Some commentators argue that there has never been a better time to invest in Europe.
Draghi’s ‘whatever it takes’ speech created a fundamental shift in the way the market perceived Europe. Fears over a breakup, and implosion of economies slowly abated, giving investors the opportunity to exploit the market by picking up cheap stocks in the belief that they would re-rate.
2013 saw stocks in the Eurozone shrug off the debt crises and produce some of the strongest global returns. However, much of these returns were delivered through an indiscriminate re-rating of shares rather than any real evidence of a rise in earnings growth; effectively demand driven returns.
Although Europe is on the road to recovery there are many different and complex strands for investors to consider.
In recent days the ECB cut interest rates and further injections of capital were issued into the market. Draghi indicated that additional measures are likely to follow showing that Europe is still teetering on the edge. Some of the biggest concerns are deflation and unrest within the peripheral economies.
Many feared the success of the far right wing parties in the European elections would disrupt the road to recovery, however despite sweeping gains the pro-European parties remain the stronger body. This is important because it is this that will drive through the political structure to tackle and deal with the problems left by the financial crisis.
For investors this opens up a challenge as to how to invest in this market, and whether the best times have has already passed.
Finding the right investment
We are a supporter of active managers as we believe over the long term they will significantly outperform funds which simply track an index. One of the benchmarks we use is the iShares MSCI Europe-Ex UK ETF.
Over the last 12 months this ETF has outperformed a number of well-respected European active managers and for us this raises a number of questions. Firstly whether we got the wrong managers and secondly is change in the Euro-zone making it almost impossible for managers to respond in this market going forward?
We approached Mark Page, (Manager of Artemis European Opportunities Fund) and Francis Ellison (Investment Specialist of Threadneedle European Smaller Companies Fund) for their views on what has occurred.
One phrase which came out of all of this was that the market has been driven by a ‘dash to trash’ (a move away from quality). This has meant that the winners of the last twelve months have been those offering high dividends (but are not growing them), low return on earnings, high debt levels and are cheap. For example, Italian and Spanish banks saw a strong rally in 2013, and coming into 2014 this has started to scale back.
The ETF benchmark is made up of 334 holdings and although is discriminate in the economies it invests in, there is no discrimination in the type of company it holds. Its current bias is to financials (22.67%) and its’ fourth largest regional holding is Spain at 7.89%. This has meant that because there is no bias to what is termed a quality trade the ETF has significantly benefited from the ‘dash to trash’.
This is important because as Mark indicated what we have seen is an unprecedented polarisation of style basis towards low quality stocks which then get sucked into a re-rating. This in itself creates a danger which he admits he succumbed to but has learnt from.
In 2007 Mark changed his investment style to reflect the market, but quickly the market turned against him. To assume what has happened over the last 12 months is the norm and will remain so forever is a harsh less for any investor.
Where now for investors
The winners over 12 months have been:
- those with ow earnings growth;
- high dividend payers, and those that are not growing the dividend;
- those with low return on equity, high debt to earnings value, low price to book, low price earnings ratio, and low returns on invested capital.
On a 12 month view the worst places to be differ marginally but, simply put, the opposite of the above.
This polarisation of style will favour a fund which tracks the index and is unlikely to favour an active manager unless it either matches their style or they change it to reflect what is happening now.
The Threadneedle fund has a small cap bias; however it was the manager’s focus on quality that dragged down the relative performance of the fund in an environment which favoured cyclical and lower quality stocks.
Entering 2014 the performance has improved as the market has favoured quality and the small cap focus favoured the fund at the start of the year. However, Investors should be aware the polarisation of style bias remains (although over the last three months this has started to spread).
The pendulum which favours active or passive funds will always swing in different ways over short periods, and certainly in the period just gone the favour has swung towards an index based fund.
However, all evidence points to the fact that quality companies are the ones that will deliver ‘more sustainable long term returns’ because they ‘have sustainable pricing power which gives them the ability to generate and maintain strong returns on capital.’
Taking this point further for short term investors looking to time the market the ‘dash to trash’ trade would have benefited them over the last 12 months and there is evidence that trade is starting to fade. During the same period quality companies which had appeared to be expensive re-rated downwards and this has now opened up opportunities (some are 20% cheaper).
We don’t know what the next twelve months will bring but for investors there are a number of things to consider:
- The environment over the last 12 months has benefited funds which track the index, as we can see with the weighting to both financials and some of the peripheral economies. However, good active managers can and do demonstrate the ability to significantly outperform over a period of 3 to 5 years
- As Europe moves up the recovery scale those companies which have low debt, cash on the balance sheet and potentially a growing dividend stream will benefit, what appears a bargain could remain a value trap suffocating returns
- Even when selecting fund managers care is needed, there are funds which have significantly outperformed the ETF, some of those managers will have participated in the ‘dash to trash’ benefiting from the strong rally in Italian and Spanish Banks. Chasing short term trends can work but managers have to be very good at this and few are
An ETF option for investing in Europe can be a good route for investors confused by the plethora of European Funds. There will be short periods where these can deliver outperformance of active managers because they are style agnostic but good active managers will demonstrate significant outperformance over the long term.
Style polarisation has been a big driver of performance over the last 12 months and quality companies have not participated in this (in fact they have become cheaper). Accepting that much of the growth in 2013 came from re-rating and not growth, then cheap companies with low earnings growth and high debt are likely to re-rate downwards as companies with high growth potential and dividend yields re-rate upwards. There are managers who have played the style card and benefited but investors need to look carefully at the numbers, these managers may struggle when the style card changes.
Turning to the question we posed; we don’t believe we have chosen the wrong managers, in fact it is clear that despite a polarisation of style and a temptation to chase a quick trade they have kept with the style of management what has delivered long-term outperformance, and understanding that much of the returns has been focused on unstainable long term fundamentals means that this will reverse at some point and will therefore favour good active managers.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.