TR European Growth Trust — Update 20 June 2016

As we reach the mid-point of 2016, it seems clear that the volatility which has characterised the year to date may remain for some time longer. Geopolitical worries such as the UK’s EU referendum and the US presidential election stand alongside concerns over global economic growth and monetary policy. Added to this, the lower level of market activity during the summer can mean share prices are volatile on thin trading volumes. However, investors should bear in mind that volatility can be a source of opportunity as well as risk.

Looking at the performance of European stockmarkets over the past 10 years (Exhibit 2, left-hand chart), larger and smaller companies experienced similar returns from 2006 until early 2014, since when smaller companies have outperformed. It is important to note, however, that the Euromoney index is a mid- and small-cap index, and as in the UK it is the mid-caps that have been the engine of much of this performance.

Consensus earnings growth forecasts (right-hand chart) suggest a decline in European large-cap EPS growth from 2015; small-cap EPS growth, by contrast, is forecast to accelerate by a similar margin. (In both cases European companies are forecast to enjoy higher EPS growth than their UK peers.) While investors should bear in mind that earnings forecasts may be over-optimistic and are often downgraded later, this differential may nevertheless point to a continuance of smaller company outperformance, particularly in Europe.

TR European Growth Trust (TRG) was launched in 1990 by Touche Remnant (TR), which was acquired by Henderson Global Investors in 1992. The board has continued to subcontract management to Henderson, and since July 2011 the portfolio has been managed by Ollie Beckett, assisted by Rory Stokes since 2013.

TRG aims to achieve long-term capital appreciation by investing in a diversified portfolio of European (excluding UK) small and mid-cap companies. There is a bias towards the smaller, less liquid end of the market, leading to the trust having a longer stock list (c 145 companies) than its peers, in order to mitigate risk. While focused primarily on capital growth, the trust also has a long record of year-on-year dividend increases. Performance is measured against the Euromoney Smaller Europe ex-UK index.

Lead manager Ollie Beckett notes that in an environment of low growth, low inflation and negative interest rates, market participants have been willing to pay a premium for ‘reliable growth’ from equities. However, with a market driven by earnings momentum having morphed into one driven by price momentum – where those stocks that have gone up continue to do so and vice versa, almost regardless of fundamentals – Beckett argues that investors are now overpaying for growth, and especially for low growth, as in the case of consumer staples stocks.

While investors with an earnings momentum style have produced good performance in the era of extraordinary monetary policy, Beckett argues that value investing may be on the verge of a comeback. After a period of significant underperformance for stocks with the lowest price/book valuations relative to the broad market, so far in 2016 the decline has stalled, with signs of relative outperformance beginning to emerge. Part of this may have been due to a bounce in oil and banking stocks during March, but a weaker US dollar versus the euro may prove to be the catalyst for a value renaissance.

At the portfolio level, however, what matters more is individual stock catalysts. Beckett says examples would be where he perceives a change in earnings momentum, or if there is a change in management. He gives the example of cable manufacturer Nexans – one of the top contributors to performance so far in 2016 – where operational improvements driven by the new management have led to a reassessment of the company by the market.

Beckett says he and Stokes are prepared to cast their net widely in the search for value, with holdings including Spanish security company Prosegur, which has operations in Brazil and Argentina and is benefiting from the lifting of capital controls under the new Argentinean government. However, the managers still believe in having a core of stocks with structural growth and high returns on capital, such as 3D printer specialist SLM Solutions and high-end online clothing retailer Yoox, which recently merged with Net-a-Porter.

Macro considerations include the British referendum on EU membership, which has affected sentiment towards companies that are exposed to the UK, such as Nobia (a fitted kitchen maker whose brands include Magnet) and Danish ferry operator DFDS. Beckett says that fund managers outside the UK have been selling these types of stock well in advance of the vote, and that fund flows may remain on the sidelines for a while longer, given the quieter summer months and the likely lack of any further supportive action from the ECB while politicians are in recess.

Ollie Beckett and assistant Rory Stokes sit within the well-resourced European equities team at Henderson Global Investors, which manages £8-9bn of assets across the market cap spectrum. The managers’ aim with TRG is to build a portfolio of stocks that are undervalued because of market misperceptions. They use quant screens to narrow down the universe of more than 1,300 small- and mid-cap companies, and HOLT discounted cash flow analysis to help generate ideas. Beckett and Stokes prefer in-house idea generation to the use of sell-side research, and meeting with company management is a key part of the investment process; the managers see or speak to more than 600 companies each year.

The managers build simplified valuation models for candidate stocks, using a range of metrics such as P/E ratios, free cash flow, dividend yield and EV/EBITDA. Company meetings help the managers to gauge the quality of management, the robustness of the business model and the drivers of growth. Given the focus on undervalued stocks, interactions with management are also important in helping Beckett and Stokes to understand likely catalysts for a re-rating.

TRG has a longer stock list than peers, as a result of its greater focus on the smaller, less liquid end of the market, where diversification is key to controlling risk. While the portfolio is built from the bottom up, the managers do take account of the macro environment, and also work with Henderson’s risk team to eliminate unintended biases from the portfolio.

Stocks may be sold when they reach valuation targets, if there is a deterioration in the fundamentals underlying the original investment thesis, or if the managers see better ideas elsewhere. Turnover is moderate at c 40% a year.

At 30 April, TRG had 145 holdings, a far longer stock list than its peers, which tend to hold 40-60 companies. As a result, it is also less concentrated, with only 15.1% of assets invested in its top 10 holdings, versus a peer group average of 27.7%. The diverse portfolio is a direct result of TRG’s greater focus on smaller and micro-cap companies; Beckett says 70% of the portfolio is in sub-£1bn companies, as that is where he sees the best value opportunities.

TRG’s largest holding, Brainlab (bought by a previous manager), is an unquoted German medical technology company; Beckett says further unquoted investments are unlikely, and the position will be exited when an appropriate buyer is found. Germany is also the largest country weighting, at 22.4% (see Exhibit 1); the top four country weightings (including France, Switzerland and Italy) make up 55.7% of assets, underlining the manager’s focus on mature Western European markets.

Industrial companies are the largest sector weighting (Exhibit 3) and are also the largest overweight versus the benchmark; the manager also favours technology stocks, but is most underweight financials. Recent purchases include gym equipment maker Technogym and valve manufacturer VAT, both bought at IPO, and clothing firm Hugo Boss. Sales include Swiss asset manager GAM and Aegean Airlines, as well as the exit of several acquired companies (generally sold after a bid is agreed rather than waiting for the deal to complete), including travel consultancy Kuoni, electrical retailer Darty, railway equipment maker Faiveley Transport and video game developer Gameloft.

Beckett reports that the 12-month forward P/E ratio of the portfolio is 15.5x and the underlying portfolio yield is 2.5%. Gearing stood at 12% at 30 April.

Under manager Ollie Beckett (since July 2011), TRG has outperformed the Euromoney Smaller Europe ex-UK in both share price and NAV total return terms over most periods to 31 May 2016 (Exhibits 4, 5 and 6). Share price performance was weak over 12 months, but has rebounded since the turn of the year. The strategy has also outperformed the larger company European index and the FTSE All-Share over one, three and six months and one, three, five and 10 years (Exhibit 5).

In 2016 to date, strong performance has come from takeover targets Kuoni and Darty, as well as specialist component manufacturers Valmet (Finland), BE Semiconductor (Netherlands), Nexans (France) and SLM Solutions (Germany), which together added 2.2% to TRG’s NAV from 1 January to 30 April. The top 10 positive contributors produced a combined gain of 3.5%. The top 10 detractors, which included Elmos Semiconductor (Germany), Belgian engineering and construction firm CFE, agricultural consultancy Origin Enterprises (Ireland) and Italian glasses-maker Safilo together produced a 1.4% reduction in NAV.

At 15 June 2016, TRG’s shares traded at a 13.0% discount to cum-income NAV. This is wider than the averages over one and three years (10.6% and 11.7% respectively), but narrower than the 16.2% reached in April (a 12-month high). In the recent past (Exhibit 7), TRG’s shares have tended to trade in a discount range of 5-15%. Larger discounts have been widespread across the investment trust sector during 2016’s volatile market climate. TRG may buy back shares to manage a discount, but in practice has not done so since mid-2012; the board sees increased investor appetite for European equities and good performance as key to narrowing the discount.

TRG is a conventional investment trust with one class of share; at 15 June 2016 there were 50m ordinary shares in issue. The board may buy back up to 14.99% of shares annually to manage a discount, but has not done so in any significant volume since the removal of a hard discount control mechanism (obliging buybacks if the discount exceeded 10%) in 2010. There is a continuation vote every three years, with the next due at the November 2016 AGM. The trust has a £50m borrowing facility with HSBC, indicating a maximum gearing level of 13.7% based on 15 June net assets. The board has set a working limit of 15% gearing and at 30 April actual net gearing stood at 12%.

Henderson Investment Funds acts as TRG’s alternative investment fund manager (AIFM) under the AIFM Directive and delegates investment management to Henderson Global Investors. TRG pays Henderson an annual management fee of 0.6% of net assets. A performance fee may also be paid subject to certain conditions: on a three-year basis, the average NAV total return of the trust must outperform the return on the Euromoney Smaller Europe ex-UK index by at least 1%, in which case a fee of 15% of outperformance is due. Total fees are capped at 2%; for FY15 a performance fee of £1.76m was paid and ongoing charges (which exclude the performance fee) were 0.78%.

Although it is primarily focused on achieving capital growth, TRG also has a 14-year track record of consecutive annual dividend increases (based on ordinary dividends). As an investment trust, TRG must pay out at least 85% of net income each year. In recognition of the fact that smaller companies can be volatile and revenue returns may vary significantly from year to year, the board has declared a special dividend in 10 of the last 12 years to safeguard its stable record of ordinary dividend growth. Dividends are paid annually in November. For FY15 a total dividend of 9.5p was paid, made up of an ordinary dividend of 7.0p and a special dividend of 2.5p. Based on the 15 June share price of 636p and the FY15 total dividend, TRG currently yields 1.5%.

There are four investment companies in the AIC’s European Smaller Companies peer group (Exhibit 8), with three of them being relatively large (c £318m to £430m) and long-established (one in 1972 and two in 1990). TRG is, by a narrow margin, the smallest and youngest of these three. NAV total return performance is behind the weighted average for the group over one and five years, but ahead over three years. Risk-adjusted performance as measured by the Sharpe ratio is broadly in line with averages over one and three years. TRG has the lowest ongoing charges, but is the only member of the peer group to charge a performance fee. Its discount to NAV is currently wider than the sector average, while its level of gearing is the highest of the group. TRG has the second-highest dividend yield in the peer group; the weighted average is skewed by the high distribution policy of European Assets Trust, which pays dividends partly out of capital.

TRG has five non-executive directors. Chairman Audley Twiston-Davies has served on the board since 2000 and has been in his current role since May 2002. Andrew Martin Smith became a director in 2008, while Christopher Casey was appointed in 2010. Alexander Mettenheimer, a resident of Germany, joined the board in 2011 and the newest director, Simona Heidempergher, who lives in Italy and works in Belgium, was appointed in September 2014. The directors have backgrounds in banking, accountancy and investment management (including private equity).