139. Europe: Inflation, M&A and the return of the tourist

Every year, European companies source more and more of their revenues from outside the continent. In this podcast, Niall Gallagher, manager of GAM Star Continental European Equity, tells us about this, the debt-laden balance sheets of long-haul carriers, and why private equity firms find it harder to make takeover bids in Europe than in the UK. With pricing power beginning to return along with very strong wage growth, Niall also gives his views on inflation and different types of company that can benefit from rising prices and interest rates.

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GAM Star Continental European Equity invests in large companies, with the team preferring those they believe will grow faster than the index. The team looks to buy stocks at the point where they are either out-of-favour or where growth prospects are believed not to be fully reflected in the share price. The fund has a low turnover and is not constrained to an index.

Read more about GAM Star Continental European Equity

What’s covered in this podcast:

  • Where in the world European companies get their revenues [0:25]
  • Which European companies have benefitted from changing behaviour during the pandemic [1:41]
  • Why the manager believes inter-regional flights will come back faster than long-haul [3:50]
  • How the European earnings season is shaping up [5:55]
  • If higher US inflation is feeding through to Europe [7:24]
  • How to invest in a rising inflation environment [9:32]
  • If M&A activity is picking up in Europe [11:37]

1 July 2021 (pre-recorded 28 June 2021)


Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.




Darius McDermott (DM): I’m Darius McDermott from FundCalibre and this is the Investing on the go podcast. Today our subject is European equities and I have the pleasure of the company this afternoon of Niall Gallagher, who is the manager of the Elite Rated GAM Star Continental European Equity fund. Good afternoon Niall.


Niall Gallagher (NG): Good afternoon.





DM: So you were one of our first podcast guests, over 18 months ago, and at that time you talked about how Europe was less important to European equities, is that still the case? And maybe just tell us a little bit about what that means.


NG: Yeah, so the point I was making back then, the point certainly applies now to an even greater extent, is that a minority of the revenues of the European equity markets are derived from Europe. The majority are derived from outside of Europe. So that would be places like United States, Canada, going into Asia, particularly China is increasingly important, other parts of Asia ex Japan, Japan, and then into Latin America and little bits from Africa. So if we break down the revenue split between Europe and non-Europe, it’s about 45% domestic Europe and 55% non-Europe. And that percentage has been growing over time. If we go back to 1990, 75% of revenues of the European market came from Europe. And now, as I mentioned, it’s 45%. So over time, every year in fact, the proportion of the revenue that comes from outside of Europe grows, because the non-European bits are growing more quickly than the European bit.




DM: So let’s talk about the pandemic and some of themes I think, has been well discussed on this podcast, but within Europe, what sort of trends have you seen, European equities that have either been accelerated or in fact decelerated by the effect of the pandemic? What have been the really hot areas or areas to avoid?


NG: So obviously we’ve had a pretty extraordinary period, not just with the pandemic, but how we all reacted to it, our own behaviours, and then some of the forced behavioural changes because of the restrictions that were placed upon us. So some of the obvious ones where there was a big switch in commerce. So people’s shopping behaviours from the offline world to the online world. So businesses like a Zalando, which is a big European online fashion portal, a bit like ASOS, but a lot bigger, that really boomed last year, as people in places like Italy and Spain began to shift their behaviours from the physical world into the online world, kind of catching up to an extent that people in the UK and Germany, where online penetration was higher. Saw the same in Italy in some of the, we own a bank called FinecoBank. We saw that there too. So that was one trend that was very pronounced.


Another trend we saw was people not using cash anymore. I mean, it’s not just the online transactions, people seem to almost have a revulsion for touching cash. In their… if you go to a cafe or restaurant or a bar, if they’re open, people tend to tap their phone nowadays or tap a card. So we all have a big switch towards payments.


And the final one, which was some of the kind of already built last year, was this big divergence in growth in consumption. We’d seen between Asia and Europe, but also Asia and the US that really accelerated. So we’ve seen a very, very big pick up in the growth rate, that’s driving many of the European luxury stocks or some of the powerful consumer staple stocks, like a L’Oreal and that sort of accelerated to. They have, you know, to what was discussed a moment ago, they’ve also really benefited the share of non-Europe in European equities, but those have been some of the trends that have been really accelerated over the course of the last 15 to 18 months.




DM: An obvious area, which has suffered is tourism. We were talking briefly before we recorded this podcast about our lack of holiday plans for the summer. When we last spoke, you talked about sort of inter-regional flights being the obvious first return but 18 or whatever it is, 16, 18 months on, as US looks to open its corridors as its vaccination program is reasonably accelerated, do you think we will see more travel to the US rather than into Europe? And are you spotting any early changes in tourism that you can exploit?


NG: No. I think we still believe that the intra-European and obviously intra-US and intra-China travel will go first. Europe is lagging behind. I think it will pick up. So we’ve seen, we will see, from the 1st of July that intra-EU travel restrictions will pick up, whether the UK gets included in that or not is up for debate. And we can debate the reasons why. But I do believe that intra-European will pick up first and that’ll be probably led by tourism first off. So it’ll be people wanting to go on holidays and the north to south being the typical thing, people going into Spain or Greece or Portugal. I think that that will be the first thing to go.


Now it’s very hard to call. And I think, you know, we’ve all been caught out a few times in making predictions on this because of the unpredictable nature of this pandemic. But I still think that will be the pattern and the beneficiaries are going to be the low-cost carriers who would’ve taken market share throughout this pandemic. And the consolidation in that industry, I think will benefit operating margins medium term. So it really hasn’t changed my view. I think it’ll still be the intra-European over the long haul. And then we mustn’t forget many long-haul carriers are actually not in great shape in terms of balance sheets. They’re in a lot more debt in some cases, Lufthansa and Air France, the enterprise values almost entirely debt. So the equity is extremely risky and likely to be heavily diluted.




DM: Yep. So onto earnings, there was a very strong first quarter and even stronger second quarter, which I think logically makes sense as lockdowns have eased. Do you see that continuing for European equities in the second half of this year?


NG: Yes, absolutely. I mean, we’re coming towards the end of the second quarter now, and we’ve seen a number of pre-announcements, companies of like Kingspan, Travis Perkins in the UK, Pernod Ricard have all pre-announced. The pace of recovery, particularly in certain areas has been stronger than expected and expectations were quite strong going into this. So I think that the answer is yes. So I think we’ll continue to see in Q2 and Q3 maybe even Q4, a fairly serious rebound.


We mustn’t forget that policy is still very accommodative. So we have zero interest rates. Therefore, people have very low mortgages. Now we still have the furlough scheme in the UK and similar schemes elsewhere in the US consumers are getting cheques sent to them. In Asia, they’ve already come back. So Asia is kind of rebooted already. So there’s a lot of kind of income going into consumers’ I guess bank accounts. People haven’t been able to spend over the last 18 months in the way they would normally spend. So there’s a lot of cash that’s built up in consumer bank accounts as well. So I think there is an awful lot of consumer firepower and a lot of pent up demand. And I expect this to really drive quite strong consumption. And I think this will be persistent for a while.




DM: So that leads me perfectly to my next question, which is on inflation. So that growth, earnings

growth, human behaviour coming out of lockdown. We have seen 2% in the UK, historically it’s not a huge inflation number, but it’s certainly higher than it has been, but 5% in the US that is a bit more of a punchy inflation number. How is that feeding through in Europe? Europe’s historically seen as much more of a deflationary region. Do you think this sort of strong reopening trade and earnings and pent-up demand will lead to inflation in Europe?


NG: Yeah, I think it will, but I think this time is a little different. I expect there to be more inflation. We’re already seeing it when we talk to companies that input prices are much higher and they are passing those on to customers, consumers, and they are getting some stickiness there. So pricing power is beginning to return. We have already seen a number of, I guess, dislocations caused by the pandemic. So, you know, whether it’s containers being in the wrong location, we had this issue in the Suez canal a few months ago. We’ve got issues around semiconductor. So there is some kind of cost push coming from I guess, effects of the pandemic, but we’re also seeing very strong wage growth as well. Probably more so in the US than in Europe, but obviously that does impact on European equities.


We invest in one of our portfolios in a UK company called Ashstead. That’s seen, are talking about 6% wage growth in the United States in their workforce. So we are seeing a significant wage growth. I don’t think it’s necessarily going to lead to the kind of wage price spiral that we saw in the seventies because the institutional structures in labour markets are quite different and societies are quite different in other ways too. But I do think we’ll have a little higher inflation than we’ve had before. And I think it’ll be more volatile. Not necessarily a bad thing. I think a little bit of inflation given the consequences of deflation over the last sort of decade or so, it’s not necessarily bad, unless of course it got out of hand, but we don’t think it will get out of hand.




DM: Any obvious companies that you think might benefit either in the portfolio or listed in Europe that you might look to play? ‘Cause obviously within the London market, you’ve got the whole metals and materials listed. How might you play in inflation? What sort of stock has got that pricing power that would keep up?


NG: Well I think that’s a good question. It’s really a key focus of ours and trying to think about all of the stocks in the portfolio that we have that may see inter-cost pressure, which ones can pass it on and which ones can’t pass it on. And that’s sometimes an individual decision based on the characteristics of a particular company in its industry. I guess, broadly or generally we are seeing some of our building and materials or some of the companies that supply into those industries, get pricing through and that’s pretty decent. That’s good, because if you’re getting good pricing through in a point in time when demand is quite strong, there is the potential for some fixed cost leverage, which is going to be good for the operating margins. So that’s a positive.


In areas we’re also seeing pretty decent inflation, not quite caused by the same things, but energy. So we’ve seen the oil price really rise to a much higher level than was anticipated at the beginning of the year. We have one big oil company in the portfolio, Equinor, which is a Norwegian oil and gas company. It’s a mixture of upstream and then renewables and their upstream business is generating huge amounts of cash at the current oil price. So there’s a benefit there.


And then I guess more medium term, if the higher levels of inflation lead to higher bond yields or lead to the anticipation of higher interest rates, that would favour European banks. A 200 basis point increase in short rates would increase the profitability of Eurozone banks by about 50%, which is a really big number when European banks have been really hit quite hard over the last few years by low and then negative interest rates. So the banks are another obvious area where more persistent inflation leading to higher yields, and then eventually interest rate rises would benefit the banks.




DM: And finally, there’s been a real noticeable pickup of M&A, mergers and acquisitions, certainly on the UK listed market. Is that reading through in European equities or is that something that you feel may follow? ‘Cause certainly when I look at valuations, we think about the US being more fully valued than Europe and the UK. If there’s a bit of a buyers discount are companies from either outside of Europe or in Europe starting to pick each other off?


NG: We haven’t really seen a lot yet in Europe. I think the UK is a little bit of a special case. I think to an extent that reflects the fact that the UK is a more private equity friendly market. So for a whole series of cultural reasons it’s easier for private equity to pick off UK businesses at a point in time when they are very cheap. We do believe that European equities are attractively valued. They’re potentially not quite as cheap as the UK, but they certainty are attractively valued, but we’re not quite seeing the same private equity impact on European equities. And I’ll be surprised if we did just for a whole series of cultural reasons. It’s not really quite as acceptable or seen as acceptable in some of the markets with private equity to act in the way they act in the UK.


DM: Niall thank you very much for taking us through what’s going on in European equities. If you would like more information on the GAM Star Continental European Equity fund, please visit fundcalibre.com and if you like our podcast, please subscribe wherever you get your podcasts.



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