October 2016- European Value strategy: outlook & positioning

211016 Market Commentary

October 2016- European Value strategy: outlook & positioning

Macroeconomic backdrop

  The macroeconomic environment has not significantly changed over the recent months, it remains torn between undeniably favourable factors and legitimate concerns. Geopolitical issues are undoubtedly one of the key current concern. Indeed, the migrant crisis and repeated terrorist attacks coupled with an overloaded political agenda (US elections, Brexit, Italian reforms, Spain struggling to form a government, etc.) leave markets uncertain leading to some volatility. Moreover, with disappointing profitability and sluggish earnings growth, the health of European corporates remains fragile while at the notable exception of Germany, European industrial production continues to stagnate at low levels.   But is it all gloom and doom? Not at all…there are good reasons to remain optimistic about the medium-term potential of European Equity markets. Unsurprisingly, the persistent low rate environment makes the stock market as one of the few alternatives available for investors looking for some yield. In addition, there are two overlooked aspects that should give some boost to European Equities. First, the US economy, which remains the first world economy, is currently rebounding. This rebound should have a positive impact on the world economy and therefore on European businesses. Second, when comparing the valuations of European companies with their US peers as well as relative to their historical average, we can conclude that valuations remain attractive, though not exceptionally low.  

How to invest?

A guide for sound Value investing
  Our investment strategy is not sharply dependent on the macroeconomic environment and focuses mainly on the selection of individual companies exhibiting strong undervalued earning power. However, the macroeconomic context must be taken into account as it influences the operational environment of the companies included in our universe. With a final portfolio of maximum 40 names, we must be able to identify at all times those companies who meet our strict investment criteria; and, depending on the prevailing market conditions, these investment opportunities may be more or fewer.   It is therefore essential to always keep in mind two main principles:   Stable investment approach, flexible implementation This first principle directly relates to the Value Investing philosophy developed by Benjamin Graham. According to him, the main principles of a sound investment approach should not be changed over time but the way those principles are implemented must be flexible enough as to adapt to prevailing conditions. From this first observation stems our commitment to implement an active, high conviction approach which is flexible in terms of allocation (sector, country, market capitalisation) in order to invest where the most interesting opportunities arise. We do however never compromise our key investment criteria, namely the search of companies benefiting from strong fundamentals and earning power trading at a significant discount relative to their intrinsic value.   Slow and steady wins the race The low interest rate environment which is in place for almost a decade has led many investors to the stock markets and mainly to those companies offering a certain level of yield. In this specific context, valuations were not considered as relevant! These companies have seen their stock price boosted by the ultra-accommodative monetary policies while their fundamentals did generally not justify such an increase.  However, the market will inevitably sooner or later, realise its error and those stocks will undergo a significant correction. By remaining focused on the undervalued earnings capacity regardless of fads and maintaining our long-term investment horizon, we avoid us falter and stay the course towards a strong long-term consistent performance based on the quality of fundamentals and intrinsic value of the companies we invest in.  

Portfolio positioning

A high quality portfolio
  Our investment approach described above is translated into a portfolio of maximum 40 positions exhibiting very high quality standards compared to the broader European Market. We constantly screen a universe of more than 1 500 companies in order to detect the hidden “jewels” that present the earning power and the necessary margin of safety of 40% to qualify as a candidate for portfolio inclusion. It is always difficult to reduce the earning power of a company to a single accounting metrics. The average company in our portfolio appears to be much more profitable than the market overall. As an illustration, the median Return on Equity of our portfolio is of 11.6% while the Stoxx Europe is at 6.5%. At the same time, the companies in our portfolio have usually much healthier balance sheet than the market: based on the net debt / EBITDA ratio, on average, companies in our portfolio need 7 months to pay back their entire debt, while the average European company (in Stoxx Europe) needs nearly 5 years. As Value investors, we now see that, compared to 2015, markets are becoming more discriminant in terms of companies’ quality and valuation, which creates a more favourable environment for our investment strategy. It remains a good time to be a value investor!  
Focus: does the Financial sector offer strong investment opportunities for value investors?
  Despite a positive contribution from financials stocks to the quarterly performance of the Fund, we remain cautious about the Financial sector as a whole. In our view, the situation remains very complicated and banking stocks may still prove to be a minefield for value investors who, from one side, are attracted by very low valuations (especially in terms of Price to Book Value) while, on the other side, recent examples (i.e. Deutsche Bank, Italian banks) have shown that this segment is still experiencing a major crisis. Although we believe that the central bank will do everything in its power to save the European banking system, low valuation levels do not compensate sufficiently the risks and the resulting excess volatility. The European banking sector is suffering from the collateral damage from quantitative easing policies while it sees its interest rate margins under pressure and regulation increasing. We still have some targeted investments in the Banking area, each one of them being based on a solid investment case linked to the fundamentals of each company and not on a more global sectorial view: - For Credit Suisse, we continue to believe in the earning power that will be released by a “UBS-like” restructuring and the strength of the wealth management franchise. - Caixabank is one of the best managed and most conservative Spanish banks benefitting from the reduction of cost-income ratio after the BPI acquisition. - Danske Bank has been through a long restructuring period and now emerges under the new CEO as a much leaner bank with a large captive mortgage customer base and a solid capital position.