Henderson EuroTrust — Performance is getting back on track

Over the last 15 years, there has been a perception change by international investors about European equities. During the global financial crisis, and in subsequent years, there was low regard for Europe, including criticism about the European Central Bank (ECB) being slow to cut interest rates after the global financial crisis and too quick to raise them thereafter. The ECB started quantitative easing in 2015, which was seven years later than the US Federal Reserve. However, in recent years Europe has been more responsive in terms of its monetary policy actions and the way it dealt with the COVID-19 crisis. Also, over the last 15 years the European banking regulatory framework has been made more robust and transparent, meaning there is less likelihood of Europe following the US with regards to recent regional bank failures.

Although the macroeconomic backdrop is uncertain due to a range of factors including rising interest rates (as central banks attempt to bring higher inflation under control), consumers struggling with escalating living costs and heightened geopolitical tensions, global investors may benefit from an allocation to European equities. The region has a comparable growth outlook to other advanced economies in 2024 and there is potential for a re-rating considering the wide discount between the valuations of European and global equities.

As shown above in Exhibit 2, HNE’s performance is improving following a tough time between Q121 and Q222. This period was characterised by a change in investor preference from growth to value stocks as economies reopened following lockdowns. The market shift was exacerbated by rising interest rates as central banks sought to combat higher inflation following COVID-19-induced supply bottlenecks and the Russian invasion of Ukraine. Higher interest rates generally lead to a devaluation of growth stocks due to the negative effect of a larger discount rate on the value of their long-term cash flows.

Ross reports that, in terms of the operating environment, Q123 corporate results exceeded consensus expectations on both the top and bottom line and there was strong order intake from industrial companies. Recent data suggest that the chances of a European recession have reduced despite a softening in business conditions in some sectors of the economy.

So far this year, there have been periods of both growth and value stock market leadership in Europe. Growth stocks had enjoyed a multi-year period of outperformance until November 2021 fuelled by low interest rates and a derating of lower-quality names. However, the release of positive trial data for Pfizer/BioNTech’s COVID-19 vaccine saw value stocks start to outperform, in anticipation of lockdowns ending and a pickup in economic growth.

Growth stocks derated in 2022 in a rising interest rate environment due to high inflation caused by supply chain bottlenecks during the pandemic and increased demand thereafter. With inflation moderating, there is potential for growth stocks to again lead the market. The manager highlights that looking at data to mid-May 2023, over the prior three years the MSCI Europe Value Index outperformed the MSCI Europe Growth Index by 20pp, but in the two years prior the outperformance was just 5pp, suggesting the preference for value stocks is waning.

Ross explains that over the long term, the fund has been biased towards the consumer, healthcare and technology sectors as these tend to contain high-quality, high-return businesses with decent growth. These qualities are less evident in the material, energy, real estate and utility sectors, where returns are generally lower.

The release of the positive Pfizer/BioNTech COVID-19 vaccine data led the manager to increase HNE’s financials exposure in anticipation of economic recovery; the trust has an overweight exposure, which is unusual. Following the pandemic, Ross found some additional attractive financials investments but is now inclined to reduce HNE’s exposure. As an example, he has taken profits in UniCredit, whose share price has appreciated from around €6 in May 2020 to around €21 now. The bank has benefited from inflation and higher interest rates, and is overcapitalised so has been able to distribute cash to shareholders for the first time in many years.

Combining the two consumer sectors, the trust’s exposure is currently broadly in line with the benchmark. HNE has a healthy exposure to high-quality luxury goods via its holdings in LVMH, Hermes International and Moncler. These companies have strong pricing power, sell desirable products for which there is strong demand and their business has been buoyed by China reopening its economy; China can make up a third of luxury goods companies’ total revenues.

Within technology, the manager favours semiconductor equipment companies as they are less cyclical than semiconductor manufacturers. He already had a position in ASML, but, during a period of sector weakness in 2022 when ‘the baby was thrown out with the bathwater’, Ross took the opportunity to add ASM International and BE Semiconductor Industries to the fund. He says that these are the three highest gross margin and return generators in the European semiconductor industry (there are six listed semiconductor companies with market caps greater than €5bn).

The manager is increasingly finding attractive healthcare stocks, such as large-cap pharma companies. HNE already has holdings in Novo Nordisk, Roche and Sanofi. In general, the valuations of large-cap pharma companies have derated as their innovation cycles have not produced breakthrough drugs; drug discovery has been more prevalent at smaller biotech companies. Ross comments that biotech stocks thrived in a low interest rate and easy access to capital environment. Now with higher interest rates, the funding environment is tougher so maybe the large companies that are well capitalised should do better. Roche is trading on a 13x forward P/E multiple versus 15x to 16x historically. Sanofi is trading on an 11x forward P/E multiple and has revenue growth of 3% to 5% per year, plus some operating leverage. With no debt, and free cash flow generation in the high single-digits range, the manager considers Sanofi to be an attractive proposition and he suggests that, with a modest change in investor perception, both Roche and Sanofi could re-rate to high-teens forward P/E multiples. These two pharma companies are examples of ‘compounders’.

Ross says that Novo Nordisk (a ‘compounder’) has transcended the pharma sector, consistently generating good numbers and is trading on a 30x forward P/E multiple. In 2015, there were concerns about pricing pressure in insulin and the stock was trading below 15x, so essentially the company’s valuation has now doubled. The manager explains that Novo has features favoured by his team. Novo invested in insulin products 100 years ago and by 2015 diabetes treatment was essentially all the firm undertook. The company has a long-term research and development focus, but, in 2015, it took advantage of the beneficial side effects of its semaglutide diabetes medicine, namely its ability to reduce bodyweight and positively affect cardiovascular outcomes. This product is now specifically used in obesity treatment and demand for the product is so great that it is now outstripping supply.

The largest sector changes in the six months to end-June 2023 were an increased exposure to healthcare (+2.2pp) and a lower financials weighting (-2.2pp). Compared with the benchmark, the trust’s largest overweight positions were healthcare (+2.7pp) and consumer staples (+2.6pp), with underweight positions in industrials (-4.2pp), consumer discretionary (-3.0pp) and utilities (-2.8pp).

HNE has a new position in BNP Paribas (an ‘improver’), which was funded by reducing the positions in UniCredit and Bawag. BNP is an early beneficiary of rising interest rates, although the most powerful period of a net interest margin boost is likely coming to an end. It is less interest rate dependent than the trust’s other bank holdings and has a lower beta, so essentially the manager is derisking the fund’s bank exposure.

Another new position in the fund is ophthalmology company Alcon (an ‘improver’), which was previously a low-priority business within Novartis. Alcon was spun out in 2019, having suffered from a lack of investment, so margin progression as a standalone company has been slow because of the need to invest capital. However, the benefits of the capex programme are starting to come through and Alcon posted very strong Q123 results.

Industrie de Nora (a ‘compounder’) has been added to HNE’s portfolio; it specialises in electrochemistry, is a leader in sustainable technologies and has an important role in the green economy. The company is the world’s largest supplier of high-performing catalytic coatings and insoluble electrodes for electrochemical and industrial applications and is a leading provider of solutions for water and wastewater treatment. According to the manager, Industrie de Nora generates decent margins and returns and is involved in the production of green hydrogen. It has a high market share in this new end market that is exhibiting very strong growth.

There have been no complete disposals in the fund in recent months.

While HNE’s sector and geographic exposures are all a product of its bottom-up stock selection, it is interesting to consider the fund’s composition. In the six months to end-June 2023, the largest geographic changes were a higher weighting to Switzerland (+2.4pp) and a lower exposure to Austria (-2.9pp). Compared with the benchmark HNE had a notable 9.2pp higher weighting to France, with zero exposure to ‘other’ European countries, which made up 12.1pp of the index.

At the end of June 2023, HNE’s top 10 positions made up 42.5% of the fund, which was a lower concentration compared with 45.0% six months earlier; seven positions were common to both periods.

HNE is the smallest of seven funds in the AIC Europe sector. Within the peer group there is a range of styles between high growth and value; the trust has a blended bias of growth and quality and is not at the high growth end of the spectrum. HNE’s NAV total returns are above average over the last one, five and 10 years, ranking fourth over all these periods. Over the last three years, the market has favoured funds with more of a value rather than a growth bias and the trust ranks sixth. HNE has one of the widest discounts in a group where no funds are trading at a premium. It is currently ungeared and has an above-average dividend yield, which is c. 70bp above the mean. However, it should be noted that JPMorgan European Growth & Income, the fund with the highest yield, pays dividends based on its quarterly NAV, rather than income.

HNE’s relative returns are shown in Exhibit 10. Its NAV has outperformed the European (ex-UK) market over the last one, five and 10 years, while lagging over the last three years. Although it has outperformed the world market over the last 12 months, the trust has fared less well over the longer time periods shown. This is due to the performance of the US market, which dominates global indices and has performed relatively well in most years over the last decade (in US$ terms, the S&P 500 Index has outpaced the performance of the MSCI World Index in nine out of 10 years). HNE has performed considerably better compared with the broad UK market over the last one, five and 10 years.

Ross has continued to adhere to his disciplined investment process, seeking reasonably priced, quality companies with high or improving returns on capital. He is confident that this strategy will lead to the restoration of HNE’s record of outperformance over the medium term. The manager highlights that stock selection rather than sector allocation drives the trust’s performance.

Commenting on HNE’s performance so far this year, positive contributors include financial stocks such as Bawag and UniCredit, luxury goods manufacturers, especially Hermes, Kion, which manufactures materials handling equipment and the trust’s semiconductor equipment names. Stocks that have detracted from performance include Sanofi, TotalEnergies and Universal Music Group, where the manager is positive on the company’s long-term fundamentals, but recent attention on the rise of artificial intelligence has raised questions about the ability of music artists to monetise the value of their assets; the position has recently been reduced. Euronext has been another performance detractor. The business has good revenue visibility and high returns, and the company made a surprise offer for Allfunds, which operates outside Euronext’s core business; the bid was subsequently withdrawn.

Consistent with HNE’s focus on capital growth, in FY21, the board announced a change in the company’s dividend policy, whereby distributions would be broadly based on the level of income received. At the time, the trust had significant revenue reserves, the majority of which would be paid out over the following three to four years in additional to a ‘normal’ dividend paid from income. In FY21, income was lower than expected due to COVID-19 effects on company dividends. The total distribution for the financial year was £5.3m (£3.5m income plus £1.8m from revenue reserves). In FY22 the annual dividend increased by 52% year-on-year without the use of any revenue reserves, which should be paid out in the next two financial years. Income in FY22 was particularly strong, partly due to banks Bawag and UniCredit resuming dividend payments following the lifting of COVID-19 related restrictions, but also from many portfolio companies increasing their dividends.

So far in FY23, a 0.80p per share dividend has been announced, which is in line with the prior four financial years. Based on its current share price, HNE offers a 2.7% dividend yield.

In keeping with the broader investment trust sector, HNE’s discount has widened since the beginning of 2022 during a period of higher interest rates and heightened investor risk aversion. The trust’s latest 13.1% share price discount to cum-income NAV compares with an 11.4% to 18.7% range of discounts over the last 12 months and is wider than HNE’s three-, five- and 10-year averages. There is scope for the trust to be afforded a higher valuation if its relative performance improves, or if the macroeconomic backdrop becomes less uncertain and investors are willing to take on more risk.

At the November 2021 AGM, shareholders approved the board’s proposals for a 10:1 share split to make them more appealing to retail investors and to increase liquidity. Renewed annually, HNE’s board has the authority to repurchase 14.99% of the share base and allot shares from treasury. However, no shares have been bought back or issued since FY16.

HNE was launched in July 1992 and is listed on the Main Market of the London Stock Exchange. Jamie Ross became the trust’s sole manager in February 2019, having previously been appointed as joint fund manager in October 2018 and deputy fund manager in March 2017. He joined Janus Henderson Investments (JHI) in 2007 as part of its graduate programme and has worked in its European equities team since 2009.

Ross aims to generate a superior total return from a portfolio of European (ex-UK) companies with a high, or significantly improving, return on invested capital. The fund is relatively concentrated, holding between 35 and 55 stocks, and the all-cap mandate has a bias to large and medium-sized companies. At the time of investment, a maximum 10% of the portfolio may be in a single company. There are no restrictions on HNE’s geographic or sector exposure and there is no defined yield target. Unlisted companies are permitted, up to 10% of the portfolio (none are currently held). Cash and equivalents up to 20% and gearing up to 30% of total assets are permitted. The trust’s performance is measured against a broad Europe (ex-UK) index.

Ross believes that the most effective way to make money for HNE’s shareholders over the long term is to invest in companies that are generating a high return on invested capital or those that are expected to see a significant improvement in returns. He seeks high-quality companies with strong growth potential that are undervalued versus their growth prospects or are undergoing a significant change in management or corporate structure, for example. ESG considerations are an integral part of the investment process.

The manager defines high-return businesses as ‘compounders’ and those with an improving return profile as ‘improvers’. The portfolio exposure is broadly split two-thirds and one-third between compounders and improvers respectively. Focusing on return on capital and having a long-term perspective allows Ross to determine whether a company has sustainable business practices.

For every potential investment, the manager builds a financial model and compiles an investment thesis to explain why a company appears attractive. The investment approach is the same, irrespective of a company’s sector, and is based on a ranking framework that has three elements. Quality and valuation illustrate a business’s fundamental attractiveness, while momentum provides information about the potential timelines of an investment. A score is allocated for the quality, valuation and momentum attributes to achieve a single ranking framework score for each company analysed. The score frames the debate about the ‘competition for capital’ within HNE’s portfolio. A score for sustainability considerations accounts for half of the whole quality score, so it has a meaningful impact on a company’s ranking framework score.

Ross is a member of JHI’s European equities team, which conducts more than 450 company meetings a year covering a wide range of topics including ESG and sustainability. Meeting notes are circulated and debated both within the European equities team and with the wider JHI investment teams. HNE’s portfolio has an active share of c 70%; this is a measure of how a fund differs from its benchmark, with 0% meaning full index replication and 100% representing zero commonality.

HNE’s board holds the manager to account regarding the sustainability of businesses within the portfolio. To further tighten the focus on sustainability, from 1 January 2022, the manager is required to provide a description of the extent to which environmental or social characteristics have been met with regards to being a Light Green fund under Article 8 of the EU Sustainable Finance Disclosure Regulation.

The trust does not invest in companies that derive more than 5% of their revenues from any of the following businesses: the production of shale energy, palm oil, arctic oil and gas; the production or selling of tobacco; or from involvement in the adult entertainment sector. A maximum 5% of the trust’s portfolio may be invested in companies, which are classed as ESG laggards. The ESG risk rating measures the degree to which a company’s economic value is at risk due to ESG factors, as assessed through MSCI’s calculation of the firm’s unmanaged ESG risks. The bottom 5% of the benchmark index constituents are excluded when ranked by carbon intensity, where the data used to rank the businesses is reasonably sufficient and accurate. At least 5% of the portfolio is invested in companies that are aligned with the United Nations (UN) sustainable development goal of ‘good health & wellbeing’. The manager only invests in companies that comply with the UN global compact principles, which is a voluntary framework encouraging businesses worldwide to adopt sustainable and socially responsible policies.

HNE considers that a company is sustainable if its management thinks, acts and allocates capital to maximise long-term growth in its net worth in a way that benefits its wider stakeholders. A sustainable company requires its management to consider the long-term implications of how the firm affects the environment, societies and its other stakeholders.

HNE has a £25m unsecured loan facility. The board has delegated responsibility for day-to-day gearing levels to the fund manager, with a normal level expected to be between 2% and 6% of NAV. Ross does not use gearing to time anticipated market moves. Gearing increases when he finds attractive, stock-specific opportunities in which to invest and declines when he is a net seller for stock-specific reasons.

HNE’s annual management fee is 0.65% of NAV up to £300m of net assets and 0.55% of NAV above £300m of net assets, payable quarterly in arrears. No performance fee is payable. Reflecting the board’s anticipated future total returns, HNE’s fees are allocated 80% to the capital account and 20% to the revenue account. In FY22, the trust’s ongoing charges were 0.75%, which was 3bp lower than 0.78% in FY21.

HNE is a conventional investment trust with one class of share; there are currently 211.9m ordinary shares outstanding. Its average daily trading volume over the last 12 months was c 210k shares.

The three largest shareholders (Allspring Global Investments, 1607 Capital Partners and City of London), which equate to around a third of HNE’s share base, specialise in investing in closed-end funds, which they consider to be trading at anomalous discounts to their net asset values.

Nicola Ralston has announced her intention to step down at the November 2023 AGM.

On 20 September 2022, the board announced the appointment of Stephen White as a non-executive director with effect from 1 December 2022. At that time he also joined the audit and risk, insider, management engagement and nominations committees. White is a former investment manager with more than 35 years’ experience, notably 20 years as head of European equities at F&C Asset Management, where he was also manager of F&C Eurotrust and deputy manager of the F&C Investment Trust. Previously, White spent 10 years as head of European and US equities at British Steel Pension Fund. He is currently chairman of Brown Advisory US Smaller Companies, a director of Polar Capital Technology Trust and audit committee chairman of BlackRock Frontiers Investment Trust and Aberdeen New India Investment Trust.