Investec’s European Equity team is a part of the broader 4Factor investment team, one of seven distinct investment capabilities at Investec Asset Management. The 4Factor team is responsible for between $30-35 billion dollars of client assets. Ken Hsia, Lead Portfolio Manager of the European Equity Fund, summarized this investment process during his recent visit to Miami.
«We believe that equity markets are inefficient by definition, but the level of efficiency varies depending on the headlines,» he explains. Right now, investors are hearing news on the slowdown, the United States’ presidential election, or the referendum in the UK, the type of news that grabs their attention and which has created volatility in recent times, causing major inefficiencies in the markets. «As securities’ selectors, our job is to be able to exploit these inefficiencies.»
Why do these inefficiencies exist? «Due to market participants’ behavior errors; there are certain patterns that, when it comes to investing, cause investors to buy expensive and sell cheap» replies Hsia, adding: «We believe that by doing things right you can achieve better results consistently over time.»
To achieve this objective, they apply− from a benchmark, style, and capitalization agnostic approach− their «4Factor» process, which leads them to analyze four different aspects: high quality− those companies that have created value for their shareholders in the past−, attractive valuation−, those that are cheaper than the average in terms of cash flow return on investment and asset based valuations−; improved operating results−, those that are seeing their profit forecasts revised by analysts−, and increasing attention from investors−those starting an upward trend−.
The first two, both traditional ones, are the ones which help to find high quality corporations at attractive valuations, and the last two, related to behaviors, the ones which help to choose the right moment to take or leave positions and to avoid behavior errors.
Why Europe, and why now?
Corporate revenues and profits will grow, thanks to commodities.
European markets, which Hsia considers to be at an early stage of the profit cycle, have not had any returns in recent months to evidence the start of the recovery to which the fund manager refers, but he explains that the fall in commodity prices during the last 12-to 18 months (e.g. oil has dropped from more than $ 100 a barrel to oscillate between 35 and 45, and iron has dropped from over $ 100 per ton to between $40 and $50) is weighing heavily on the ROEs. And whether or not they appear in his own portfolio, Royal Dutch, Total, BHP Billiton, or other securities with exposure to commodities, weighed on the fund’s benchmark- the MSCI Europe.
«The two most interesting facts are that for 2017 analysts expect an increase in earnings in European corporations of an ample double-digit, and that commodities will shift from curbing their growth, to propelling it,» while during 2014 and 2015, the underlying trend in earnings per share (EPS), excluding commodities, approached 5%, and for 2016 the general consensus places it at between 4 and 6%.
There are signs of recovery.
«We have identified two cyclical sectors that provide some recovery signs». On the one hand, car sales, which are a clear indicator of the confidence of investors, have been recovering since 2013, and in Europe grew by 8% in the first quarter of this year, although with differences between countries. Although still at a level of 15% below their previous highs, the fund manager is confident that these will once again reach their previous peaks, as car sales have done in the US during this recovery; the other sector with telltale signs is the cement industry. For example, the greatest difference between this product’s peak and lowest consumption rates in Spain was 80%, and 50% in Italy, both of those markets are now in recovery.
Given the slow recovery process−which frustrates some investors− and to provide depth to the study, the team looks at each sector in detail, therefore, Hsia speaks, of commercial real estate, for example, which, especially in southern European countries, is in the hands of private families or insurance companies, which have received no incentive to reinvest. «Energy efficiency in Italy or Spain is not optimal, as only 15% of office complexes obtained the highest («A») rating, while in France and Germany more than 30% have achieved that rating, with up to 40% in the United Kingdom, so it is necessary to improve the system» But we’re also seeing actions that will change the sector, such as that regulation in Italy is shifting from favoring property owners to favoring tenants, and the emergence of REITS in Europe, which are facilitating the inflow of capital to carry out these improvements in the sector.
These are just some examples showing recovery, says the fund manager, who admits to having mixed feelings, because, while he wishes improvement for that environment, which in turn favors the whole world, he believes that it’s best for investors if recovery doesn’t come too fast because «when economic growth is very strong there is more competition.»
Balance sheets are growing.
Corporate balance sheets are in recovery and much healthier than in 2008-2009, thanks to improved operating cash flows that the gradual growth of the economy and strengthening demand have brought about, as well as the fact that some companies no longer rely on high future economic growth and are streamlining their costs and cleaning up their balance sheets, which will also create more value. Should we expect more mass layoffs? Not necessarily, says the strategist, cost rationalization can also be achieved by an improvement in the production process, acquisitions, etc. We think that unemployment should fall.
Valuations remain attractive
With a cyclically adjusted P/E ratio 15x earnings and a historical average of between 20 and 21, the opportunity seems clear, and the strategist is confident that it will return to maximum levels. Another favorable factor is the lack of issuance of sovereign bonds by the ECB, which will cause the flow of investment into other types of assets, such as equities.
«In short, there are signs of growth, sometimes frustratingly slow, but that is what increases the difference between winners and losers.»
«In an environment such as this, we see that there are sectors whose indicators improve, such as the industrial, although in our portfolio it remains underweight in relation to the benchmark; in this, we have included Siemens, which is shifting from obsolete businesses to creating a new supply line more tailored to current consumer requirements. Other sectors we like are information technology, the most overweight in our portfolio, and consumer discretionary. Not so with consumer staples, where we don’t see any value, or healthcare.»
Regarding the financial sector, adds Hsia, in which we are overweight by 2% in relation to the benchmark, we are pragmatic about its enormous volatility, but we like FinTech, banks focused on retail business in countries where consolidation has already occurred, such as France, Benelux and the United Kingdom, and not so much in those in which there is still much fragmentation− Germany, Italy and Spain−, because, although we see some consolidation, we can’t see any creation of shareholder value. Nor do we like investment banks in Europe and we are underweight in insurance and real estate.
By country, the UK, which although accounting for 24.7% of its assets− with much diversification−, is 5% underweight; France is 6% overweight, and Germany, by slightly higher than 6%, is the one he likes best. «When we saw the first ECB rate cut, we believed that there would be opportunity in Germany, but then Japan, its largest competitor, lowered rates and this was circumvented. However, we do find good ideas now.
Seizing the opportunity that Hsia lives in London, we asked about the sectors which could be most affected if the referendum to be held in June in UK propels a «disengagement» from the EU. He doesn’t seem worried about this and points out that, large corporations have a «B» plan and perhaps one of the most affected would be agriculture, but neither banks nor other big companies worry him because «they hopefully will have enough time, and have the resources to prepare their structure for an environment which could change.”
Once again, he summarizes: «The biggest driver of European equities will be corporate earnings, as the headwind has turned to become a tailwind».