Fidelity European Values — Following the same tried-and-tested strategy

Morse says that while the outcome of the COVID-19 outbreak is very difficult to assess, it is worth trying to determine what shape the economic recovery will be. He suggests that a ‘V’ is out of the question and a long ‘U’ is more likely, but the shape will ultimately be determined by whether the European Union and the individual country governments have done enough to stimulate their economies. Morse says that consensus earnings estimates are ‘wrong’ and share prices are not pricing in what is to come. He explains that analysts look at companies’ guidance and adjust their estimates according to their own expectations; however, almost 50% of European index constituents have not yet revised their guidance as they do not know themselves how much they will earn or lose, hence consensus earnings estimates are not offering a complete picture. The manager expects aggregate earnings declines as a result of the coronavirus pandemic will be larger than those experienced in the global financial crisis. ‘We are dealing with a very difficult beast here’, he adds. Morse says the pace of recovery will be very different on a sector-to-sector basis – construction may be one of the earliest, while travel could take quite some time to improve, as we may experience social distancing measures into 2021.

The manager comments that fiscal stimulus measures seen in Europe are lagging those in the US and Asia to a certain extent. Looking at Germany and France in isolation, total stimulus as a percentage of GDP is high – 30% in Germany and 15% in France – but Morse suggests it is important to differentiate between real fiscal stimulus (5% of GDP in Germany and 2% in France) as opposed to guarantees on loans to avoid corporate bankruptcies. Europe has been working to keep its budgets under control since the global financial crisis, but the manager believes deficits will become so large as a result of measures to offset the negative effects of the coronavirus that there are bound to be ‘consequences’.

Morse continues to look at FEV’s portfolio on a stock-by-stock basis, rather than positioning it for the macro environment. He notes that along with the coronavirus outbreak, another defining event so far this year has been the collapse in the oil price. The manager wonders if there will be a third disruption to global markets; ‘maybe a weather-driven event’, he suggests. Part of FEV’s investment strategy is seeking companies that can generate sustainable dividend growth. However, this approach cannot be reliably employed when so many companies are cutting their dividends. Along with individual corporate decisions about whether dividends will be paid, governments are asking banks to suspend their distributions and in France utilities are being discouraged from paying dividends. The manager says this is a tricky, very fluid situation, which is made more confusing due to pressure from governments and regulators. In aggregate, he believes dividend payments will fall more than earnings will decline, but company managements that have chosen to suspend their dividends may change their minds by the end of the year.

At end-March 2020, FEV’s top 10 positions made up 43.8% of the portfolio compared with 40.2% a year before; nine positions were common to both periods. The trust is broadly diversified by both sector and geography, as illustrated in Exhibit 2.

Morse’s instinct during the recent market crash was to ‘sit on his hands and watch’ due to rising trading costs and the risk of making costly mistakes. As an example, he considered selling the position in lift manufacturer KONE in late January/early February due to the economic slowdown in China. However, with hindsight it was a good decision not to sell the stock, as it has held up relatively well despite an initial sell-off; KONE has a strong balance sheet with a net cash position.

FEV has a position in DKSH Holding, which offers international market expansion services with a focus on Asia, helping businesses grow in existing markets and expand into new ones. The manager considered selling this holding, but he believes that the company should be a long-term beneficiary from the coronavirus lockdown. ‘You need to make slow and measured portfolio responses’, he suggests. Morse has increased FEV’s level of gearing due to stock market volatility (now c 8% versus a historic average of c 5%), closed all three short positions, which were positive contributors to Q120 performance and increased long futures exposure. The portfolio now has 47 long positions. Over the medium and long term, the manager believes the trust can keep pace with the benchmark during a recovery. He says it was not prudent to increase gearing in 2019, as the market looked very stretched. ‘Now is the right time – if not now, then when?’, he says, adding: ‘I do not want to miss out on a market recovery’.

While FEV’s portfolio turnover is modest, typically 20% to 30% per year, Morse highlights important changes to the fund in recent months. He started selling Royal Dutch Shell in early December 2019 as the outlook for higher dividends kept being pushed back. The company has invested heavily in renewable energy and there were question marks about its ability to raise margins. Proceeds from the Royal Dutch sale were reinvested into Enel, which the manager had been monitoring for some time. He considers the company to be attractively valued as it is being priced as a traditional utility conglomerate, which he considers ‘unfair’. The manager says that estimated income growth of c 8% per year for the next three years, along with a c 5% dividend, offers an attractive potential total return that could be higher if the stock is revalued. ‘Enel is accelerating its renewables business; the company is in good shape and its cost of debt is declining’, he adds.

The remainder of the position in French telecom company Iliad was sold. Morse says he had given its management team the benefit of the doubt but decided the original investment thesis is no longer valid. The manager highlights the company’s stretched balance sheet, negative free cash flow and a lack of dividend growth. FEV has a new position in SIG Combibloc Group, which was listed in September 2018. It is a competitor to packaging firm Tetra Pak, with a number two global market position; both companies have different technologies. SIG generates high margins from selling machinery and then provides servicing contracts and consumables. Research from Fidelity shows that the company is taking share from Tetra Pak, helped by its Chinese exposure and shifts away from plastic packaging to cartons. Morse says this is a small position in a small-cap company and a somewhat unusual holding for FEV, but the analyst covering the stock has high conviction in this name and it provides differentiated exposure within the portfolio. Some of the trust’s positions in more leveraged companies have been trimmed, including Fresenius Medical Care, which has a meaningful US exposure. A high percentage of its costs are nurses’ wages, which are expected to rise. The manager is also closely monitoring other more leveraged portfolio names, including Italian infrastructure company Atlantia.

In FY19 (ending 31 December), FEV’s NAV and share price total returns of +23.8% and +30.6% respectively were meaningfully ahead of the benchmark’s +20.4% total return. The outperformance was primarily the result of successful stock selection, although gearing also contributed positively. The top contributors on a relative basis were semiconductor equipment maker ASML Holding (+1.2pp) and luxury goods company LVMH (+0.7pp). ASML’s shares almost doubled as investors anticipated a recovery in demand for memory chips and trade tensions between the US and China began to ease. The company experienced strong demand from logic chip makers and its third-quarter earnings report revealed its strongest-ever order intake. LVMH benefited from the spending power of the Chinese luxury consumer and announced the takeover of US high-end jewellery retailer Tiffany’s. The largest detractors to FEV’s relative performance were ABN AMRO Bank (-1.0pp) and telecommunications company Telenor (-0.7pp). Investors had concerns about ABN’s lack of robustness in its anti-money-laundering processes, while Telenor failed to complete the mooted merger of some of its Asian operations with local competitor Axiata.

Morse notes there was indiscriminate selling during the coronavirus-led market decline in March, although certain areas such as some consumer, travel and cyclical businesses were particularly badly hit. The manager explains that FEV has a balanced portfolio, so has some exposure to the worst-affected areas of the market; however, relative performance has held up well, helped by its healthcare and consumer staples exposure such as Novo Nordisk, Roche, Nestlé and Swedish Match. Its focus on companies with strong balance sheets has proved beneficial in an environment of widening credit spreads and many firms finding it difficult to pay their bills. Recent detractors to relative performance include financials ABN Amro, DNB, Intesa Sanpaolo and KBC Group, and travel-related businesses such as Amadeus IT Group and MTU Aero Engines.

The trust has outperformed the continental European market over all periods shown in Exhibit 5, in both NAV and share price terms. It has also significantly outperformed the broad UK market over all periods shown.

In keeping with many other investment trusts, FEV’s discount to NAV widened considerably during the recent period of coronavirus-led stock market weakness, reaching a three-year widest point of 15.5% on 18 March. Its current 7.5% discount to cum-income NAV compares with average discounts of 7.8%, 8.9%, 9.0% and 10.6% over the last one, three, five and 10 years respectively.

There are eight funds in the AIC Europe sector, of which FEV is the largest. Its NAV total returns are above average over one, three and five years, while lagging modestly over the last decade, ranking fourth over the last 12 months, second over three years, fourth over five years and fifth over the last decade. All of the peers are currently trading at a discount; FEV’s is narrower than the mean. It has an average ongoing charge, a higher-than-average level of gearing, and a below-average dividend yield.