EUROPE IN 2017: ‘THE’ IN­VEST­MENT

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EUROPE BE­COMES THE FLAVOUR DU JOUR

As global economies emerged from a sear­ing fi­nan­cial cri­sis at the turn of the decade the US and UK seemed to pull ahead of their Euro­pean cousins. Earn­ings there lagged; growth tin­kered on the edge of de­fla­tion; its misaligned cadre of politi­cians toiled with Grexit and Brexit and much in be­tween.

2017 has switched for­tunes – Europe has be­come the poster­child for its cousins and the catch-up trade. GDP growth is strong. Mar­gins are im­prov­ing. It has the big­gest earn­ings up­grades in de­vel­oped mar­kets. Where the US and UK have be­come vic­tim to pop­ulism, Europe has re­jected it.

In­deed the strength has not gone un­no­ticed by the Euro­pean Cen­tral Bank (ECB) with its pres­i­dent Mario Draghi be­gin­ning to the pre­pare the market for a with­drawal of their un­prece­dented quan­ti­ta­tive eas­ing (QE) pro­gram, most likely in the lat­ter part of 2018.

The euro has also strength­ened, which is now at lev­els last seen be­fore Euro­pean QE started in spring 2015. It has meant larger Euro­pean companies, whose earn­ings tend to be har­vested from across the globe leav­ing them at the be­hest of cur­rency swings, have per­formed less well in re­cent months. Smaller companies, where we are in­vested, tend to have more of a do­mes­tic fo­cus and so have per­formed bet­ter.

SMALL IS MIGHTY

TR Euro­pean Growth Trust is a truly small com­pany trust, with a large slice of the port­fo­lio – over 50% - in­vested in firms un­der a £1bn market cap­i­tal­i­sa­tion. As in­vestors in larger companies in Europe have strug­gled to find value amid re­newed en­thu­si­asm for Euro­pean shares, they’ve re­set their sights fur­ther down the scale and tar­geted mid- sized busi­nesses, which in-turn have be­come more ex­pen­sive. It means the smaller end of the market is one of the last re­main­ing places to find rel­a­tive value, and it’s an area that we have a long his­tory of seek­ing ex­cit­ing growth op­por­tu­ni­ties for our in­vestors.

We’re cog­nizant of the risks that come with in­vest­ing in much smaller firms: they are more sus­cep­ti­ble to market swings than big­ger busi­nesses and can be dif­fi­cult to trade in large amounts, but to off­set this and di­ver­sify the risk we run a longer stock list than most funds, at around 140 hold­ings.

WHAT TO BUY

So how do we find the sorts of in­vest­ments that have the po­ten­tial for strong cap­i­tal growth?

We look for busi­nesses with man­age­ment teams that will con­tinue to take the right de­ci­sions to ei­ther fix what is

bro­ken in­ter­nally or con­tinue grow­ing their earn­ings strongly, re­gard­less of geopo­lit­i­cal un­cer­tain­ties or po­ten­tial ad­verse market re­ac­tions to more hawk­ish cen­tral banks. It broadly trans­lates into three ar­eas of in­vest­ment.

‘Value’ is one – companies that we be­lieve the market is pric­ing be­low their in­trin­sic value. The next is growth-at-the-right-price (GARP): firms whose earn­ings are per­ceived to be grow­ing more vig­or­ously than their peers or the wider market, but the tra­jec­tory of which is be­ing un­der­val­ued by the market. The fi­nal is turn­around sto­ries, or ‘self-help’ as we call it – busi­nesses that have been un­der­per­form­ing and are unloved by the market but striv­ing to change their des­tinies. Be­low are some port­fo­lio ex­am­ples.

Self-help

Van Lan­schot - Dutch bank­ing

Van Lan­schot is the old­est in­de­pen­dent bank in the Nether­lands, dat­ing back to 1737. It’s in the busi­ness of pri­vate bank­ing, as­set man­age­ment and mer­chant bank­ing, and in the process of run­ning off a loan port­fo­lio serv­ing cor­po­rate clients.

Back in April 2016 it pre­sented a new strat­egy de­signed to rein­vig­o­rate the pri­vate bank­ing arm – at the time the di­vi­sion earned around half of VL’s rev­enues yet ac­counted for only 7% of to­tal prof­its, in­di­cat­ing poor ef­fi­ciency and enor­mous scope for self-im­prove­ment. Look­ing for­ward, it is at­tempt­ing to be more as­set-light and build up its cap­i­tal ra­tios, re­turn­ing cash to share­hold­ers wher­ever pos­si­ble. As it stands, its re­turn on equity – a mea­sure of prof­itabil­ity – is poor at around 7%; this we be­lieve should be much higher.

Value

Alma Me­dia

The Trust has taken a num­ber of po­si­tions in Fin­land as we are find­ing un­der­val­ued busi­nesses there which we think will per­form well amid an im­prov­ing econ­omy.

Alma Me­dia pur­ports as a me­dia owner of regional, lo­cal and free cir­cu­la­tion news­pa­pers for print and on­line, and the market is pric­ing it as such. But it should be fo­cus­ing on what the busi­ness is re­ally about: on­line clas­si­fieds - web­sites that deal in used cars, used equip­ment and in real es­tate – of which Alma Me­dia is a market leader. Axel Springer, a sim­i­lar out­fit in Nor­way, pro­vides guid­ance in this re­spect, with the market plac­ing sig­nif­i­cantly more value on its op­er­a­tions. In our opin­ion other in­vestors will catch-up with this think­ing.

Growth

(at the right price) Zur Rose

Founded in 1993, the group is in the busi­nesses of on­line drugs; op­er­at­ing a pre­scrip­tion mail or­der busi­ness un­der its DocMor­ris brand in Ger­many, and a market lead­ing on­line phar­macy busi­ness in Switzer­land un­der its Zur Rose brand.

The phar­macy market is ripe for dis­rup­tion in Europe: small, rel­a­tively high value non-per­ish­able pack­ages are ex­tremely well-suited to e-com­merce, which re­mains a very un­der-pen­e­trated market con­sid­er­ing the 125 thou­sand bricks and mor­tar phar­ma­cies across Europe which have op­er­ated as such for 500 years.

What is more, the Ger­man market has re­cently been prised open by a Euro­pean Court of Jus­tice rul­ing and we be­lieve market leader DocMor­ris will be a key ben­e­fi­ciary.

All-in-all it has been a good year for Euro­pean eq­ui­ties, and in par­tic­u­lar small-caps. But we think they have much fur­ther to go: prof­itabil­ity lan­guishes as the earn­ings of Euro­pean firms have yet to catch-up to those of their de­vel­oped market coun­ter­parts. In the port­fo­lio we will con­tinue to seek out those busi­nesses that have the po­ten­tial for su­pe­rior cap­i­tal growth over the longer term.

De­fla­tion – a de­crease in the price of goods and ser­vices across an econ­omy.

Quan­ti­ta­tive eas­ing – when a cen­tral bank print money to buy as­sets and stim­u­late the econ­omy. Market cap­i­tal­i­sa­tion – the to­tal value of a com­pany’s is­sued shares. Hawk­ish – pol­icy stance by the cen­tral bank aimed at cool­ing the econ­omy Cap­i­tal ra­tios – the amount of liq­uid as­sets a fi­nan­cial in­sti­tu­tion holds against its risk op­er­a­tions. Re­turn on equity – the amount of net in­come rel­a­tive to the share­hold­ers in­vested equity.

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