By Hamlin Lovell, NordicInvestor
European equities in general have produced disappointing performance but some high conviction stock-pickers, such as Jupiter’s Alex Darwall, have found hidden gems and compelling growth stories despite the sclerotic economic backdrop. Darwall has been managing money at Jupiter for over 20 years, and was able to share some insights into his team’s distinctive philosophy and process with NordicInvestor contributor Hamlin Lovell.
HL: How do Europe’s aggregate corporate profits in 2017, compare with 2007? Has Europe had a “lost decade” for corporate profits growth? How much of this can be explained by the problems of the banks?
Darwall: According to brokers European corporate profits have on average not recovered from their pre-Global Financial Crisis peaks. The mainstream banks have certainly had their challenges in the past few years but the reasons for Europe’s lower growth compared to the US and other markets run deeper. The European political class, which harbours some suspicion of free markets, is not helpful, compounded by a lack of flexibility in the labour market and over bearing regulations. Nonetheless there are reasons for optimism. Companies that can sidestep, as far as possible, these challenges and deliver products and services that consumers are willing to pay for, can thrive.
HL: You have been running money at Jupiter since 1996. What kind of profits growth have your portfolio holdings delivered over the past ten years? How many companies in your 2017 portfolio were also owned in 2007?
Darwall: Earnings growth has consistently been above market growth across the strategy. More importantly the reliability and consistency of those earnings have been a key attribute of the strategy both in bear markets, such as after the Internet bubble burst, post the GFC and Eurozone sovereign debt crisis, and bull markets. Two companies have been held continually since 2007 representing on average 12% of the fund. Over five years 10 holdings have been consistently held representing 43% of the fund on average.
HL: Europe’s economy has grown slower than have the US and Asian economies, but Europe is home to multinationals selling worldwide. What is the highest, lowest and average percentage of sales that your portfolio companies derive from Europe?
Darwall: Flexibility is a key attribute we look for in the companies we invest. On costs, they can typically shift them, perhaps recruiting software engineers abroad or sourcing workers on a cruise ship from afar, examples that would be harder for companies such as utilities. On revenues, global sales allow a company to tap into high growth markets and to weather the vagaries of regional economic cycles. Global sales are not a prerequisite for an investment: some excellent companies generate all their sales in Europe. Nonetheless, the majority of our holdings are global in nature: some companies in the fund generate less than a quarter of their sales in Europe. Currently under half the fund’s look-through sales are generated in Europe. Consider that some of the world’s most advanced agricultural technologies are developed by European companies that are prohibited from selling them in their home market, but can tap into healthy demand elsewhere.
HL: As a growth investor, your key sectors are TMT and healthcare. We could take one example from each.
Darwall: The fund’s sector allocation is a reflection of the areas of the market where we find companies that meet our investment criteria. Many companies in the fund are difficult to define because they are the ‘exception of the rule’ and therefore do not sit neatly into sectors. For example, two of our investments in alternative financials, which each own banks, are classified as Industrials. Moreover, we do not like to label ourselves as ‘growth investors’. A company must be profitable for us to consider an allocation, which helped avoid many a pitfall during the dotcom bubble. The starting point for any investment is to consider the downside, before assessing the management and only then do we look at the structural growth opportunities.
We have consistently been under-weight the telecom sector, even at the height of the dotcom bubble. We never held the likes of Nokia, Ericsson and Vivendi. These are typically capital-intensive businesses with fixed assets and unionised labour. Healthcare, meanwhile has been an area where we have been overweight over the years. A number of companies in this sector have been beneficiaries of technological advances as well changing consumer behaviour. For example, Novo Nordisk addresses the diabetes and obesity pandemic with its technologies.
HL: You look for disruptive technology. How is your largest holding, Wirecard, disrupting payments? The stock has multiplied by factor 20 over the past 10 years. Given your large cap focus, when did you first buy Wirecard?
Darwall: As generalists, we are firm believers in total market coverage and meet companies in all sectors and across market caps. We first bought Wirecard for the Jupiter European Growth SICAV in 2008 when it was a small cap holding. We believe the digitisation of payments is at an early stage and the company’s focus on technology and a flexible, global platform has served it well.
HL: In technology, are you confident that Infineon is geared towards secular growth segments, such as electric, hybrid and autonomous vehicles, rather than just riding high at a good point of the semiconductor chip cycle?
Darwall: We believe the key to successful long-term investing is finding companies with timeless, strong business characteristics. These include companies with a favourable industry structure, control over their destiny, flexibility over costs and revenues and global appeal. Structural trends offer a tailwind but are a secondary consideration. Infineon has a leading market position, a history of strong organic growth and its prospects are underpinned by several structural drivers, in our view.
HL: Have you found any interesting disruptive media plays listed in Europe?
Darwall: Advances in digital technology are bringing change and disruption to many industries. While some business models are being disrupted, others are thriving. Currently we do not have any direct investments in this sector. However, companies such as Carnival, the cruise line, which we believe are not being disrupted by digital technology (an e-cruise could not replicate the real thing), have developed their own digital offerings, such television series as a novel form of relatively inexpensive advertising.
HL: In healthcare, does Denmark’s Novo Nordisk have any real competitors in diabetes treatment?
Darwall: The diabetes care market is dominated by a small number of companies with cutting edge technology, a strong distribution network and global reach. History shows that it is difficult for new entrants to compete against them. Nonetheless, competition between these players is intense and their customers have demonstrated a degree of pricing power in insulin treatments.
Valuations and Value versus Growth
HL: Headline equity valuations are lower in Europe than the US. Is this partly due to Europe having a lower weighting in healthcare and technology companies that can attract higher valuations?
Darwall: We consider ourselves investors, rather than speculators. As investors, we focus on finding world-leading businesses. Where they compete with non-European companies, we may evaluate the differences on a case by case basis. We occasionally meet the management of companies listed outside Europe. The index composition, sector breakdown and weightings does not impact our decisions; the US index even less. Approximately 15% of the fund is invested in companies that are outside of the benchmark index.
HL: Are European equities on lower valuations than the US, when you compare like for like – meaning companies in similar industries, with comparable growth rates?
Darwall: Our benchmark, the FTSE World Europe Index, has consistently traded on a lower Price/Earnings multiple than the S&P500 Index since before the GFC. However, the S&P500 has outperformed this index (or the similar MSCI Europe) very significantly over that timeframe. We believe that portfolio of ‘special’ companies, backed by strong structural drivers, has the ability to eclipse the vagaries of index returns.
HL: For instance, how do Europe’s listed cruise ship operators, and clinical diagnostics specialists, shape up versus valuations of the US peer group?
Darwall: The top three largest cruise operators have a significant market share over the global cruise market. They have differing legal and tax setups, but their management teams are largely based in the United States and all have primary listings there. The cruise ship operators that compete with these three players, some of which are located in Europe, are typically small by comparison and the specifics of their business models make them quite different. The same can be said about the clinical diagnostics businesses. We prefer to consider the specifics of every business rather than sector generalities.
HL: Should European equities trade on lower valuations than in the US, given that return on equity is on average lower, and they will therefore be compounding at a slower rate?
Darwall: There are good reasons for US equities to be trading at a premium to European markets. Whereas President Trump is boosting business activity by lowering taxes, the European countries (including the UK) are planning tax rises, thereby choking economic activity. The US also benefiting from lower energy prices, whereas Europe is pursuing a high cost energy policy. However, Europe is home to many companies offering world-leading products and services, and we are confident that some of these – the exceptions to the rule – can compete successfully against the best on the global stage.
HL: The “growth” style of investing has outperformed “value” globally and in Europe since 2009, and in Europe some “value” investors have fallen prey to some particularly nasty “value traps” in sectors such as banks and utilities. You have outpaced the broad indices by c.6% annualised over the past 10 years, and also beaten the MSCI Europe Growth index – by what annualised percentage?
Darwall: Since 31 March 2007 to 30 June 2017, the fund returned 152% vs MSCI Europe Growth 78% and MSCI Europe Value’s 21%. Morningstar Europe Large-Cap Growth Equity has returned 60%. We believe that the differentiation between growth and value is a false distinction. Our ambition is look for companies with timeless, proven business models. We are confident that with a degree of patience, companies delivering good cash-flow will be rewarded by the market, trumping market fashions such as swings between growth and value.
HL: With an average of 35-45 companies in the portfolio, you show tracking error around averaging 6%, and active share above 90%, versus the FTSE World Europe Index. Would it also be informative to look at the metric relative to an index of European “growth” equities? Eg what is your “active share” and “tracking error” relative to MSCI Europe Growth? Have you ever owned stocks that were constituents of the MSCI Europe Value index?
Darwall: The tracking error of the fund versus the benchmark index is 6.3%.
The tracking error of the fund versus the MSCI Europe Large Cap Equity is 6.04%. The fund frequently has a number of investments trading below market average price/earnings, so some could conceivably be classified as ‘Value’ stocks. Unfortunately, we do not have the breakdown of the constituents of the MSCI Europe Value to check. We are therefore unable to run the Active share.
Valuation and tail risks
HL: Do you feel that valuations in some parts of the growth universe in European equities are too high? eg some luxury goods firms?
Darwall: We make our investments without reference to the index. We also do not split the universe of companies available to us – around 3,000 companies – between growth and value. We eschew labels such as these, preferring to focus on the specifics. How would a lossmaking internet or 3D printing company be classified?
We have been consistently under-weight the European luxury goods firms. We have clearly missed out: they have been exceptional investments. We have found it difficult to assess whether their products are classic in nature, with consistent, stable earnings, or fashionable products, with inconsistent demand. We typically prefer measurable, proven differentiation, such as that offered by an improved plant germplasm or corn inoculant that field trials showed increased crop yields. The benefits of technology can be split between the producer and the customer, making for a straightforward business model. The ownership structure of some of luxury goods companies has also been problematic for us, as these companies are not always managed for the benefit of minority shareholders. We only invest in companies where we believe we have understood something different to others, which is not the case here. We do not invest in a company on outwardly favourable valuation metrics without first having confidence in the business model and forming a favourable impression after meeting the management.