated in Exhibits 4 and 5). Over one year, the NAV total return underperformed its benchmark by 4.6%, although the share price outperformed by 5.9%. 2016 was a particularly challenging year as the portfolio suffered from poor stock selection in a small number of holdings and also from an overweight position to Ireland at the time of the EU referendum. A number of the Irish holdings had significant exposures to the UK and were substantially affected by the referendum result, both from a fall in sterling and investor expectations for a weakening UK economy. At the time, the manager assessed the share price falls to be excessive relative to fundamentals and selectively added to positions. Since then, many of these stocks have performed well and allowed for profit-taking.

NAV performance has stabilised over one, three and six months. The manager notes that the portfolio’s more recent purchases, since the beginning of 2016, have performed strongly and reaffirms the team’s investment philosophy and rigorous stock-selection process.

Despite the one year underperformance, EAT’s share price has outperformed its benchmark over all periods shown. This is likely a reflection of its attractive dividend yield, solid long-term performance track record and, more recently, increased flows into European equities from investors seeking exposure to the region (ex-UK).

Exhibit 7 shows the volatility of the premium/discount over the past 12 months, which reached its lowest point on 20 October 2016, ahead of the US elections. EAT currently trades at a 0.7% premium to cum-income NAV. The averages, however, show discounts over one, three, five and 10 years of 4.5%, 1.1%, 2.0% and 5.9%, respectively. These figures are skewed by events such as the EU referendum vote and US elections, but belie the fact the trust has traded at a premium for most of the past three years.

EAT has one class of shares; there are currently 33.5m ordinary shares in issue. The number of authorised shares is 50.0m and during 2016, the company issued 1.32m new shares at €13.65 per share. The trust has a €45m flexible facility with Kas Bank and as at end-May 2017, had net gearing of 0.53%. BMO Global Asset Management (formerly F&C Investment Business Limited) provides the investment management and services to the trust. It receives an annual fee of 0.8% of the gross value of assets under management paid on a quarterly basis. The Dutch management board received a fixed annual fee of €114,091 in 2016 (€103.975 in 2015).

Barring unforeseen circumstances, the board intends to pay an annual dividend of 6% of the euro-denominated NAV per share at the end of the preceding financial year. A scrip alternative is available. The policy is to pay dividends from a mix of current year net profits and other reserves. As the company reported a net loss in 2016, the declared dividends of €0.94 per share and cash dividends of €30.5m were fully paid out of distributable reserves, which as at end-2016 stood at €421.0m.

The AIC European Smaller Companies sector is small with just four companies and absolute performance over all periods shown has been strong for all funds. EAT’s NAV total return performance is second among peers over one year and lower ranked over three, five and 10 years. Despite this, it is the only trust to trade at a premium to NAV, probably reflecting its significantly higher dividend yield. Ongoing charges are higher than the sector average.

EAT is incorporated in the Netherlands and has a two tiered board. The management board has a single director, FCA Management BV, represented by Wilbert van Twuijver and Tim Koster. The supervisory board is akin to a board of directors on a UK investment trust. It consists of five independent non-executive members: chairman Jack Perry, deputy chairman and chair of audit professor Robert van der Meer, senior independent director Julia Bond, Laurence Jacquot and Martin Breuer. Martin Breuer, the newest member of the board, joined in May 2016.