This article appears in the November 2020 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
As European economies struggle to survive the coronavirus pandemic, the region’s stock markets — which lack exposure to the massive tech giants turbocharging U.S. markets — are sagging.
Economic growth in the European Union (EU) contracted by 11.8% in the second quarter of this year and Covid-19 infection rates in many eurozone countries are rising, dashing hopes for an economic recovery.
The European Commission recently estimated the EU economy will shrink by an annual rate of 8.3% in 2020 despite almost US$600 billion in stimulus efforts so far. EU countries are still ironing out the details of another US$860-billion relief package, which must be ratified by all 27 EU states.
Risks are tilted to the downside, with the possibility of a severe subsequent wave of infections and a return to restrictions on social and business activity, a protracted domestic fallout and depressed exports to international markets.
David Moss, head of European equities with BMO Global Asset Management Ltd., senses a nervous mood in European markets attributed to virus cases on the rise and uncertainty about what cold weather might bring.
“There have been huge liquidity injections and government support in just about any country you can think of, and the financial support is likely to continue well into 2021,” says Moss, who works in Dover, U.K., and is lead portfolio manager of the BMO European Fund. “What’s going to happen when the [stimulus] bill comes in, we don’t know.”
Despite the stimulus, European stock markets have been slow to recover: on Sept. 30, the MSCI Europe index was 12.75% below where it started the year, a poorer showing than the year-to-date gain of 5.6% for the S&P 500 composite index.
The BMO European Fund Series F declined by 0.4% during the same period. The fund had a three-year average annual compound gain of 2.9% as of Sept. 30 and a top-quartile five-year average annual gain of 4.8%.
“Europe has been out of favour for a while, but the lag has been exacerbated during the Covid period,” Moss says. “What has been working lately has been the ‘stay at home’ stocks, and there are more of those in the U.S. than in Europe. Europe has some great tech companies, but does not have giants on the scale of Amazon or Apple.”
The BMO team’s strategy is to seek European companies that are global leaders with multinational operations that are not dependent solely on the domestic market. Furthermore, the team looks for companies that can prosper through economic cycles and have a strong business advantage relative to competitors.
Once these superior companies are found, they tend to remain in the BMO fund for at least three years. Recent annual turnover of holdings was a relatively low 27%.
The BMO fund currently holds 41 companies and usually is diversified by sector, but is not necessarily exposed to all sectors, Moss says. For example, there are no utilities, telecoms or oil and gas producers. Environmental, social and governance criteria are important, and the BMO team focuses on firms with sustainable business models.
“We like to run a concentrated portfolio, where every stock matters,” Moss says. “But we also like to have a wide breadth of businesses.”
The biggest sectors in the BMO fund are health care, technology and consumer goods. A few companies were sold in the spring after the Covid-19 crisis hit, including Dutch multinational bank ING Group and Italian bank Intesa Sanpaolo SpA.
“We recognized interest rates would remain low for a long time and it could also be a difficult environment for economic activity,” Moss says.
Another discard was Lenzing AG, an Austrian company that produces wood-based viscose fibres used in clothing and textiles as an alternative to cotton. The BMO team was worried about the financial burden posed by some of Lenzing’s necessary capital expenditures.
However, the stock market drop in the spring presented the opportunity to buy Switzerland-based Lonza Group AG at an attractive price. Lonza is a global partner of various pharmaceutical and biotech organizations and is collaborating with U.S.-based Moderna Inc. on developing a Covid-19 vaccine. The BMO fund already held a small position in Lonza, and Moss was watching the company for some time. Lonza’s shares have now risen in price.
Health care is the largest sector holding in the BMO fund. Key holdings include AstraZeneca PLC, Novo Nordisk A/S and GlaxoSmithKline PLC. Another important name is Netherlands-based Koninklijke Philips NV, a leader in diagnostic imaging and patient home-monitoring equipment.
Shares in Italian luxury sports car manufacturer Ferrari SpA was a recent purchase. Ferrari has fat profit margins and knows how to market its high-end brand, Moss says. The company shut down production temporarily in the spring due to Covid-19, but has reopened. Product scarcity has served to increase orders, Moss says.
Matt Peden, vice-president and portfolio manager with Atlanta-based Invesco Advisors Inc. and portfolio co-manager of the Invesco Europlus Fund, views the current European stock market environment as “highly speculative.” He says many stocks’ prices are at elevated levels due to massive amounts of fiscal and monetary stimulus by governments and a dearth of attractive fixed-income alternatives.
“There is a significant risk of a second wave of the virus and it may already be here,” Peden says. “People may decide to shelter at home even if there is no lockdown. We are avoiding companies where an optimistic recovery scenario is priced into the stock. We’re focusing on companies that can perform well even in a tough economic environment and where there is an opportunity to be compensated despite the risks.”
The Invesco fund maintains a cash position of about 20%. The level of cash has been high for the past couple of years because the Invesco team sold some fully valued positions and has faced a lack of attractively priced stocks to redeploy the proceeds. Although high cash levels can hinder fund returns in rising markets, the Invesco Europlus Series F version had a mildly positive year-to-date return of 1.1% as of Sept. 30 and a three-year average annual compound return of 7.7%.
Although European stocks have lagged more robust North American markets and remain below pre-Covid levels, valuations remain inflated in many high-quality businesses. Peden sees few attractive buying opportunities. He is maintaining a highly concentrated portfolio of 15 stocks, and always invests in fewer than 20 names.
“We firmly believe in putting conviction behind the best opportunities,” Peden says. “We focus on high-quality businesses that are dominant market leaders with a competitive advantage and high certainty of growth. We avoid cyclical, low-quality companies.”
For example, the Invesco fund has avoided bank stocks for the past 10 years, as Peden believes the banking business is highly commoditized in Europe and “doesn’t stack up in terms of quality.”
One of the Invesco fund’s largest holdings is Benefit Systems SA, which administers workplace benefits and is Poland’s largest fitness club operator.
In the health-care sector, a top holding is Eurofins Scientific SE, a Luxembourg-based global operator of laboratories that test pharmaceuticals, food and agricultural products. Eurofins also covers Covid-19 testing and conducts prenatal tests for genetic conditions.
Another key holding in the Invesco fund is German company Scout24 AG, which specializes in online listings for real estate and automobiles. Peden says the service offers a wide assortment of tools that allow agents to promote properties and customers to target their searches.
“Scout24 benefited from the lockdown and subsequent recovery as people began to look for different kinds of housing space in the post-Covid environment,” Peden says.
The Invesco fund continues to hold Belgium-based Anheuser-Busch InBev SA/NV, the world’s largest brewery that’s known for brands such as Budweiser, Corona and Stella Artois, even though the firm has been hurt by shutdowns of bars and nightclubs.
Peden recently sold holdings in two businesses that had risen to fully valued levels: Just Eat Takeaway.com NV, a Dutch online food ordering platform, and Domino’s Pizza Group PLC, the U.K.-based franchisor of the American pizza chain. Proceeds of these discards were reinvested in existing holdings rather than used to add new names to the portfolio.