188. Building materials, healthcare, renewables and luxury goods – Europe is actually quite good at a lot of things

8 April 2022 (pre-recorded 31 March 2022)

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.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Today’s episode focuses on the opportunities in European smaller companies with three excellent examples of high-quality European companies and why investors should continue to consider European equities in their portfolio. 

Sam Slator (SS): I’m Sam Slator from FundCalibre and today I’ve been joined by Rosemary Simmons, co-manager of the Barings Europe Select Trust. Hi Rosemary. 

Rosemary Simmons (RS): Hi there, good morning.  

[INTERVIEW]

SS: So perhaps we could start with how European smaller companies usually fair in a high inflation and a rising interest rate environment.

RS: Yeah, of course. I mean, let’s be honest the last couple of years has been a complete rollercoaster for all of us, including investors in European smaller companies. You know, we all had to learn basically a new language, not even COVID, furlough, but you know, the language of pandemic markets, reopening, COVID plays, recovery stocks, lockdown beneficiaries. And just as we thought that we could see the tentative signs of recovery in global economies and markets, we’re now, as you say, thinking about interest rates and inflation alongside a whole host of other. 

The attractions to me of European smaller companies over long term is that these swings and styles and trends in the long term shouldn’t matter. And it’s the bottom-up stock selection that dominates. And back to your question, there are always market commentaries that you can find that’ll be supportive of your investment case.

But for me, European smaller companies are an asset class for the long term. You know, there companies, smaller companies that will grow faster, they’re less well covered and ultimately add more value over the longer term. However, history does seem to show that small caps outperform when interest rates rise. And if we look to Japan where we’ve seen a challenging low growth environment for some time, small caps have been a good place to be, they’ve outperformed large caps over recent decades. And so, when you are looking for growth in a challenging environment, small caps are a pretty safe bet. 

And as to the point on inflation. For me, I think that comes back to the individual stock selection. You know, the joy of small caps is that the universe is fast and the individual companies within are very idiosyncratic. You know, they’re very, very focused often on individual products and services. And so, for me, the winners in an inflationary environment are those individual companies that can successfully pass on their inflationary pressures to their customers. So, they’re those with pricing power, those with a strong competitive advantage, those that are doing things that other companies aren’t and doing it better. And this is where bottom-up stock selection should come into its own. And I think identifying those companies that can in such challenging environments prosper and prove their worth.

SS: And perhaps we could talk about some of those stocks that you hold within the portfolio. 

RS: Of course. 

SS: I’m just packing up my car ready to go away for Easter holidays, wondering how I’m going to get everything in. So perhaps, I think it’s pronounced Thule, is a good company to start with bike racks and things.

RS: Quite, yeah. Thule, it’s a great company for me, you know, it’s one that’s been in the portfolio for some time. It’s clearly been a beneficiary of staycations, a COVID winner if you like, but for me and for us on the team, it’s so much more than that. 

This management team inherited a business that yeah was very strong in roof boxes, as you mentioned, and bike racks but they had a lot of underperforming businesses, which they divested to focus on the core. They focused on building a brand, I mean building a brand in roof boxes, it sounds mad, it’s such a commodity in some senses, but they’ve built a brand that’s centered on outdoor living. It’s aspirational. It’s us wanting to be the kind of person that, you know, has their bike seats on the back of our car, that’s got their trailers. Cause we all go out into the outdoors. They’ve built an aspirational brand. They’ve focused on the quality of the product and on the profitability of each and every product line. So, they’ve done this really successfully. 

And they’ve also added value through M&A to establish really strong other product lines. And in 2014 they added organically a whole new product line in baby strollers. And the exciting thing is it doesn’t stop there. You know, they’ve announced that this year there’s going to be two more product lines and there’s loads of speculation as to what they might be. But they’re ambitious and confident that each of those product categories can add another a hundred million euros in sales in the next 5 to 10 years. 

So, for us, it’s a small business. It’s really unique. It’s really idiosyncratic, but it’s a quality business. It’s got a great management team, great franchise, strong balance sheet. They have cash to deploy if they need it. And if don’t, they’ll pay it out as a dividend. And the quality credentials drive pricing power and enable them to withstand the challenges of inflation in this environment. And for me, their growth potential is consistently underestimated. And similarly, the valuation, everyone’s assuming that this was a flash in the pan, this COVID beneficiary, but actually I think it’s still consistently and materially undervalued. 

And one thing that I haven’t mentioned is their ESG credentials. You know, this is a business that has, I think it’s got a moral compass, they’ve brought out sustainability targets, but they want them to be science based, they want them to able to be checked and audited. They’re keen to improve their business. They’re keen to make it better. They’re keen to make it greener. They’re keen to be good to their people. They’re keen to have really good governance standards. And it’s exactly the kind of company that I like to invest in for our clients.

SS: And you also hold Elis, which is all about health, safety and well-being of employees. Is that sort of, well it’s been a theme that’s been strong in recent years, but perhaps you could tell us a bit more about that?

RS: Yeah, of course. And yeah, Elis a French company. It’s an outsourced, it’s a provider of outsourced services effectively. So, it’s involved in the rental and maintenance of professional clothing, of linen for restaurants, hygiene, and wellness equipment. And what’s really exciting about them is it’s a company founded in France over 130 years ago, but now it’s a global player. It’s in 29 countries. It’s in a whole host of sectors. It’s a leader in Europe, but it’s a strong position in South America. So, it’s not just washing napkins from French restaurants, but thankfully, they diversified into healthcare. And this was a strong asset during the pandemic. And I think it has been a COVID beneficiary, but not in a flash in the pan sense, in a structural sense where the value of its offering, the value of deep cleaning and the value of outsourcing has become much clearer over recent times.

And I think it’s been very defensive business, in a very challenging environment, their sales declined in 2020 by about 14%, but they managed to actually expand their down margin only modestly but expand it. And you know, this is in a world where no one was going to hotels where no one was eating in restaurants. This is a really impressive achievement. And that kind of thing gives us confidence that in a challenging economic environment, the one, that looks like we’re going to be seeing, a company that is a market leader in a loss of its markets. It has pricing power. And that gives confidence in the resilience of its margins through the cycle. So hopefully it benefits from a resurgence and catering and hospitality and to tourism. 

And hopefully the fact that they’ve been very keen to manage their cost base, they’ll emerge from the COVID crisis, a more profitable business. You know, it’s a business that generates cash. It’s scalable, it’s international, and let’s be honest, it helps with the circular economy, it’s avoiding using single use solutions, it’s optimising product sharing, and hopefully it helps clients to reduce their emissions. So, there is an environmental, ESG angle with Elis as well, which I think isn’t always appreciated. So, for me, it’s a classic quality growth at a reasonable price stock that is really attractive for us to invest in for our clients.

SS: And the third company I wanted to touch on is Rexel, which is involved in renewable energy amongst other things. Could you tell us more about that?

RS: Certainly. Yeah, so Rexel, it’s one of the global leaders in distributing electrical equipment for professionals within the building sector. And clearly it should be a beneficiary of a cyclical post-COVID recovery, in building activity and so on. But also, as you point out a beneficiary of structural trends, supported by demand for renewables, as you say, but also the drive to electrification, the drive for energy efficiency. But for us, it’s been a company that’s been brilliantly managed historically, management have innovated they’ve navigated a shift to online, pretty expertly, in many ways, right now this business should be in the eye of the storm, you know, it’s a distributor in a world where product availability is tricky and supply chain management is all but impossible and then there’s inflation. 

But for me, this is where being a high-quality distributor is actually a great position to be in, this isn’t their first rodeo if you like, they’ve navigated volatile pricing environments before, you know, steel goes into a lot of the products they sell very volatile input, and their online price allows them to make more regular updates to pricing. And the fact that they have diversified suppliers enables greater stock availability. You know, they’re not relying on just one supplier and equally, they’re not just relying on one customer. 

So this from a [inaudible] perspective, you know, they’ve got a very strong competitive position, which makes it very attractive. But I mean, you pick on a really kind of key point in the addressing the carbon footprint of our buildings. It’s one of the largest climate issues that we still need to address. And the building sector is a vital part of that, has a great big role to play. And clearly Europe has strong ambitions to address these issues. And I think there are a lot of very innovative European smaller companies that are able to play a vital role in these ambitions. Rexel is one of them, but there are a lot of others that are in our portfolio. And also, some that we’re looking at just now to learn more about. 

I think just one other point is that, you know, when you’re working in an inflationary environment, you often default to companies like brands or traditionally defensive companies. But I think for me, companies that are distributors are actually quite an interesting place to be companies like Rexel, like IMCD even a company like Apifon who work with a range of suppliers who offer a vital service and a really important service. And they have some immunity for inflation because they’re passing on pricing directly to their consumers and able to protect their margin in the process. And I think it might be an under-appreciated place to invest.

SS: One thing I noticed is that each one of them has a really strong ESG characteristic in some way. Now the fund itself isn’t an ESG fund, but how much do you look at ESG aspects when you’re picking some of your holdings? Is it really fully integrated or is it just that you think that there are some really good tailwinds behind some of these stories?

RS: No, for us, it’s really important to fully integrate ESG and it has been since 2016, I think we’ve been integrating our ESG thoughts into how we value the company so that through the discount rate, the cost of funding that we apply, but also how we assess the quality of a business. And I think that’s not really that innovative anymore, but it maybe was back then. 

But for me, I think one, ESG can be a really powerful growth driver because we’ve got so much opportunity out there in making companies greener, better, more socially aware. But also, it really is part and parcel of the quality of a business nowadays. I mean, we’re all pretty well versed in the “Great Resignation”, for example, you know, treating your employees well, having a business that is doing something that your employees can be proud of is fundamental to your competitive advantage now, because so often we see that the competitive advantage lies with the people that people need to be bought into business. So that’s just one element of where we need to try and get a sense of that when we’re investing in companies, you know, why would people want to work with you? Why would consumers want to buy your products? That makes you a better company, if you’re doing something worthwhile, so for us, it’s certainly the case that ESG is embedded. It’s certainly the case that we think that is the right thing to do both in terms of analysing companies and for society. And yeah, I think it’s the only way to invest nowadays is to embed ESG in your research, because if you don’t, you’re missing key risks, but also key opportunities right there for the businesses that you’re looking at.

SS: Finally, perhaps you could just give us a few pointers as to why you think investors should consider European smaller companies at the moment, what would be their biggest attraction?

RS: Yes. Sure. Well, I mean, sadly, it’s very clear that Europe’s facing some pretty serious geopolitical challenges at the moment. But I think if we can take a bit of a more positive look on Europe and smaller companies, there is an argument that they’re also pretty powerful growth drivers. We’ve touched on green issues, the green deal, renewables, electrification also, de-globalisation, it might make us a bit sad but also its driving more onshoring. There may be worries about supply chains are going to force more investment within Europe and smaller companies may well be a particular beneficiary from some of these. 

And I think the other thing that upsets me a bit and is often overlooked is that Europe’s actually quite good at a lot of things. You know, I’ve mentioned building materials, but look at healthcare, look at the testing companies that we’re all too familiar with, Europe was really innovative and really pioneering in this space, look at luxury goods, something we haven’t really talked about all that much recently, look at renewables’ companies. 

So, I think Europe is often under-appreciated and as such is a pretty ripe hunting ground for stock pickers. And I think that’s true of Europe and it’s also true of small caps. And small caps we’ve talked about it a lot, my entire career, about the structural tailwinds of small caps. And I don’t think they’ve disappeared. You know, small caps tend to grow faster. They’re more beneficiaries when it comes to M&A, and also, they tend to be less well covered by fewer people. And for me, evaluations right now, it’s a movable feast obviously, but they look pretty reasonable, certainly relative to large caps, relative to other asset classes, in particular, for the growth that they offer. 

And so, for me, I think over the longer term, small caps are a very attractive area for investing. There might be a lot of noise in the short term, unfortunately, but I think over the long term, bottom-up company specific attractions should shine through and be the main drivers of performance. And this is when it’s a really exciting time to be invested in European smaller companies.

SS: That was really informative. Thank you very much, indeed.

RS: Thank you so much for your time. Thank you.

SW: The Barings Europe Select Trust invests in small and medium-sized companies and is run on ‘growth at a reasonable price’ basis. The team is looking at both the growth and quality aspects of a company, as well as an integrated approach to ESG as Rosemary demonstrated in this episode. To learn more about the Barings Europe Select Trust visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts. 

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 the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.