Global poor relations hit big time

Europe and Japan used to be regarded as the poor relations of the global economy. These economies, however, look stronger than they have for many years. Eurozone economies, for example, enjoyed their strongest growth for six years in the second quarter of 2006, out-stripping both the US and the UK. While gross domestic product grew 0.9 per cent in the 12-nation eurozone in the second quarter of the year, the UK expanded 0.8 per cent and the US grew 0.6 per cent. France’s economy grew at an annualised rate of between 4.5 per cent and 4.9 per cent while Germany expanded at a rate of 3.6 per cent. This comes on the back of strong performance from European stock markets. Over three years to 24 July 2006, according to Standard and Poor’s, the S&P Europe 350 returned 64.72 per cent. Obviously, this does not mean European economies are not without their risks. There are concerns that inflation could rise above 3 per cent next year, particularly if the oil price remains high and wage pressures grow, leading to higher interest rates. Restructuring could falter and the global economy might slow more than expected later this year. While there are macro economic concerns, their importance varies from one fund to another. A wide range of investment approaches is used by the largest cross-border funds in Europe. Many take a bottom up approach, with little consideration of macro economic developments. Mixing it up Some funds use a mixture of top down and bottom up approaches, others invest on a sector basis and some focus on companies with attractive dividend yields or which are growing their dividend yields. Whatever their approach, all funds were impacted by the stock market volatility in May and June. Gary Clarke, manager of the Schroders ISF European equity fund, for example, says it has been an interesting few months for European stock markets. “From the start of 2006 to May, the market continued to be led by small and mid caps and cyclical stocks,” says Mr Clarke. “Since then, there has been a change in the market environment, which has been linked to interest rate expectations in the US. The question is whether this is an inflexion point. “I believe there has been a major change. I do not believe we are in the Goldilocks scenario we have enjoyed since March 2003, in which reduced interest rates increased growth. This led to greater focus on riskier assets, such as small and mid caps and emerging markets. I believe we are now in a normal market environment.” As a result, Mr Clarke has increased exposure to large caps even though the fund has a large proportion of small and mid caps because “that is where the growth opportunities are to be found”. Mr Clarke has also raised his exposure to defensive stocks. “Bayer in Germany, for example, has pharmaceutical and chemical operations. It has acquired pharmaceutical company Schering, which has made Bayer more defensive. “Continental was over-sold. It started May at ?97 then fell to ?71. We bought at that point and it has since recovered to ?80. “We like Mittal Steel. It is the largest steel company in the world and has a 10 per cent global market share. It is still cheap as it has not been well covered but that is likely to change.”

‘We do not take strong views on economic growth, currency movements and the oil price. Our time is spent more effectively on selecting stocks’ - Gary Clarke, Schroders

Mr Clarke says his fund – which has returned 79.75 per cent over the past three years compared to 64.72 per cent from the S&P Europe 350 index – is a stock-picking fund that puts a lot of importance on valuations. “Growth is difficult to predict. We look at whether a company can deliver excess returns above the market over the next three to five years. We do not take strong views on economic growth, currency movements and the oil price in selecting stocks. We believe our time is spent more effectively on selecting stocks.” Undervalued stocks The largest European equity fund domiciled in Luxembourg or Dublin is Fidelity Funds European Growth. Victoria Cheeseman, analyst at Fidelity, says the manager Graham Clapp has access to 70 pan-European analysts. The analysts offer stock ideas, including in emerging Europe where around 9 per cent of the portfolio is invested. Mr Clapp looks for stocks that are undervalued by the market, companies that generate faster than average growth, where the market forecasts for corporate earnings are too low or there is an unrecognised recovery of companies. He takes a bottom up approach and has a bias towards mid cap stocks. But the fund, which has more than 200 holdings, has been increasing its weighting towards large caps recently “because of the greater number of investment opportunities in this part of the market”.

Barakos: volatility creates opportunities

The fund is overweight in oil, energy and support services companies. It is under-weight in telecoms stocks and slightly under-weight in pharmaceutical companies. Fidelity Funds European Growth is more than three times larger than the next biggest fund. But Ms Cheeseman says the size of the fund at ?21.49bn has not led to a dilution of the investment process. “We are fully invested and we have not had any difficulty in being able to invest the assets in sufficient opportunities.” The performance of the fund has not been as strong over one year to 24 July 2006 (12.4 per cent) as over three (73.88 per cent) and five years (38.89 per cent). Ms Cheeseman attributes this to many mid cap stocks “taking a hit over the past few months and some disappointing performances from oil and pharmaceutical stocks”. She adds that stock markets have been driven recently by sentiment more than fundamental factors. Cheap companies Michael Barakos, manager of the JPMorgan Europe Strategic Value fund, which holds more than 300 stocks, says he focuses on investing in value stocks. “We buy companies we believe are cheap. It is a bonus if the company grows faster than the market average. But just because stocks are cheap it does not mean they will not grow fast.” Mr Barakos says he has to strip out value traps from the potential investment universe. “Some stocks are cheap for a reason. This is because they are serial under-achievers. They regularly disappoint the market through under-achieving results or profit warnings.” Deutsche Telekom is an example of a value trap stock, according to Mr Barakos. “Deutsche Telekom has a single digit P/E and a dividend yield of 4 to 5 per cent. But the cheap price is caused by the company serially disappointing the market in its earnings growth.” In valuing stocks, Mr Barakos says he uses price earnings measures. This is both on a historical and prospective basis. A key part is to find companies where there is a catalyst for them to reach their true valuation. To manage risk, Mr Barakos says he limits sector exposure to 10 per cent overweight positions to prevent it becoming a thematic fund. Mr Barakos is currently finding opportunities in the financial sector, which represents a significant proportion of the European market. “Many stocks have single P/Es yet are delivering earnings at least in line with expectations if not better.” He highlights French banks as well as Barclays and HSBC. “They have delivered better than expected and high quality results.” The correction in May and June has created greater investment opportunities, says Mr Barakos. “Volatility in markets presents opportunities. Industrial cyclical stocks have been sold off aggressively over the past few years, for example.” Over five and three years, the fund has returned 44.61 per cent and 74.45 per cent respectively. But over one year, the fund has returned 15.39 per cent and is ranked 62nd. Mr Barakos says that while the market over the past five years has favoured a value approach, the last year has been more difficult for value funds. “We cannot go against the environment for value stocks but we expect to out-perform the value index.” No minimum The DWS Invest Europe Dividend Plus LC fund selects stocks that have a high dividend yield or a growing dividend yield. Michael Sieghart, manager of the DWS Invest Europ Div Plus LC fund, says around 90 per cent of the portfolio is invested in large cap stocks. This explains why the fund is ranked 218th with a return of 10.56 per cent over the past year.

‘We expect dividend growth in the energy sector. They have large cash flow growth so this could lead to special dividends’ - Michael Sieghart, DWS

“Companies do not need a minimum dividend yield to qualify for the fund,” says Mr Sieghart. “This is because we invest in stocks that we believe will grow their dividend yield. Companies, however, usually have a dividend yield of at least 2.5 per cent. This results in a portfolio of 60 to 70 stocks.” Dividend yields can be volatile and they have improved since the recent correction. The average dividend on the EuroStoxx 600 index is 3.2 per cent while it is 3.5 percent on the EuroStoxx 150 index. The UK has traditionally had a higher dividend yield than continental Europe so it is not surprising this market comprises 35 per cent of the fund. In choosing stocks, Mr Sieghart says he takes both a top down and a bottom up approach. This involves the selection of sectors and then his favourite stocks within them. He says the fund takes a fundamental approach to selecting stocks, which involves 2,000 company meetings a year. Mr Sieghart says conditions are not perfect for dividend funds but liquidity will support equity markets. “If market growth is driven by large caps from now on then that will favour this fund because of the bias we have towards large caps.” Since the fund was launched, says Mr Sieghart, it has out-performed the index by 2 per cent. Over one year, it is not so good, returning 12 per cent against 14 per cent by the large cap index. He argues that the fund should be compared against a large cap index rather than a mainstream pan-European index. He favours energy stocks because of their windfall profits. “We expect dividend growth in this sector. They have large cash flow growth so this could lead to special dividends. We like oil services companies and expect dividend growth from continental European banks. “We like Société Générale, UBS and DnB, for example. DnB has a 66 per cent market share in Norway. UBS is the leading private bank in the world. It has excellent management, good underlying growth and an increasing dividend yield. It is attracting a lot of the millionaires and billionaires from emerging markets.” Robert Burdett, co-head of the Credit Suisse Portfolio Service, says it has been over-weight in European equities for a while. In fact, Mr Burdett has been adding to his exposure to this region recently. Growth to come “Europe has been behind the global economic cycle so there is further growth to come,” says Mr Burdett. “There has been structural change as well, although there is more to come, notably in France.“European equities are not especially cheap but they offer attractive valuations compared to other asset classes and on an historical basis. This is despite the fact that interest rates are likely to keep on rising while they may have reached their peak in the UK and US.” Mr Burdett’s Luxembourg-based Pan European Portfolio holds 20 funds. He says these provide a range of investment approaches. “Some are pan-European managers, some are single country funds and some are European ex-UK managers. Artemis takes a quantitative investment approach, others are stock pickers and some like Rod Marsden at JO Hambro Capital Management take a sector and more of a macro view.”