Fidelity European Values — Update 9 January 2017

Exhibit 2 (left-hand side) shows the valuation of European equities versus both world and US equities over 10 years. European equities are currently trading at a 3% discount to world equities and a 16% discount versus US equities. While continental Europe has been slower to recover from the global financial crisis than some other developed markets, there are signs of improvement – in its October World Economic Outlook; the International Monetary Fund modestly increased its European growth estimates to 1.7% for 2016 and 1.5% for 2017. As shown in Exhibit 2 (right-hand side) the European economic sentiment indicator has recovered from the depths of March 2009 and has been in an upward trend since September 2012. In addition, the European Central bank continues to adopt an easy monetary policy. For investors looking for exposure to a region with recovery potential, a fund with a disciplined investment process and a medium- and long-term record of outperformance versus its benchmark may be of interest.

FEV was launched in 1991 and is listed on the London Stock Exchange; it aims to generate long-term capital growth primarily from investment in continental European equities. It is benchmarked against the FTSE World Europe ex-UK Index and since January 2011 has been managed by Sam Morse; he has more than 25 years of investment industry experience. Up to 20% of gross assets may be invested in companies that are outside the benchmark; this includes UK-listed companies. Up to 10% may be invested in unlisted securities and the maximum permitted in a single company at the time of investment is also 10%. The use of derivatives is permitted to protect or enhance investment returns. While this gives scope to take short positions in stocks, this facility has been used selectively as the manager is aware that the risk of losing money can often be greater in a short position than a long position, including when a shorted company receives a take-over bid at a significant premium. Gearing of up to 30% of net assets is allowed, but in practice is much lower (since 2011 it has been between 2.8% and 11.3%); this is achieved via CFDs.

In November 2016, FEV celebrated its 25th anniversary; the manager comments that since its launch there have been a lot of important changes in Europe such as the 1993 formation of the European Union and creation of the single market, and the 2008 great recession, followed by the eurozone crisis and quantitative easing. The manager stresses that he invests in individual companies rather than countries, aiming to outperform the benchmark through different economic periods and social environments. He suggests that two-thirds of his outperformance over the long term has been the result of stock picking, with other factors such as sector allocation or gearing driving the rest of his performance.

With regards to Brexit, the manager suggests potential developments need to be kept in context; he will continue to focus on picking stocks with a two- to three-year investment horizon, where he says corporate profitability and dividend growth will drive shareholder returns. Only a small percentage of European corporate earnings are generated in the UK, while many European companies have global exposure; in aggregate more than 50% of sales are generated outside of Europe.

The manager is currently somewhat cautious on the European market due to elevated valuations (this is reflected in FEV’s relatively low level of gearing) – the MSCI large-, mid- and small-cap indices are all trading close to the high end of their 10-year forward P/E ranges. Morse suggests that we are closer to the end of the stock market cycle and hence is cautious over investor sentiment rising and FEV’s discount narrowing. He suggests, however, that we may yet see a level of euphoria in the European stock market; in such an environment there is likely to be elevated M&A activity and IPOs. In this scenario, the manager would be more likely to reduce gearing than increase it. Morse comments that he needs to stay open-minded and flexible, but does not consider it in investors’ best interests if he tries to second guess the direction of the stock market, as this would increase the risk of underperformance.

The manager has three principles for equity investing: 1) bottom-up stock selection with a focus on dividend growth; 2) a long-term view, which he believes leads to better investment performance as well as lower costs; and 3) a cautious approach, which takes into account potential downside risk. He seeks companies that are able to sustainably grow dividends over a three- to five-year period based on the belief that companies consistently growing their dividends tend to outperform over multiple time periods. These companies demonstrate positive fundamentals such as structural growth opportunities, disciplined capital allocation and proven business models. Strong cash flow generation is seen as a good indicator of future dividend growth and a strong balance sheet provides a margin of safety with regards to sustainable payment of dividends, while allowing a company to continue to invest for the future. To qualify for inclusion in the portfolio, potential investee companies should trade at a discount to their estimated intrinsic value. The resulting portfolio typically comprises 55-60 holdings.

FEV tends to perform better in difficult stock markets; the manager has outperformed 75% of the time in declining markets and tends to lag in rising markets. His cautious approach is reflected in FEV’s portfolio beta; during the manager’s tenure, it has ranged from 0.92 to 1.03, with an average 0.96 (at end-October 2016 it was 0.93). Portfolio turnover is c 25% per annum, and illustrating the long-term investment approach, 60% of stocks in the current portfolio were held five years ago.

At end-November 2016, FEV’s top 10 positions accounted for 37.2% of the total portfolio, a modest decrease in concentration from 38.0% at end-November 2015. In terms of active weights, the top 10 were between 1.4pp and 3.4pp above their respective benchmark weightings, with the largest overweight position in UK-listed financial company 3i Group, which is not included in the benchmark. 3i has three complementary businesses: private equity, infrastructure and debt management – the stock has been performing well and the manager expects this to continue. FEV’s portfolio has a large-cap bias; the manager suggests that large-cap financials and oil stocks are out of favour with investors and offer attractive yields. He sees good value in these sectors, such as Norwegian bank DNB and London- and Amsterdam-listed oil company Royal Dutch Shell. DNB is the largest bank in Norway with a 35% market share; it has positive fundamentals, a strong balance sheet, is cash generative and has a reasonable valuation. Royal Dutch Shell has a history of poor capital allocation, which led to low returns in a buoyant commodity price environment. Now that the oil price is considerably lower, Royal Dutch is actively reducing costs, allocating capital more efficiently and is expected to benefit from the acquisition of BG Group; recent results are showing improvement and the manager suggests the dividend may be covered in 2017.

The manager highlights top 10 position Novo Nordisk, a Danish pharmaceutical company. Its share price has been weak in recent months due to competitive pressure and concerns about product pricing in the US. However, the company has exhibited strong fundamentals over the long term, with dividends compounding at an annual rate of 20% over the last five years. Although 2016/17 could be a transition period for Novo, the manager is confident in the long-term outlook as the company’s key products address diabetes, where the number of patients being diagnosed is rising rapidly across the world. A strong pipeline of new products, if successful, will offer higher pricing to offset pressure on existing products. Novo is currently trading on a forward P/E ratio of 16.4x on reduced earnings and offers a 3% dividend yield, which is expected to grow over time.

In terms of sector exposure, as shown in Exhibit 3, FEV has the largest overweights in healthcare and technology (this sector saw the largest percentage point increase in exposure over the last 12 months), with the largest underweights in basic materials and telecoms.

FEV’s portfolio is unconstrained by geographic weightings; therefore its country exposures may differ significantly versus the index. At end-November 2016, the largest overweights were in the UK and France, with the largest underweight in Germany. A notable change over the last 12 months is 5.1pp lower exposure in Switzerland.

FEV’s current manager, Sam Morse, took over running the trust on 1 January 2011; since then to end-October 2016, FEV’s NAV and share price total returns of 10.2% pa and 11.1% pa compare to the benchmark’s total return of 8.1% pa.

FEV’s absolute NAV and share price total returns over the last six months have been boosted by the weakness of sterling following the result of the UK’s European referendum.

Relative returns are shown in Exhibit 6; FEV’s NAV and share price total returns have outperformed the benchmark over three, five and 10 years, but have lagged over one year as sterling weakness has held back relative performance due to FEV’s UK exposure. The largest detractor to performance has been the healthcare sector including positions in Sanofi and Novo Nordisk, which have been affected by competitive issues and drug pricing pressure in the US. FEV has also outperformed the MSCI Europe Index over three, five and 10 years. Underperformance versus the MSCI World Index is primarily attributable to the strong performance of US equities in recent years; the US now represents c 60% of this index.

FEV’s current 13.2% share price discount to cum-income NAV is wider than the 11.3% average of the last 12 months; over the last year, the discount has ranged from 4.1% to 17.3%. The widest discount occurred on 5 July 2016, soon after the result of the UK’s European referendum, which led to higher investor risk aversion and wider discounts for investment trusts in general. The current discount is also wider than the averages of the last three, five and 10 years of 8.9%, 10.2% and 11.2%, respectively. This suggests potential for the discount to narrow meaningfully if FEV’s near-term relative investment performance improves or if there is increased investor appetite for European equities.

FEV is a conventional investment trust with one class of share; there are currently 415.4m ordinary shares in issue. Share repurchases restarted on 30 March 2016, the first since July 2014; since then 1.1m shares have been bought back at an average price of 168.7p per share. The board considers that a modest level of gearing can enhance investment returns; FEV generally employs a low level of gearing via CFDs. At end-November 2016, net gearing was 3.2%. FEV pays an annual management fee of 0.85% of net assets; no performance fee is payable. In FY15, the ongoing charge was 0.94%, a slight reduction from 0.97% in the prior financial year. FEV is subject to a two-yearly continuation vote; the next is due at the May 2017 AGM.

FEV aims to generate long-term capital growth, but also has a history of growing dividends (see Exhibit 1); revenue earnings are distributed in full. Annual dividends are paid in May; the FY15 ordinary dividend of 3.33p per share was a 7.4% increase versus the prior year. FY14 benefited from a special dividend of 54p per share as a result of the trust recovering £2.3m of French withholding tax and interest. Based on the current share price, FEV’s dividend yield is 1.8%.

Exhibit 9 shows a comparison of the trusts in the AIC Europe sector, of which FEV is the largest by some margin. FEV’s NAV total returns are ahead of the weighted average over one year and broadly in line over three years. While below the peer group average over five and 10 years, we note that FEV’s performance remains ahead of its benchmark over these two periods (see Exhibit 6). In terms of risk-adjusted returns as measured by the Sharpe ratio, FEV is broadly in line with the sector average over both one and three years. FEV’s discount is modestly wider than average, while its gearing is lower than average. Both FEV’s dividend yield and ongoing charge are in line with the peer group average, and like most of the trusts in the peer group, FEV does not have a performance fee.

There are five directors on the board of FEV, four of whom are considered independent. Chairman Vivian Bazalgette was appointed as a director on 1 December 2015 and assumed his current role on 12 May 2016 following the retirement of Humphrey van der Klugt, who had served on the board for nine years, including six as chairman. The other directors and their dates of appointment are Simon Fraser (26 July 2002), James Robinson (1 June 2007), Robin Niblett (14 January 2010) and Marion Sears (17 January 2013). Simon Fraser spent 27 years at Fidelity before his retirement in 2008, including six years as chief investment officer for Fidelity International; therefore he is deemed a non-independent director.

On 20 December 2016, FEV announced that a sixth board member has been appointed, effective 1 September 2017. Fleur Meijs will be an independent, non-executive director; she is a chartered accountant with experience of complex audits at major financial institutions and was recently appointed to the board of Invesco Asia Trust.