We size up the credentials of Fidelity European Values - an all-weather trust that should hold its own in the difficult macroeconomic conditions.
It has been an uncomfortable year in Europe. Political uncertainty – notably in the shape of the gilets jaunes protesters in France and Italy’s populist government – has returned and could disrupt Europe’s fragile economic recovery. To the extent that there ever was a party in European stockmarkets, it appears to be over.
With this in mind, it seems wise for investors to consider opting for a defensively orientated European trust in 2019. The Fidelity European Values trust (FEV) appears to fit the bill. It proved resilient in the ‘Red October’ downturn, and manager Sam Morse, while firmly a stockpicking manager, does not take the concentrated, smaller-cap approach of many of his peers. His top holdings include high-quality, large-cap European names such as L’Oréal, Nestlé and Roche.
Unlike most fund managers, Morse does not claim never to look at the benchmark. On the contrary, he pays close attention and likes to keep sector and geographic weights relatively close to the index, with no more than a 5% difference either way. Overall, the trust has around 80% commonality with its benchmark, the FTSE World Europe Ex UK index.
This approach may be unorthodox, but it has been effective, and the performance figures show Morse is no index-hugger. He has been running the fund since 2010 and it is first-quartile over three and five years. It is about 12% ahead of the index on a net asset value (NAV) basis since December 2013.
Morse says: “We are benchmark-aware and are trying to deliver consistent outperformance relative to the benchmark. It is not particularly fashionable to pay attention to the benchmark, but we like the idea that an investor can buy the trust, get 1-2% outperformance every year and build up a real differential performance year-on-year. We shouldn’t have too many horrendous years, and investors can just buy and hold.” He considers his strategy an ‘all-weather’ approach, rather than a defensive one.
Ongoing charge figure: 0.93%
Dividend yield: 2.00%
Share price one-year high: 239p
Share price one-year low: 199.5p
Net gearing: 13.0%
Five-year annualised return: 8.7%
Benchmark’s five-year annualised return: 6.4%
Source: Fidelity, as at 3 January
Morse’s process incorporates three main elements: a search for dividend growth, a long-term view and a focus on downside risk. To ensure dividend growth, he looks for companies with strong balance sheets that generate good cash ‑ ow, where dividend growth is supported by structural growth, disciplined use of capital and well-established, proven business models.
Take L’Oréal, which has a natural growing market for its products: the middle class in emerging markets and ageing populations in the West. It generates a lot of cash, has low debt and is therefore in a position to grow its dividend sustainably over the long term.
Morse says: “Our highest weightings are generally in sectors such as healthcare, consumer staples and IT. They are steady companies. Nestlé, for example, has tended to deliver over time. Healthcare companies have been out of favour, but this has left quite a few of them on attractive dividend yields – companies such as Roche, with a 3.5% dividend yield.”
This means he avoids companies more sensitive to the economic environment, such as car companies. These cyclicals can grow dividends when times are good, but growth does not endure through the cycle. They can look cheap at various points, but earnings can fluctuate wildly. Morse also avoids ‘blue sky’ companies that don’t make profits as well as business that don’t pay dividends. That means no biotech or oil exploration companies. “People tend to remember the ones that do well and forget 99% of the others,” he says. This has helped protect the portfolio over the past three months or so, as the market soured.
Morse wants to ensure that where companies have all the right qualities, they are not already factored into their share prices. Looking for dividend growth has become a popular strategy in recent years, as investors have recognised the risk inherent in simply seeking out shares with high dividend yields. This has created crowding in some parts of the market, to which he pays attention.
In terms of areas of concern, Morse steers clear of some sub-sectors in the financial sector. He says: “We are underweight insurance. It’s perceived to be defensive, but we are very wary. We believe all the regulation in the banking sector has seen banks de-risk and deleverage. My fear is that the bad stuff in the banks might end up in the insurance companies. If we have a crisis in the corporate bond markets or in leveraged loans, insurance companies might suffer.”
Banks could also be in trouble if the fragile environment is rocked further.
Morse adds: “The European economy weakening is an issue. There are concerns on the outlook for loan loss provision in some parts of the banking sector. That said, some are reasonably profitable and we like local champions. Many banks have de-risked since the global financial crisis. ABN Amro has pulled in its horns under Dutch government influence, for example.”
Interest rate risk
Morse admits his process can fare badly in a rising rate environment. He says: “Historically, rising interest rates can be quite negative for the type of stocks I hold, including bond-like equities such as Nestlé. But we find that when bond yields are rising, there are usually offsetting factors. These things don’t tend to happen in isolation.”
However, the fund is not all ‘safe’ European blue-chips. Just as Morse is unafraid to be unfashionable in his approach, he is happy to row against the tide. He says: “The market gets excited by certain areas. In the first half of 2018 the market got extremely excited about anything technology-oriented. Technology companies generally have good structural growth and recurring revenues, so they fit my criteria. However, valuations moved to quite unsustainable levels.” By the end of March 2018, the fund had a 6% overweight in IT sectors, but noting that valuations were becoming pricier, Morse rebalanced. This has helped him avoid much of the recent rout in the technology sector.
In other areas the decision is more difficult. He says: “Atlantia owned the Morandi Bridge in Italy that collapsed in August 2018. It was a tragedy and the stock collapsed. But we believed it was unlikely that Atlantia’s licence to operate would be revoked. The Italian courts move slowly and there is evidence that it was a tragedy, rather than the operator being culpable. Renationalisation is unlikely and the fundamental value of the business is sound. We will continue to hold Atlantia shares in spite of the fact that it will cut its dividend.”
FEV shares are currently sitting on a 10.3% discount to NAV, as at 3 January 2019. This is well behind the long-term average discount of 8.2%, and analysts such as Winterflood have highlighted it as a value opportunity.
For Morse, the Brexit saga is a concern over the short term. He says: “The European stock market is not dissimilar to the UK’s. We are investing in multinational firms, and the importance of domestic Europe is dwindling every year. Equally, the UK market provides less than 5% of revenue and profits for European companies. Today, emerging markets are much more important for European companies – and for our portfolio.”
Two experts’ views on Fidelity European Values
Laith Khalaf, senior research analyst at Hargreaves Lansdown: “The investment style of Fidelity European Values can broadly be described as GARP (growth at a reasonable price), but with a particular focus on the prospects for rising dividends, which the manager views as a key indicator of reliable earnings growth. Dividends can also act as a buoyancy aid when markets are falling, and are a big contributor to the long-term returns earned by investors.
Back in 2014 the trust amended its allocation restrictions to allow greater investment in UK companies, and the manager is making use of this extra freedom, with almost 9% now invested in the UK. The benchmark index does not include the UK, so this gives the manager an extra lever to pull to deliver outperformance, though clearly this is a double-edged sword if the manager gets his calls wrong.”
Tony Yousefian, investment trust research analyst at FundCalibre: “Morse is a very experienced and competent manager, and since taking the fund on in 2011, he has still done better than the sector average (as the chart shows). He has been helped by the fact that the trust tends to fall less than its competitors and the benchmark when markets fall, as was the case during the most recent correction.”