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November 2023 may not be a particularly memorable month for most, but for us it marks an important milestone – the three-year anniversary of the VT Downing European Unconstrained Income Fund. It also happens to be three years since Pfizer announced the stunning efficacy results of its Covid-19 vaccine - effectively marking the beginning of the end of the pandemic era. It seems timely for us to reflect on the three years gone, but more importantly, assess what the future holds for the fund.
The Pfizer vaccine announcement was significant as after the bleak pandemic years we were finally able to look beyond the lockdowns that had laid waste to the global economy. The market was euphoric. Investors piled into reopening plays. ‘Covid losers’ became ‘re-opening winners’ and risk appetite surged on the promise of things returning to normal. But times had changed – a Sea Change as Howard Marks has coined it. Three years on from a vaccine, and those early hopes for markets haven’t panned out quite as expected.
After what was a decade of near zero interest rates, the vaccine was the starting gun for a resurgence in inflation. Consumers emerged from lockdown eager to spend their Covid savings, while at the same time, frozen supply chains became snarled up. Labour markets tightened, logistics were disrupted and semiconductors were in such short supply that waiting lists for new cars ballooned. Goods, services, and labour were bid up and inflation spiralled. As central banks grappled to curb the surging prices, sharp interest rates rises savaged bond markets and hurt valuations, with growth equities and small and mid-caps most impacted. If that wasn’t enough cause for concern, geopolitical risks erupted. Russia’s invasion of Ukraine saw war sadly return to Europe, and recent troubles in the Middle East point to a much more uncertain world. The worrying spectre of a China-Taiwan conflict hangs unnervingly in the background. As things stand, 2024 doesn’t have the makings of a vintage year in terms of equity market returns. With a growing list of things for investors to worry about, why then are we so excited about the future?
Contrarian stock picking to the fore
For a long time now, it feels like returns have been driven by getting factor bets right. Growth over value in the pre-pandemic, zero-interest rate years. Now it’s value’s time in the sun. Large caps over small caps has been the winning trade in recent times. Much of these factor moves have been driven by an overarching view of the macro and on the trajectory of interest rates.
As inflation and rates gradually find a new equilibrium, we find ourselves in a new investment landscape. One, we hope, where company fundamentals and valuation really matter. As long-term stock pickers, we find our best ideas when there are high levels of stock dispersion. Sometimes regarded as volatility, this more specifically refers to the difference between individual stock price movements and the market average.
Right now sentiment is very fragile, and stocks are moving all over the place. Within sectors, we are seeing huge disparities between the share performances of otherwise similar companies. If a company is deemed an AI winner, there is no ceiling on valuation. If pigeonholed as an AI loser on the other hand, the market pummels the shares down to a valuation that implies collapsing revenues. Stocks are trading irrationally on narratives over fundamentals.
Former growth darlings such as Worldline (payments company) and Teleperformance (business services), are now trading on single-digit P/Es. Kering, the owner of Gucci, is on half the valuation of luxury goods peers. Are these moves justified? We think not, and there is a growing list of opportunities to buy great companies at cheap and often distressed valuations. However, the biggest contrarian opportunity is in smaller companies.
Small and mid-caps at multi-decade lows
Looking at blue-chip indexes, equities have seemingly performed pretty well. But beneath the surface, smaller companies have been battered. Risk aversion has seen small caps sold to fund flows to large caps, with passives and ETFs exacerbating this move. Since the vaccine announcement, the broad European index has outperformed smaller companies by c.20%. The largest 50 companies are up 20% during that period compared with smaller companies that are down 5%. Valuations of smaller companies are at multi-decade lows compared with large caps, despite their superior growth potential.
With two-thirds of our fund invested in small and mid-caps, this has been a frustrating headwind. Looking forward, we believe this remains the biggest source of opportunity. Smaller companies have generated superior returns over the long term, and we expect the future to be no different. Furthermore, Europe is at the forefront of a once-in-a-generation theme that could see a number of these small, and not well-known companies, be the winners of the future.
Europe’s green revolution
The green energy transition is the biggest reallocation of capital since the Industrial Revolution. Net zero targets will see trillions spent on rebuilding the world’s energy infrastructure. Ever since the Kyoto Protocol of 2005, Europe has been at the forefront of this move. With limited fossil fuel assets, Europe is striving for net zero. Russia’s isolation has made energy independence a political imperative. With this as a backdrop, a young industry is shooting up in support of the transition. Renewable energy and electric vehicle supply chains are being built from scratch, and carbon capture and hydrogen technologies although still in their infancy, are being developed at pace. The long-term investment opportunity is enormous.
“When you are in a gold rush, sell shovels”
While the US is home to technological innovation, the European market is full of leading industrial companies. From Schneider Electric and its expertise in energy management, down through a long tail of companies that specialise in various critical niches, Europe is beginning to dominate many aspects of energy transition. Complex and dynamic supply chains make for great opportunities for a stock picker. We are scouring these supply chains, looking for tomorrow’s winners. These are not always the obvious plays. Many fly under the radar. For example, one of our preferred plays on electric vehicles is not lithium (as favoured by many investors), but dehumidification systems. With lithium being highly reactive to water, it needs to be processed in a dry room. In fact, c.20% of the capex of a gigafactory is the dry room, with a large amount spent on dehumidification systems. A small Swedish company, Munters (whose founder pioneered climate control) is at the forefront of developing and installing these solutions. It also leads the way in data centre cooling systems, an even more under-the-radar way to play AI given the number of data centres springing up. With a large proportion of the fund invested in similar companies, we are excited about many of the other plays along these various value chains.
Near-term challenges, long-term opportunity
Markets are precariously positioned right now. Leading indicators are soft, and companies are profit warning with increasing frequency. We are very mindful of the fact that Europe could tip into recession. However, we are positioning the portfolio in front of a wave of capex linked to energy transition and it is therefore less cyclically sensitive. We are seeing that in order books of our industrial companies which are booming. In time, we think this will be fully reflected in company valuations.
The macro-outlook is weak and investors are nervous. Allocations to Europe are low and valuations are historically cheap. Small and mid-caps have been hammered and investors are crowding into large caps. Why are we still so excited? Because so many of our holding companies are!
Risk warnings: This has been prepared for investment professionals only. Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice.
Important notice: This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025).
