Richard Pease, manager of the New Star European Growth Fund, gives his views below on the pressures on equity markets in Europe excluding the UK and the areas in which he sees opportunity. The New Star European Growth Fund is AAA-rated by Standard & Poor's†.
European equities were weak and volatile over the summer months, with investors concerned by economic contraction in the eurozone and rising inflation. On a long-term view, however, the market weakness provides some of the most attractive opportunities in years to buy quality companies on attractive valuations.
Investors have been unnerved by economic difficulties and share prices appear to have been unusually affected by shifting sentiment, with companies reporting even marginally negative news being significantly marked down. Such trends affected the New Star European Growth Fund's performance in July. Such periods of volatility, however, tend to have little bearing on the long-term fortunes of sound, well-managed companies - as favoured by the fund. Indeed, in August, many stocks that had previously been marked down harshly regained ground. Such volatility shows the need to take a detached long-term view in stock selection during periods of febrile sentiment.
The next 18 months are likely to be challenging for corporate Europe. Germany appears to have succumbed after its early resilience, with gross domestic product (GDP) down by 0.5% in the second quarter while the eurozone as a whole contracted 0.2%. While escaping the worst of the sub-prime fallout, the eurozone economies are now feeling the squeeze of high commodity prices, weaker consumer spending trends, a strengthening euro, tighter borrowing conditions and the knock-on of a US slowdown. While consumers are likely to come under increasing pressure over the coming months, some sectors and individual companies should prove resilient. These are the opportunities that the fund will seek to target.
Fund positioning
The fund has been positioned for more challenging conditions. Cyclical stocks have been sold or reduced. MAN, the German truck company, was sold in early 2008; Aalberts Industries, the Dutch industrial supplier and a long-term favourite, was reduced from 2.24% of the portfolio at the end of 2007 to 1.50%* by mid August; sales of consumer goods companies meant that the sector made up only 4.08% of the portfolio in mid August* compared to the 13.84% weighting in the fund's benchmark, the FTSE Europe excluding UK Index. Carrefour, the French food retailer, has hurt performance but the holding has been retained at 2.04%* of the portfolio. This is because activist shareholders have continued to force change, aiming to unlock the value of the property portfolio and shift Carrefour's focus towards profits rather than sales growth.
In mid August, the fund's holdings were trading at an average estimated price/earnings (p/e) ratio of 10.3 for 2009. Excluding financial stocks, the estimated adjusted free cashflow yield was about 10% for 2009#.
The fund's medium-sized company holdings have increased, making up 44% of the portfolio† compared to 33.1% at the end of 2007. This does not reflect any change in strategy but results instead from the opportunities that have presented themselves and falling stockmarkets, which took some holdings down into the mid-cap bracket. The fund's definition of medium-sized companies is between €1 billion and €5 billion and most of the fund's holdings are at the top end of this scale. They include world class companies that dominate niche markets. In this range, the fund is able to find companies with attractive attributes. Management should have a significant stake; the business should be focused and susceptible to in-depth analysis; and it should not suffer from the kind of heavy regulation affecting such businesses as big pharmaceutical companies and utilities. Favoured holdings tend to demonstrate recurrent earnings potential, offering protection in downturns and setting them apart from more exposed peers.
Industrials
The fund remains overweight in industrial stocks, which made up 25.62% of the portfolio in mid August against 12.63%* for the benchmark. It is important to note, however, that the fund's industrial companies are typically cash generative and have solid service elements attached. This provides strong recurrent earnings potential and lessens the cyclicality risk more widely associated with industrial stocks. Current holdings that remain well-placed despite tougher conditions include Kone, the Finnish lift and escalator operator, making up 2.63% of the portfolio, and Fuchs Petroleum, the oil services company, which makes up 2.50%*.
The key question is whether the risks among industrial stocks are now fully reflected in depressed market prices. Pessimists might argue that growing pressure on consumers means there is room for further falls. It would seem, however, that much of the bad news has been discounted. Growth will be hard to find in the coming 18 months but when it is found, and is cheap and safe from a balance sheet point of view, then it should be valued highly. On that basis, certain cash generative businesses are trading on substantial discounts and look unusually attractive, including a number of the fund's top 10 largest holdings.
Financials
The fund's financial sector weighting has come down from 18.55% at the end of 2007 to 14% in mid August against a benchmark's 25.79%* weighting. Financial stocks face further problems although some support may come from easing inflation and tentative signs that the US housing market is approaching the bottom. The credit cycle in Europe is, however, behind that of the US. Housing markets this side of the Atlantic are still in the early stages of a downturn, suggesting tough times lie ahead. In this environment there are likely to be further management changes at investment banks and takeover activity.
Sector weakness should provide attractive buying opportunities. The fund's strategy, however, remains selective and it is avoiding banks with questionable assets on their books. Such assets make it difficult to value banks and while a bottom fisher may be lucky and time a purchase ahead of a bounce, now is not the time for such risks. Instead, the fund favours financial stocks with clearer prospects. These include Sampo, the Finnish insurer, which has a sound balance sheet and is led by management with a large position in the business. Sampo, which made up 2.63% of the portfolio in mid August*, has a stake in another of the fund's holdings, Sweden-based Nordea. This has a strong banking presence in all four Nordic countries and an improving cost structure. The bank, which has a 1.70% weighting*, is expanding by acquisition in the mature Nordic region and operating a green field strategy in Eastern Europe.
A struggling banking sector has implications for any business requiring credit. The high-end, quality mid-caps that feature in the fund have, however, not as yet reported problems obtaining debt or been asked to overpay. The fund will continue to focus on companies that generate high levels of their own cash, which removes the need to tap banks. The Swiss pharmaceutical company, Actelion, first bought by the fund in October 2004, is a good example. This has a sound balance sheet and upside potential, with Actelion's recent deal with GlaxoSmithKline possibly justifying a revaluation of two to three times regardless of any wider economic slowdown. In mid August, Actelion was trading on 19 times 2009 estimated earnings and had a strong free cashflow yield#. It made up 2.70% of the portfolio*.
Energy
Oil and gas stocks made up 13.76% of the portfolio at mid August against 6.99% for the benchmark*. This negatively affected performance in July as the crude oil price retreated. The long-term story, however, remains intact. The fund has avoided drilling companies, which tend to be hit the hardest when the oil price falls. Instead, it has focussed on service companies that can redeploy their capital between production and other areas of oil field development. Current favourites include Fugro, the Dutch seismic and survey company, which makes up 1.93% of the portfolio*, and two oil service companies, CGG Veritas and SBM Offshore. These forecast continued profitability with the oil price anywhere above $40 per barrel. The $115 price in late August provides plenty of leeway.
Two energy majors, Total and Shell, remain in the portfolio as sound companies trading on inexpensive valuations. They were on 7.2 and 6.8 times 2009 earnings at 15 August and made up 3.30% and 2.71% of the portfolio respectively*. Both have interesting prospects in alternative energy. Another recent addition to the portfolio was Sulzer, the Swiss oil services company, which had fallen by about a third by mid August from its November 2007 peak. This derating meant that it was trading on about 12.5 times next year's earnings yet it operates in a strong niche and has attractive longer-term prospects.
Emerging markets
With GDP contracting in the eurozone and consumers under pressure, companies with emerging markets interests provide welcome growth potential. There are no guarantees that China, India, Brazil and the Middle Eastern markets will not be dragged down, but the signs are good. The fund plays these regions indirectly. Stock examples include lift-maker Schindler, which is catering for the construction boom in Dubai, and Wincor Nixdorf, the German cash dispensers maker, which is enjoying strong demand from India and China. Fuchs Petroleum, the world's leading independent lubricant provider, gains 25% of its revenues from emerging markets and expects significant further growth. Through investing in such niche players and maintaining its focus on the underlying prospects of individual companies, the fund should retain its potential for outperformance over the long term while providing protection if economic and financial conditions deteriorate further over the next few months.
†At 31 July 2008
*Source: New Star at 19 August 2008
#Source: New Star at 15 August 2008
Past performance is not necessarily a guide to future performance. The opinions expressed here represent the views of the fund manager at the time of writing and should not be interpreted as investment advice.