European Opportunities Trust — ‘Special’ stocks beginning to shine

EOT’s manager, Alexander Darwall, is a high-conviction investment manager targeting ‘special’ stocks – innovative global leaders, with large and rapidly growing markets, capable of riding the wave of structural change and exploiting the opportunities it creates. Darwall’s long-term approach has delivered outperformance over time; the trust has outpaced its benchmark, the MSCI Europe Index, over the past 10 years to end July 2023, delivering an average annualised return of 8.7% in net asset value (NAV) terms over this period, compared to a benchmark return of 7.6%. This track record attests to Darwall’s stock selection skills, although investors have required patience in more recent years. Returns over the past three- and five-year periods have been disappointing relative to benchmark, due to poor performances in 2020 and 2021 (discussed in previous notes Positioned for positive news and growth and Consistent, resilient trust returning to form).

However, Darwall has remained patient and true to his investment strategy, and this appears to be paying off, as performance seems to be returning to its long-term course. Performance began to show signs of improving in mid-2022, as discussed in our last couple of update notes (links above), as many of EOT’s holdings began to deliver the positive performance Darwall and his team foresaw. And this improvement has gathered momentum in recent months, to the extent that the trust has delivered outright gains, and decisively outpaced its benchmark, over the past six months ended 31 July 2023, returning 6.3% in NAV terms and 9.0% on a share price basis, compared to a benchmark return of 3.6%. It is particularly encouraging that these returns have been derived from many of EOT’s holdings, including some of its largest positions, which is further evidence of the manager’s ability to pick long-term winners. Contributors to returns since the beginning of 2023 have included Novo Nordisk, a Danish pharmaceutical company that has developed groundbreaking treatments for diabetes and obesity, Infineon, a German semiconductor manufacturer, French software company Dassault Systèmes, and Edenred, a French credit services company (see Performance section for details).

Investors are beginning to notice and respond to this improvement in performance. As can be seen from Exhibit 1, EOT’s share price discount to its NAV has begun narrowing over the past year, to around 10% at present, from 10-year highs of more than 15%.

This narrowing trend has been encouraged by the board’s consistent efforts to support the share price via buybacks. In the financial half year ended 30 November 2022, the company repurchased c 1.145m shares and it has since repurchased a further c 4.350m (as at 14 August 2023). The marketing efforts of EOT’s new broker, Singer Capital Markets, and a series of investor roadshows early in 2023 may also be contributing to the recent discount narrowing.

However, EOT’s shares are still trading a long way from their long-term average discount of less than 5%, so if the recent improvement in performance can be sustained, there is, arguably, scope for the discount to narrow further. This suggests that now may be an opportune time for investors to acquire or top up exposure to this trust.

The improvement in EOT’s recent performance has been quite marked. Returns for the year to end July 2023 trailed the benchmark by 8.5 percentage points on an NAV basis. While the trust returned 5.4% on an NAV basis and 8.3% in share price terms over the past year, the benchmark gained 13.9%. However, the trust has made up all this ground in the past six months and is now outperforming the benchmark by 2.7 percentage points, returning 6.3% in NAV terms and 9.0% in share price terms, compared to a benchmark return of 3.6%. EOT has also outpaced the UK market over this period, as well as over the long-term (Exhibit 4).

According to Darwall’s colleague Luca Emo, most of the trust’s holdings have posted ‘very good numbers’ in recent times, with several making upward revisions to earnings projections. But the best performers year-to-date have been EOT’s largest holdings, most notably Novo Nordisk, as the strength of its earnings have continued to take investors by surprise. Sales rose 25% in the first three months of 2023 and the company has revised up its forecasts for the full year. Sales are now expected to rise by 27–33% during 2023, while profits are forecast to increase by 31–37% for the year, thanks especially to strong demand for its GLP-1 class of drugs for diabetes, and for its weight loss drug, Wegovy. Competition is intensifying and health authorities are investigating the safety of this drug for users with mental health issues, following recent concerns. However, the company’s shares jumped in August on news that Wegovy has positive health benefits: a trial showed the drug significantly reduces the risk of heart attack and stroke. This latest news will no doubt reinforce Darwall’s confidence in Novo Nordisk’s ability to realise further significant growth over time.

Other large holdings such as Dassault Systèmes, Infineon and Experian that have been out of favour with investors are beginning to recover, and boost performance accordingly (Exhibit 6). Dassault has benefited from an 8–9% increase in revenues and strong operating margins, while the unexpected rise in sales of electric vehicles (EVs) and the recent focus on artificial intelligence are providing tailwinds for Infineon. Experian offers a variety of data-driven credit services to businesses and individuals in the UK, Europe, the US and Latin America. The US regulatory threat appears to have receded, as the Biden administration seems less likely to set up a new public credit bureau. Additionally, there are early signs that investors are finally beginning to appreciate the growth potential of Experian’s businesses, with some viewing recent guidance as unduly conservative.

The list of contributors to recent returns also includes another credit services company and top 10 holding Edenred. It announced the acquisition of an employee engagement platform in May and Darwall believes this transaction provides the company with a major new growth opportunity. Second quarter results showed a 20% rise in revenues and a larger increase in profits. The company also confirmed its ambitious full year targets. Recent acquisitions budget airline Ryanair and Prysmian, an Italian cable manufacturer, both discussed below, have performed well since purchase.

The year-to-date has not been without its disappointments from a few portfolio holdings, but, as ever, the managers are prepared to remain patient and give these companies the time they require to fully realise their potential. The largest detractor from returns so far this year has been Genus, a UK animal genetics company focused on the production of disease-resistant pigs. It came under pressure following precipitous falls in Chinese pork prices due to a new outbreak of African swine flu. However, Darwall remains confident in the longer-term prospects of this company. Initial feedback from farmers on gene-edited pigs has been positive and Chinese farmers will eventually begin to restock, creating an opportunity for Genus. In addition to the massive Chinese market, there is scope for strong growth from the US, where current sales of pork are low, but rising. Genus is due to file an application for US regulatory approval of its gene-editing animals before year-end and, if this application is successful, it will, according to Darwall, ‘transform the company’s medium-and long-term prospects’.

German pharmaceuticals and life sciences company Bayer has also disappointed recently, due to poor performance from both its pharma and crop sciences businesses. The company benefited from the price rise in glyphosate fertilisers following Russia’s invasion of Ukraine, but prices have since declined. However, Darwall sees Bayer as ‘a world leader’ whose extensive investment in R&D will ultimately be rewarded by the success of new products such as short stature corn, despite current market scepticism.

Darwall believes EOT’s ‘special’ companies sidestep many of the challenges faced by the European economy – inflation, persistently high interest rates and medium-term rises in energy costs – and are well-placed to grow on the back of structural growth trends. This confidence in the portfolio, combined with his long-term investment focus, means turnover tends to be low, at less than 20%.

However, the manager and his growing team are always on the look-out for interesting investment opportunities. In May they opened a new position in Irish budget airline Ryanair. This stock has performed well since and the managers expect the numbers to get ‘even better’, for several reasons. Ryanair purchased new planes cheaply during the pandemic when demand was low. These aircraft are 20% more fuel efficient than existing planes, which will limit fuel bills over the medium term and provide the company with a competitive edge accordingly. In addition, unlike some competitors, Ryanair kept its pilots on the payroll during the pandemic, so it has the resources to meet the post-pandemic surge in air travel. Demand for holiday travel is expected to remain strong, but customers are likely to ‘trade down’ to cheaper travel options in response to current cost-of living constraints. As a budget airline, Ryanair is likely to benefit from this shift. The company has also profited from shrewd hedging of fuel costs, and it appears to be willing to pay more to use sustainable aviation fuel (SAF), as it sees this a marketing tool that appeals to environmentally conscious customers.

The managers purchased Prysmian in June. This company is a world leader in the supply of energy and telecoms cable systems, including for power transmission and distribution, and as such it is set to benefit from long-overdue US investment in grid upgrades, and from global demand for renewable energy infrastructure. Within the US, the company is likely to benefit from the reluctance of American utility companies to source cable infrastructure from Prysmian’s Chinese competitors, for security reasons. EOT’s managers have indicated that the trust’s small position in this name is likely to grow over time.

Market fluctuations have provided the managers with the opportunity to add to some favoured holdings at attractive prices. They have recently topped up positions in Genus, Edenred, Oxford Instruments, a UK producer of semiconductor equipment and materials, and Intermediate Capital Group (ICG), an alternative asset manager, following a run of good results and a meeting with management. EOT’s holding of Worldline, a French software company providing payments and transactions services to financial institutions, corporations and governments, was increased in July after the company reported excellent results. Worldline continues to benefit from the trend to digital money, which Darwall expects to underpin profit growth for the foreseeable future. As discussed in our last note, the managers began to wind down their position in Mowi, a Norwegian salmon farmer, in late 2022, following the introduction of a hefty and controversial tax increase intended to capture externalities related to companies’ use of natural resources. They closed the position in Q123. However, since then, the resource tax has been reduced from 45% to 25%, and the managers have signalled that they may re-purchase the stock at the right price, as they believe alternative forms of salmon farming are expensive, due to high electricity costs.

Recent disposals have included the outright sale of Network International, a software infrastructure provider focused on digital commerce, following an agreed takeover. A position in Hikma, a UK pharmaceuticals manufacturer, was also closed, locking in profits after the stock performed well and reached what the managers believed to be a realistic valuation. They also trimmed the position in Novo Nordisk, to maintain its 11.5% portfolio weighting, although they stress that their confidence in the company is undiminished. The exposure to Experian was also reduced to limit its substantial portfolio weighting. Exposure to Infineon was also trimmed after a recent share price bounce.

EOT’s objective is to achieve capital growth, rather than income, and the trust invests in companies focused on structural growth, which tend to reinvest their earnings in further growth, rather than pay dividends to their shareholders, so the dividends EOT receives from its investments tend to be low. EOT’s policy is to pay out income equal to 85% of this investment income, the minimum required by legislation to maintain its investment trust status. This means that the trust’s dividend is quite low in absolute terms, and relative to its peers, and does not usually make a significant contribution to total returns. As can be seen from Exhibit 7, the dividend may fluctuate in line with EOT’s investment income.

In the financial year to end-May 2022, the company paid a final dividend of 2.5p per share, up from 2.0p per share in the previous financial year. The dividend for the year to end-May 2022 represents a yield of 0.3%, based on the current share price. EOT makes one final dividend payment per year. It is expected to announce its final dividend for the current financial year ended May 2023 at the time of publication of its annual results, in September 2023. Subject to the agreement of shareholders at the annual general meeting, the dividend will be paid in November 2023.

For further information about EOT’s fund profile, capital structure, investment process and fees and charges, please see our initiation report.