Henderson EuroTrust — Good stock selection outweighing headwinds

HNE offers investors exposure to the European stock market via a fund of high-quality companies with either high or improving returns. Despite style headwinds, Ross has adhered to his successful investment process, selecting stocks on a bottom-up basis, and has generated a commendable performance record; the trust’s NAV is ahead of its benchmark over the last one, five and 10 years.

Exhibit 1 shows HNE’s upside/downside capture over the last 10 years. Its upside capture of 106% suggests that in months when European stocks rally, the trust is likely to modestly outperform the European market. However, its 100% downside capture implies that the trust is likely to perform in line with the market during months of share price weakness. The downside capture was below 100% for most of the last decade, suggesting until HNE’s performance was negatively affected by style headwinds from Q121 to Q222 the trust would have outperformed during a falling market.

Over the last 12 months, HNE’s NAV has been ahead of the Europe ex-UK market despite a style headwind (Exhibit 2, left-hand side). Higher interest rates, rising inflation and concern about quality growth companies have seen investors favour cyclical stocks, which generally do not fit the manager’s investment criteria. However, successful stock selection has outweighed an unfavourable investment backdrop.

Exhibit 2 (right-hand side) illustrates how growth stocks outperformed in a low interest rate environment. The manager comments that when interest rates moved from 0% to 5%, growth stocks underperformed, and it was ‘a terrible place to be’. This is evidenced by HNE’s underperformance between Q121 and Q222, which is highlighted on the front-page chart.

HNE’s portfolio metrics compared with the benchmark are shown in Exhibit 3. Reflecting the trust’s bias to quality growth stocks, its portfolio has a higher valuation in terms of price-to-book and forward P/E multiples and has a lower historical dividend yield. HNE also has a superior earnings growth outlook and generates a higher return on equity and operating margin, while it has less leverage than the benchmark.

Over the last 18 months, the manager has initiated positions in very high-quality stocks, while selling lower-quality businesses. This has increased the quality of the portfolio and raised its overall margins. New positions include Airbus (aerospace and defence), Sartorius (medical equipment and services) and Universal Music Group (media), while sales include BAWAG Group (bank), Kion (industrial engineering) and UniCredit (bank).

Over the 12 months to the end of October 2023, the largest changes in HNE’s sector positions were an increase in healthcare (+4.1pp) with a decrease in financials (-3.9pp). The largest active weights compared with the benchmark were above-index weightings in consumer staples (+5.3pp) and healthcare (+4.2pp) with underweight positions in industrials (-4.3pp) and consumer discretionary stocks (-4.2pp). However, it should be remembered that the trust’s relative positioning is a result of bottom-up stock selection.

Within consumer staples there is a new holding in Dutch brewer Heineken. The brewing industry has had to deal with cost inflation, including higher prices for barley, which is a major ingredient. In addition, Heineken has struggled in some of its important markets such as Vietnam and Nigeria, which drove a decline in its share price that allowed the manager to pay 14x earnings for a business he expects to grow at 15% per year.

In the healthcare sector, Ross initiated a position in Denmark-listed Zealand Pharma. It is a pharmaceutical business focused on research and development and licensing, with no commercial operations. The company has a series of products in various stages of development, two of which have the highest potential value – an obesity product and a drug for the treatment of the rare condition short bowel syndrome. Given HNE’s long-term holding in Novo Nordisk, the manager has a particular interest Zealand’s obesity product. Although it is only in Phase II trials, Ross believes that it could fill a niche within the market for the treatment of non-alcoholic fatty liver disease (commonly known as NASH), which would set the company apart from Novo Nordisk and Eli Lilly, which are currently the market leaders in drugs to combat obesity. He considers that this product is not fully reflected in Zealand’s share price.

Within the underweight consumer discretionary sector, HNE has an overweight exposure to luxury goods companies. The Hermès position has been in the portfolio for around seven years, and Moncler and LVMH for around five and two years, respectively. These companies have strong pricing power and high returns, having built their valuable brands over multiple decades, thereby providing high barriers to entry. However, their businesses have a level of cyclicality and Chinese economic weakness is negatively affecting current trading conditions. Despite this, Ross retains a positive outlook on the long-term prospects for the trust’s luxury goods names, so is not inclined to trim these positions.

The manager has reduced HNE’s prior overweight position in semiconductors down to a market weight, locking in significant profits. ASML has been in the portfolio for many years but the holdings in ASM International and BE Semiconductor were initiated within the last year to 18 months and have rallied strongly, making their valuations less attractive. Also, semiconductor stocks can move dramatically in a short space of time due to swings in investor sentiment and these companies’ fundamentals may come under pressure due to the risk of further US sanctions on the sale of specific semiconductor technology to Chinese firms. Ross will look to increase the trust’s semiconductor exposure when he considers it is appropriate.

The manager has been reducing HNE’s bank exposure and the trust now has an underweight position versus the benchmark for the first time since the announcement of Pfizer’s COVID-19 vaccine in November 2020. Ross believes that we are close to the peak in interest rates, so while banks are now benefiting from higher net interest margins, if the economy weakens, they will likely have to increase their loan-loss provisions. The manager is therefore anticipating a move from an interest-rate cycle to a credit cycle.

In terms of HNE’s geographic exposure, the largest changes in the 12 months to end-October 2023 were higher weightings to France (+4.4pp) and Denmark (+3.0pp) and a lower weighting to Austria (-2.8pp). Versus the benchmark, the trust’s largest active weights were a 10.2pp higher weighting to France, with zero exposure to ‘other’ European countries, which made up 12.5pp of the index.

At end-October 2023, HNE’s top 10 positions made up 42.0% of the fund (Exhibit 8), which was a lower concentration compared with 46.6% a year earlier; five positions were common to both periods. Ross has been taking profits in HNE’s largest position, Novo Nordisk, as the stock has performed so well, the holding had become too large from a risk perspective. The company’s Wegovy weight-loss product is in very high demand for the treatment of obesity. Also, positive trial data show that the use of Wegovy can reduce adverse cardiovascular outcomes by 20%.

According to the manager, it appears that the worst of the interest rate concerns have passed, and inflation is moderating; however, a tight labour market is supporting wage inflation. Higher interest rates are having a negative impact on economic activity. There has been increased commentary about weakening demand, especially in more cyclical areas of the market including industrials and consumer discretionary businesses. Several companies are citing China as an area of weakness, including BASF (chemicals), Siemens (broad industrial exposure) and Pernod Ricard (premium spirits), which has also experienced wholesale destocking in North America following strong post-pandemic demand growth.

European growth outlooks are relatively lacklustre – the International Monetary Fund World Outlook that was updated in October 2023 shows Euro area growth projections of 0.7% for 2023 and 1.2% for 2024. These are lower than 1.5% and 1.4% for advanced economies and 3.0% and 2.9% for world output, respectively. However, lower growth may already be reflected in European valuations. As shown in Exhibit 9 (right-hand side), using Datastream indices, on a forward P/E multiple basis, Europe ex-UK is 16.8% less expensive than the world market. In relative terms, Europe ex-UK is trading at a 13% discount to its 10-year average, which is wider than the world’s 1% discount. Europe ex-UK has a more attractive price-to-book valuation and offers a higher dividend yield.

There are seven funds in the AIC Europe sector following a range of investment mandates. HNE has the smallest market cap and has a total return mandate, focusing on quality growth companies rather those at the high growth or value ends of the style spectrum. Stablemate Henderson European Focus Trust also has a total return mandate but is growth/value style agnostic. Fidelity European Trust seeks to generate long-term growth in capital and income. The four other companies have capital growth mandates: Baillie Gifford European Growth can invest in both private and listed companies; BlackRock Greater Europe has a broad remit and can invest in emerging European markets, although currently all the fund is invested in developed markets; European Opportunities Trust invests taking top-down factors into consideration; and JP Morgan European Growth & Income seeks capital growth and a rising share price, but also pays dividends based on its quarterly NAV.

HNE’s relative NAV total return performance has improved in recent months as it now ranks third over one year compared with fourth when our last review was published in July 2023. The trust ranks sixth over the last three years and has above-average returns over the last five and 10 years, ranking fifth and fourth respectively. Despite its relative performance HNE has one of the widest discounts in a sector where no funds are trading at a premium. Its ongoing charge is in line with the mean, and along with all its peers, no performance fee is payable. The trust has a lower-than-average level of net gearing, and has an above-average dividend yield, which is 80bp above the mean. HNE ranks second, surpassed only by JPMorgan European Growth & Income with its NAV-based distribution policy.

Despite the difficult performance period between Q121 and Q222, when investors favoured value rather than growth stocks, HNE has a respectable relative performance record (Exhibit 13) as its NAV total returns are now ahead of the European ex-UK market over the last one, five and 10 years. The performance of the world market has been boosted by the dominant US market (70% of the MSCI World Index) that has outperformed for much of the last decade (the US S&P 500 Index has outpaced the MSCI World Index, in US dollar terms, for nine out of the last 10 years). HNE is noticeably ahead of the UK market over the last one, five and 10 years.

Looking back to the trust’s FY23 results (ending 31 July), its NAV and share price total returns of +16.7% and +19.7%, respectively, were ahead of the benchmark’s +16.1% and the AIC Europe sector’s +14.6% total returns. The largest contributors to the trust’s returns were: UniCredit (+2.8pp), Munich Re (+1.5pp) and Hermès (+0.8pp). On the negative side, the largest detractors were: Koninklijke DSM (prior to the merger with Firmenich, -1.6pp), EDP Renováveis (-1.0pp) and Cellnex (-0.9pp).