Fidelity European Values — Update 21 June 2016

European stockmarket valuations peaked in mid-2015, with the Datastream (DS) EU market forward P/E multiple reaching 16.5x, placing it at a 3% premium to the world market (see Exhibit 2 left-hand chart). Arguably due to a weaker economic growth outlook, European markets have subsequently de-rated faster than other markets, with the DS EU market forward P/E multiple declining to 13.8x, representing a 5% discount to the world market and an 18% discount to the US market, a similar level to its 10-year average 16% discount. This suggests that, while European market valuations remain higher than average levels over the last 10 years, they do not appear overstretched relative to other developed markets.

European economic growth expectations remain modest, with IMF GDP growth projections of 1.5% and 1.6% for 2016 and 2017, affected by low investment, high unemployment and weak corporate balance sheets. However, after declining at the start of the year, the European economic sentiment indicator has moved higher in the last two months (Exhibit 2 right-hand chart), which may signal an improving outlook. Global economic uncertainties including the UK’s EU referendum, the timing of US interest rate hikes and the pace of growth in China could lead to periods of elevated market volatility, but there appears scope for European markets to move higher and further quantitative easing by the ECB could support higher market valuation levels. In this low-growth and uncertain economic environment, a largely unconstrained fund with a slightly contrarian approach, selecting stocks across European markets based on longer-term growth prospects may appeal to investors.

FEV is an LSE-listed investment trust, launched in November 1991, with the objective of achieving long-term capital growth from an actively managed portfolio of primarily continental European securities. Performance is benchmarked against the FTSE World Europe ex-UK Index, but bottom-up stock selection guides portfolio construction and sector and geographic allocations are not set by reference to the benchmark index. The portfolio typically comprises 55 to 60 investments and the investment approach is to focus on companies believed to be capable of delivering consistent dividend growth over a three- to five-year time horizon. FEV has been managed by Fidelity since launch, with Sam Morse acting as portfolio manager since January 2011.

Exposure to companies listed outside continental Europe is permitted up to 20%, which has given the manager flexibility to invest in UK stocks. FEV’s investment policy also permits derivatives to be used, allowing investment returns to be protected or enhanced. While this gives the manager scope to take short positions in stocks, these types of investment are not a current feature of the portfolio.

Sam Morse sees the relatively elevated valuations of European stock markets as a feature that is likely to constrain overall market progression, with a general lack of earnings momentum across the region also contributing to a subdued broader market outlook. However, Morse sees pockets of opportunity, particularly in out-of-favour segments of the market such as companies exposed to commodities and emerging markets. He has been identifying attractive stock-picking opportunities among larger companies where valuations look appealing relative to small and medium-sized companies, and this has given FEV a slightly contrarian large-cap bias compared with its peers. While modestly underweight in large caps (market cap > £10bn) versus its benchmark, FEV has overweight exposure to mega caps (market cap > £100bn).

The manager highlights that FEV’s portfolio remains focused on attractively valued companies able to grow dividends consistently, taking into account the current uncertain and low-growth economic environment. As a positive indicator for FEV, he points to the portfolio’s dividend yield relative to the MSCI Europe ex-UK Index standing at 91% (historical range: 70% to 95%), suggesting that market valuations may not fully reflect the superior dividend growth prospects of portfolio companies.

DNB is a portfolio holding that the manager sees as a good example of the contrarian opportunities on offer. DNB has been out of favour due to its relatively large exposure to the oil and gas sector. However, as the leading Norwegian bank with a c 35% market share, proven lending expertise, a cash-generative business, a low c 7% leverage ratio and an attractive c 5% dividend yield, it ranks highly on the manager’s investment criteria. The portfolio also has direct oil and gas sector exposure through Total and Royal Dutch Shell, seen as financially sound companies with unappreciated long-term earnings and dividend growth prospects, trading at attractive valuations.

While portfolio turnover remains relatively low at c 25% pa, FEV’s UK exposure was increased through the switch of part of the Shell holding to the UK listing, which was trading at a discount to its Dutch listing. Other recent changes to the portfolio include the sale of Norwegian media group Schibsted on valuation grounds and a new investment in German software company SAP. The previous holding in SAP was sold due to concerns over competitive pressures, but subsequent analysis showed that new SAP products were performing well and the manager sees the repurchase as a reflection of the investment discipline that is maintained in running the portfolio.

The manager seeks to identify companies that he believes are capable of delivering consistent dividend growth over a three- to five-year horizon and looks for the following main characteristics:

The manager is able to draw on Fidelity’s pan-European analyst team in assessing stocks and a strong emphasis is placed on meeting company management to gain a more qualitative insight.

Bottom-up stock selection drives portfolio construction. Stocks are screened by comparing yield against dividend growth prospects, while portfolio holdings are ranked using a more comprehensive total shareholder return (TSR) analysis, which considers earnings growth, dividend yield,
re-/de-rating potential, liquidity and volatility, as well as Fidelity’s internal analyst rating. Differences between TSR rankings and stock weightings indicate where portfolio rebalancing may be appropriate. While TSR analysis may lead to increased portfolio turnover, it is expected that the effect of this will be more than compensated by improved execution of the investment process.

Top-down geographic allocations are not imposed, but countries represented in the benchmark index should comprise at least 80% of the portfolio, with up to 20% invested in companies listed elsewhere that have some European exposure. The manager aims to keep sector weightings within five percentage points of the benchmark. Up to 10% can be invested in any one quoted company at the time of acquisition and aggregate exposure to unquoted securities is limited to 5%.

FEV maintains a relatively concentrated portfolio of c 60 holdings with the top 10 representing 37.7% of the portfolio at 31 May 2016, very similar to a year earlier (see Exhibit 1). As shown in Exhibit 3, FEV’s largest active sector exposures are overweight positions in healthcare and technology and underweight positions in basic materials and telecoms, with industrials seeing the greatest increase in exposure over the last year. While financials and consumer goods represent the largest portfolio weightings, these sectors have seen the greatest decrease in exposure over the last 12 months and FEV is underweight in both sectors.

FEV’s portfolio is broadly diversified by geography but, with allocations not constrained, individual country weightings can differ appreciably from the benchmark. At end-May 2016, the portfolio had notable overweight exposures to the UK and France with an underweight exposure to Germany (see Exhibit 4). The greatest shifts in exposure compared with a year earlier were increases in France and Spain and decreases in Switzerland and Germany.

As shown in Exhibit 6, FEV’s share price and NAV total return have outperformed its FTSE World Europe ex-UK index benchmark over three, five and 10 years. While NAV performance has been similar to the benchmark over one year, a widening of the discount is reflected in the weaker share price performance. Financials made the strongest contribution to relative performance over the last year, particularly FEV’s lack of exposure to Banco Santander, Deutsche Bank and Credit Suisse, which outweighed the negative effect of overweight holdings in GAM and Zurich Insurance. Industrials also made a strong contribution, driven by holdings in Intertek (UK-listed), Kone, Schindler Holding and Flughafen Zurich Airport. Consumer discretionary was the main detractor from performance relative to the benchmark, primarily due to FEV’s overweight holding in Volkswagen. Within healthcare, FEV’s lack of exposure to Novartis largely offset the drag on performance from its overweight holding in Sanofi. During the last five years, FEV achieved its strongest period of outperformance between October 2011 and April 2012 (see Exhibit 7), particularly noticeable while the market declined in March and April 2012, reflecting a tendency for the manager’s investment style to create a defensively-positioned portfolio.

The board maintains an active discount management policy, with the primary aim of reducing share price volatility relative to NAV, while noting the secondary effect that repurchasing shares at a discount enhances NAV per share. While share buybacks were at a very modest level, FEV’s share price discount to NAV including income narrowed from 11.2% to 6.6% between March and May 2016. Concerns over the UK’s EU referendum appear to have contributed to the recent widening of the discount to the wider end of its 2.8% to 12.9% three-year range (Exhibit 8), suggesting that any near-term improvement in market sentiment could lead to a significant narrowing of the discount.

FEV has 416.3m shares in issue, having repurchased 0.2m shares since restarting share buybacks in March 2016. Prior to this, no shares had been repurchased since July 2014. FEV has authority to repurchase up to 14.99% of its outstanding shares and buybacks have been a regular feature in previous years (see Exhibit 1). The board’s view is that gearing can enhance long-term returns and FEV’s normal policy is to maintain a modest level of gearing using contracts for difference (CFDs). While gearing of up to 30% is permitted, the current range set by the board is 0% to 10% and at end-May 2016, gross and net effective gearing stood at 3.1%. FEV pays a management fee of 0.85% pa of net assets and from 2015 no performance fee is payable. All management fees and expenses are charged to revenue rather than capital. For 2015 the ongoing charge was 0.94%.

FEV is subject to a two-yearly continuation vote, with the next scheduled at the May 2017 AGM.

FEV pays an annual dividend in May, distributing in full the prior financial year’s revenue earnings. The trust’s objective is to achieve long-term capital growth, but the manager’s focus on companies able to grow dividends has provided a rising income, leading to the ordinary dividend increasing in each of the last five years (see Exhibit 1) with a 7.4% gain to 3.33p for FY15. Special dividends are paid exceptionally; the 0.54p paid for FY14 related to the recovery of £2.3m of French withholding tax and interest. There is no certainty that dividend payments will continue to rise in future years, but the manager sees potential for portfolio companies to deliver high single-digit dividend growth in 2016. At end-2015, FEV’s revenue reserves in excess of the FY15 dividend payment equated to 1.8p per share; these may be used to smooth the progression of future dividends.

Exhibit 9 shows a comparison of FEV with AIC Europe sector peers. The only trusts with over 5% UK exposure are FEV (7%) and Jupiter European Opportunities (24%), which are also the largest funds in the sector with market caps over £500m. FEV’s NAV total return performance, while ahead of the benchmark over most time periods, is lower than the peer group averages over the periods shown. The manager notes that recent small-cap outperformance has been unhelpful to FEV given its large-cap bias relative to peers. In terms of risk-adjusted returns, FEV’s one- and three-year Sharpe ratios are similar to the peer group average and reflect increased market volatility over the last year. FEV’s share price discount to NAV is slightly wider than the peer group average, while its ongoing charge is similar to the average and its gearing is modestly below average. FEV’s 2.1% dividend yield is moderately lower than the peer group average, but in line with the average excluding JPMorgan European Income, the only income-focused trust in the peer group.

Humphrey van der Klugt stepped down from the board in May 2016 after nine years’ service, including six years as chairman, leaving the board comprising five non-executive directors, four of whom are independent. Vivian Bazalgette (appointed December 2015) has taken over as chairman. The other independent directors are James Robinson (senior independent director, appointed June 2007), Robin Niblett (appointed January 2010) and Marion Sears (appointed January 2013). Simon Fraser (appointed July 2002) spent 27 years at Fidelity before retiring in 2008, including six years as CIO for Fidelity International, and is therefore deemed not to be an independent director.