A bargain way to buy Europe’s best

The biggest trust in the Association of Investment Companies’ Europe sector, Fidelity European, looks for quality companies at a reasonable price using a rigorous investment process. It focuses on companies that can grow their dividends sustainably over a three to five-year horizon. 

While not an income-focused trust – the dividend yield is pretty modest at 2.2 per cent – managers Sam Morse and Marcel Stötzel use dividend growth as a metric to spot good companies. And by “good”, they mean businesses with positive fundamentals such as structural growth, disciplined use of capital and proven business models, which are also cash generative and have strong balance sheets. The portfolio is reasonably concentrated, with the top 10 holdings accounting for 46.2 per cent of the total, and the managers aim for low portfolio turnover, with a typical holding period for companies of three to five years.

The strategy has paid off in spades in the past decade, as the chart below shows. The trust has comfortably outperformed its peers on a 10-year basis, and came second over five and three years. Reflecting its focus on dividend growers, it has also increased its own dividend by an average of 12.1 per cent a year over the past five years.

Morse and Stötzel are under no illusions about Europe’s prospects in 2024, and prefer to “continue to err on the side of caution”, as they put it. They point to a series of risks for the continent, including geopolitics, the inverted yield curve and tighter credit conditions for companies. The latest inflation data for the eurozone came in at 2.8 per cent in January and was broadly seen as good news, but core inflation remained a bit higher than expected. Rate cuts could still be months away and, even once they start, rates are not expected to return to their 2021 levels any time soon.

But Morse and Stötzel argue that, in the long term, markets are driven by “real dividend growth of companies”, rather than by economic growth. The European stock market has some solid businesses that operate around the world, not just in Europe, and the managers try to single them out. 

As we recently pointed out (‘The funds backing Europe’s market darlings’), Europe’s best-known companies do not form a huge part of the index – particularly when compared with the heavily skewed US market. This gives active managers more room for manoeuvre and a better chance of outperformance. For investors, it means it can make sense to get active exposure to the region rather than opt for an index fund.

With the exception of Baillie Gifford European Growth (BGEU), whose high-growth strategy has recently delivered a blow to its performance, and European Opportunities Trust (EOT), which had a tough 2022, in the past decade all the investment trusts in the Europe sector have beaten the FTSE World Europe ex UK index.

Pricing power

In response to a less than rosy outlook for the region, Fidelity European’s managers are focusing on companies that have “superior pricing power and balance sheet strength, which should make them relatively resilient to a weaker economic backdrop”, said Morse. This includes Nestlé (CH:NESN) and Hermès International (FR: RMS) because demand for their products is “inelastic”, as well as chipmaker ASML (NL:ASML) thanks to its competitive position.

As of the end of 2023, ASML and Nestlé were among the trust’s biggest bets, some 2.8 per cent and 2.6 per cent above benchmark, respectively. While ASML’s share price climbed some 28 per cent towards the end of January off the back of a very positive earnings update, Nestlé has detracted from the trust’s performance in the past year.

“We have started to cautiously increase our exposure to some companies that have performed poorly recently and now look particularly attractive… Conversely, we are wary of companies that have historically demonstrated limited pricing power and are therefore more exposed to margin pressure, as well as those that are overly leveraged and could struggle as interest rates continue to be ‘higher for longer’,” Morse added. The trust also predominantly invests in large-caps.

This comparatively cautious approach makes it a less aggressive option than some peers, such as the aforementioned Baillie Gifford European Growth or BlackRock Greater Europe (BRGE), another trust with an outstanding long-term track record but whose racier portfolio saw a big drop in 2022. Fidelity European held up well in the market’s latest annus horribilis, losing only 3.8 per cent in 2022 against the benchmark’s 7 per cent. It then had a less buoyant 2023 than some peers, which gained more in the end-of-year rally, and its shares slightly underperformed the index in the year to December 2023.

A private equity twist

Despite a broadly cautious attitude, the trust is not averse to some spicier calls. It has a mostly non-benchmark exposure to private equity via publicly listed companies 3i Group (III), Partners Group (CH:PGHN) and EQT (SWE:EQT). 3i was the trust’s biggest overweight position as of December 2023 with a 3 per cent allocation, and thanks to the performance of Benelux discount retailer Action, its main asset, the investment trust returned over 40 per cent in the year to February, contributing to Fidelity European’s performance. 

Other significant bets in the portfolio include EssilorLuxottica (FR:EL), L’Oreal (FR:OR) and French industrial group Legrand (FR:LR). Like many European funds, it has a chunky allocation to pharmaceutical group Novo Nordisk (DN:NOVO.B), whose shares have been enjoying an extraordinary ride in the past year thanks to the success of Wegovy, the company’s weight-loss drug. But at 6.1 per cent of the portfolio, it is less prominent than in other funds. 

Fidelity European also makes ample use of gearing, which is somewhat in contrast to its cautious stance. Structural gearing was doubled in 2020 and, now at 13 per cent, the trust is the most geared among its peers. This has paid off in the past few years, although, as ever, gearing enhances returns when the portfolio is up but also magnifies losses. The trust also occasionally goes short on companies, with two short contracts for difference (CFDs) accounting for 1.2 per cent of the portfolio in June 2023. 

Fidelity European traded at a discount to net asset value (NAV) of 9 per cent on 5 February. With the average sector discount standing at 10 per cent, this is less cheap than some peers, perhaps unsurprisingly considering the trust’s strong track record. But the discount still represents an opportunity to get exposure to big European quality companies at a lower price. As the biggest trust in the sector, Fidelity European has a decent chance of seeing its discount close if market conditions improve, which would add to its NAV performance.