European Assets Trust — Long-term capital growth and income

As shown in Exhibit 2 (LHS), European equities made good gains in 2019 and the EMIX Smaller European companies (ex-UK) Index produced a total return of 20.6% in sterling terms. Market sentiment was extremely poor at the start of 2019 following a very weak quarter for global equities in Q418, which reflected prospects of a slowdown and possible recession in major economies. At that time, investors were expecting central banks to normalise interest rates and withdraw liquidity, which could have compounded the damage being dealt to global trade from an escalating US-China trade dispute. Instead, central banks were, once again, a significant source of support for equity markets; the US Federal Reserve cut interest rates three times, while the European Central Bank also undertook monetary stimulus. Recession risks have receded and some of the major geopolitical risks that heavily influenced the direction of equities in 2019 appear to have de-escalated, including steps towards the resolution of the US-China trade dispute and a reduced chance of a chaotic Brexit. As shown in Exhibit 2 (RHS), valuations of European equities in aggregate do not appear overstretched, and continue to present relative value, trading at a considerable discount to global equities.

EAT aims to generate attractive long-term capital growth through investment in quoted small and medium-sized companies in Europe, excluding the UK. The fund is managed by Sam Cosh (lead manager) and Lucy Morris. Cosh believes that smaller companies, defined as those with market capitalisations below that of the largest company in the EMIX Smaller European Companies (ex-UK) index are under-researched and offer potential for significant outperformance from good stock-picking. He follows a rigorous bottom-up and patient approach to selecting a relatively concentrated, yet well-diversified portfolio of around 40 companies, representing his highest-conviction investment ideas. The board adopts a high dividend payout policy and EAT’s prospective dividend yield of 6.6% is significantly higher than that of its peers.

The trust was launched in 1972 as a Dutch company and EAT’s shares were previously dual listed in London and Amsterdam. The board assessed that a migration of legal seat and structure to the UK should be beneficial to shareholders for multiple reasons including a simplification of the corporate structure and potential to reduce ongoing charges. It would also reflect the fact that the vast majority of EAT’s shareholders are UK residents, while the investment management and marketing activities are conducted out of the UK. The migration was completed on 16 March 2019 and EAT has a premium listing on the London Stock Exchange and is a member of the FTSE SmallCap and FTSE All-Share indices.

Cosh believes Europe’s economy is more resilient than often perceived. Germany has suffered an acute economic downturn, particularly hit by a sharp contraction in international trade and the autos sector. However, an improvement in the domestically focused services sector has helped it to avoid recession. This is mirrored elsewhere in the region and recent economic leading indicators for the eurozone’s services sector have risen, with all nations surveyed recording higher activity, led by Spain and Ireland. Meanwhile, the manager observes that market sentiment for equities has improved as there appears to be progress in resolving the US-China trade dispute and the UK election result has removed some uncertainties. If trade tensions can indeed be resolved, and Middle-East risks recede, the backdrop for equities should be benign, as valuations, in Cosh’s view, are not over-stretched. He cautions, however, that there remains a wide dispersion in valuation with stocks that have bond-like qualities trading at lofty levels, which may be vulnerable to correction if interest rates start to rise, or growth disappoints. The manager does not focus on macroeconomic or geopolitical predictions, but instead concentrates on finding companies with resilient businesses and strong balance sheets that can generate earnings growth through economic cycles. In his view, the portfolio is in good shape for the coming year, in aggregate, containing shares in businesses that are high quality, have modest leverage and trade at reasonable valuations.

The investment process is well-established, disciplined and bottom-up, and Cosh and Morris are able to draw on the deep resources of BMO’s European and global small-cap specialists. The fundamental approach, which generates detailed, proprietary research, has three main components: quality, valuation and management. The manager looks for companies with attractive, understandable business models, competitive advantages, low leverage and are cash generative. Criteria for company managements include evidence of good capital allocation, with interests aligned to that of shareholders, including appropriate incentives. Valuation is critical and Cosh and Morris seek companies that trade at a substantial discount to their assessed intrinsic value, that have the potential to generate superior returns over multiple years. Many companies meet the manager’s quality criteria, but in their view, are not attractively valued. These are added to a ‘patient fishermen’ list of stocks, which is monitored regularly, awaiting a better entry point.

There are four broad investment themes in the portfolio:

Following a quiet H119, the manager was more active in H219, taking advantage of the market rally to pare back more expensive cyclical exposures, and raising the quality characteristics of the portfolio. As shown in Exhibit 3 (RHS), EAT’s aggregate return on equity is significantly higher than that of its benchmark index and the net debt to equity ratio is much lower. The portfolio is more expensive in forward P/E multiple terms; however, the manager believes the valuations of investee companies are reasonable relative to their quality and prospects.

Exhibit 3 (LHS) shows the portfolio’s industry exposure as at end-December 2019 and changes over the past 12 months. The most significant increase is a 3.5pp addition to the technology sector, partly reflecting new purchases in Scout 24 and SimCorp. German company Scout24 is the country’s leading operator of digital marketplaces for real estate and automobiles (the equivalent to Rightmove and Autotrader in the UK). The manager believes their business model is well-proven in more mature markets, generating gains from economies of scale, which supports pricing power and presenting a barrier to new entrants. Cosh observes that the German market is much less mature compared to the UK and considers Scout24’s duration and trajectory of growth as very attractive. In December, the company agreed the sale of the auto business at very favourable valuation. Cosh also initiated a new position in Copenhagen-listed SimCorp. The company provides software for financial institutions – in particular, solutions for asset management firms’ back offices. The manager believes this business can sustain attractive rates of growth as reporting requirements for asset managers become increasingly onerous and complex to meet ever more demanding requirements from regulators and clients.

EAT’s exposure to the healthcare sector has also increased over the past year (+3.2pp), partly reflecting the purchase of Swedish company, Elekta. Elekta is a global leader in precision radiation medicine, facilitating precise and personalised radiotherapy treatment. The company has demonstrated high levels of innovation and its new product Unity, used in conjunction with real-time magnetic resonance imaging, improves the accuracy and potential effectiveness of treatment. The technology is gaining regulatory approvals and the manager believes the company has excellent long-term growth potential.

Recent purchases also include the beverage company, Royal Unibrew. Based in Denmark, the company manufactures and distributes alcoholic and non-alcoholic brands, primarily in the Nordic and Baltic countries where it has dominant market share. Morris believes the company’s strong management and competitive advantage should help it sustain around 3% sales growth over the medium term. She also identified the entry point for Lisbon-listed Amorim, a long-standing candidate on their ‘patient fisherman list’. The company is the world’s leading producer of cork products with around 35% market share of cork stoppers, which is meaningfully ahead of the second largest producer at around 10%. This gives the firm significant scale advantages, and combined with its strong relationships with suppliers and customers nurtured over its 150-year history, the manager believes Amorim has a significant economic ‘moat’.

The manager recently sold EAT’s holding in Dutch food services company Sligro as it struggles to implement the operational changes agreed with strategic partner Heineken. In addition, the firm has been losing market share and these factors have contributed to pressure on profit margins. Cosh believes Sligro’s business has attractive longer-term potential; however, he suggests the pain from the integration process with Heineken could get worse before it gets better. He will continue to monitor this company, which may present a more opportune re-entry point in the future. Another source of funds for the portfolio’s recent purchases was trimming Swedish mobile vehicle accessories company Dometic following strong performance share price performance.

As shown in Exhibits 5 and 6, EAT has delivered strong long-term performance; the trust’s 10-year NAV total return has significantly outperformed the EMIX Smaller Europe ex-UK, FTSE AW Europe ex-UK and FTSE All-Share indices. Over one year, its share price return of 25.1% has outperformed the benchmark; however, the NAV total return has lagged marginally. The NAV total return over three and five years is relatively weak reflecting significant underperformance in the period immediately following the UK’s EU referendum in June 2016. EAT was poorly positioned for the outcome with sizeable exposure to Ireland-listed companies, which were heavily exposed to sterling and the UK domestic economy. Many of these investments subsequently recovered and contributed positively to the portfolio.

EAT is currently trading on an 8.4% discount to cum-income NAV, which is significantly greater than its five-year average of 2.7%. As shown in Exhibit 8, the trust has often traded near to, or at a premium to, its NAV and suffered setbacks at times of heightened uncertainty, including after the UK’s EU referendum result in June 2016 and President Trump’s election in November that year. The board actively monitors the trust’s share price volatility relative to its NAV and has the authority to manage the demand and supply balance for EAT’s shares through share issuance and repurchases. It believes that the trust’s migration to the UK as a premium listing on the LSE, and inclusion in the FTSE indices, should improve demand for EAT’s shares, and help the NAV discount to narrow or trade at a small premium over time.

Following the migration of EAT from the Netherlands to the UK on 16 March 2019 there is just one class of share; there are currently 359.9m shares in issue. In May 2018, the trust had a 10-for-one stock split. Historically, demand for EAT’s shares has been robust and the board issued new shares to meet investors’ demand. During FY19, the board was focused on the migration exercise and issuance was de minimis. EAT has a €45m loan facility with Royal Bank of Scotland International, which was unused as at end-December 2019, and the trust held net cash of 3.3%. BMO Global Asset Management is paid an annual management fee of 0.80% on the value of funds below €500m, reducing to 0.65% on funds above €500m.

The board has a high distribution policy, paying an annual dividend equivalent to 6% of the trust’s NAV as at the preceding year end, funded from both income and distributable reserves. The annual total dividend is declared in January and the board has announced a 7.02p per share for FY20, representing an increase of 17.2% from FY19, payable in four equal instalments of 1.755p in January, April, July and October 2020. Starting from FY20, dividends are declared in sterling (previously in euros). At the current share price, EAT’s dividend yield is 6.6%, which is meaningfully higher than its peers.

EAT is a member of the AIC European Smaller Companies sector, which consists of four funds. As shown in Exhibit 9, EAT’s 10-year NAV total return has been strong, and although it ranks second, its performance is just marginally below the top-ranked trust. EAT’s performance ranks third over one and three years, and fourth over five years. The trust’s dividend yield ranks first and is significantly higher than that of its three peers, which helps support the shares’ discount to cum-fair NAV, where it ranks second.

Following the appointment of Stuart Paterson (with effect from 22 July 2019), the EAT board consists of six independent non-executive directors. Paterson’s appointment is part of an orderly succession process in anticipation of the retirement of deputy chairman, Professor Robert van der Meer, at the May 2020 AGM. He has served on the board since 2007. Paterson is a co-founder and partner of Scottish Equity Partners and has over 20 years’ experience of investing in technology companies and private European companies. The board continues to be chaired by Jack Perry, appointed in 2014. Senior independent director, Julia Bond, was appointed in 2014. The other directors and the dates of appointment are Laurence Jacquot (2011) and Martin Breuer (2016).