267. The long (and short) of investing in Europe

20 July 2023 (pre-recorded 6 July 2023)

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. We’re focused on the European continent for today’s episode highlighting both long – and short – opportunities for equity investors and how macro narratives such as inflation and interest rates have influenced the market.

James Yardley (JY): I’m joined today by Stephanie Bothwell, the Elite Rated manager for the BlackRock European Absolute Alpha fund. Stephanie, thank you very much for joining us today.

Stephanie Bothwell (SB): Thank you for having me.

[INTERVIEW]

JY: Stephanie, perhaps we could start with an overview of the economic and market conditions in Europe today. There was quite a lot of negativity around Europe last year, but actually, things haven’t been quite so bad I don’t think, so, where are we today?

SB: Well, I think for pretty large parts of the last 12 months, market direction has seemingly been more dominated by a macro narrative, particularly around inflation and the anticipated direction of interest rates. And I think that this theme is still partly playing through, but we are increasingly seeing more dispersion between the European market amongst different equity sectors, but also within equity sectors.

And I think this in turn, is generally a more supportive environment for bottom-up stock selection on both long and the short side. And we’re increasingly seeing stocks respond in a way that really reflects the positive and negative earnings revisions that we’re seeing. And we actually think this is evidence that fundamentals have really come to the fore again and are becoming more of a dominant part of stock selection, which in turn, I think should be a pretty positive environment for the European Absolute Alpha strategy.

JY: Great. And let’s talk about the fund’s long positions then, the investments you’re making which you think will do well over time. So, what sort of companies do you look for and can you give us some examples of your current holdings?

SB: Yeah, absolutely. So, when we think about investments that we’re going ‘long’ in, I think there’s probably four key attributes or characteristics that we’re looking for in those companies. So, the first one would really be stability and resilience in earnings and cash flows.

The second one, we really place a strong emphasis on management teams with a good track record in terms of value creation.

Then it’s return on capital, and what’s really important here is incremental return on capital, so, the incremental return on the dollar that you invest today versus history.

And I think the final point, which is very important for this strategy, is really around avoiding a material capital loss.

And then to answer your question around some of the investments that are in the fund today, I would highlight a couple. So, first one would really be Novo Nordisk [A/S]. This is one of the largest long positions within the fund today.

The Novo investment case is really one driven by innovation in some of its key therapies like Ozempic and Rybelsus in diabetes and then Wegovy for obesity.

And what makes this really exciting is that the global addressable market for these drugs is really significant. We know that obesity alone is now affecting around 15% of the global population, and only around 2% of that population today is receiving treatment. And obviously high levels of obesity has pretty negative implications for GDP in terms of healthcare costs, time lost to illness at work, and essentially reducing the number of those obese people can actually lead to really large savings for, you know, various governments.

So, Novo’s growth profile to us really stands out. We expect revenue growth to compound in the coming years at something like 15%, which is really in excess of many of its peers, both in pharma but also in the wider European market.

And then maybe a second one that we also have in the fund. This has been a long-term investment for us, is Royal Unibrew [A/S]. This is a Danish drinks company with core markets being in northern Europe, Italy, and France, but also increasingly other international markets. And it has its brands in beer, malt, but also in soft drinks.

And the group is increasingly deploying its multi-beverage strategy outside its core home markets. And we’re really excited about the opportunity here to deploy the balance sheet into attractive, value-enhancing M&A. And the latest example of this has been a deal that they conducted just this week in the Netherlands, which is going to provide a really good new platform for organic growth.

JY: And the interesting thing with your fund, of course, is you do do a lot of shorting. You do have the ability to go short and make money from when the share prices fall. So, could you tell our listeners – in layman’s terms – how you go about doing that, and what do you look for in a short opportunity? Are there any particular areas, any particular industries or countries where you’re finding particularly good short ideas at the moment?

SB: Yeah, so to your point, in this strategy, we’re really trying to generate alpha when share prices also decline through shorting. And when we go about looking at the opportunity set for what makes a good short, I think there’s a few characteristics that we’re typically trying to find. So, companies in those industries or sub-sectors with a relatively low degree of pricing power. Perhaps it could be companies where there’s a high degree of capex [capital expenditure] requirements with potential for execution risk on that. It could be a very leveraged business model, where there is a high degree of a capital raise. And I think the final point on where we tend to direct quite a lot of our time is where there is a material risk of earnings disappointment relative to market expectations.

Our strategy on the whole is fully flexible, so, we do invest both long and short across multiple industries and countries. And the short ideas are really a function of the bottom-up ideas that we find.

And as I talked about in my earlier remarks, we are seeing a wider dispersion at market level today than perhaps we’ve seen over the course of the past 12 months. And typically speaking, when you have that dispersion, it tends to provide a good opportunity for shorting.

And then in terms of some of the themes or ideas that we’re looking at, at the moment, one pretty prevalent theme is really related to risks around refinancing in a higher [interest] rate environment. This obviously has the potential to lead to earnings cuts, but also balance sheet stress and the potential for capital raise.

And then a second area, which has really come to the fore more recently, has been around companies where we see potential for de-stocking as demand has begun to normalise from very high levels that we saw through the course of 2022. And again, this can create risk of earnings cuts, leading to equity under performance and downside.

JY: Very interesting, thank you very much. And in terms of that refinancing risk, I mean, is that in any particular sectors like real estate, for example, or anywhere else where there’s particular weakness?

SB: Yeah, so I think the most obvious places to look are really in some of those very highly-leveraged sectors. Those are the first ones where we’ve been focusing our time. So, examples of this would be real estate to your point. We’ve also been looking at some of the European telcos, that’s also a sector with a high degree of leverage, and also some of the European utilities: all of these essentially have high levels of debt relative to a lot of their European counterparts.

And I think the other important thing to note here is really looking at the timeframe for refinancing. So, spending a lot of time understanding when some of these financing needs and commitments are falling due and also the structure of the debt ie. is it fixed [or] is it floating? All of that feeds into how we sort of build up the short thesis.

JY: Yes. And we are of course now in a different world with much higher interest rates than we’ve been used to in the last few years, and higher inflation. I mean, how has this changed things for you, I guess, and do you expect this inflation and higher interest rates to persist for a long time going forward?

SB: I don’t think I can necessarily give you an exact timeline! But what I would say is that our process is set up in a way that we really look to adapt to changes in the macro environment. We incorporate higher interest rates, higher inflation versus history within our bottom-up stock selection. And because we have a fully flexible approach, we do have the ability to look for new ideas across the market, rather than focusing on one specific sector or sub-area.

So, I don’t necessarily think that today it’s more challenging to find really good new opportunities; we just adapt, we have the process in order to be able to do that. And again, you know, the dispersion that we are seeing throwing up in the market is enabling us to find, you know, some really good, interesting opportunities on both the long and the short side, despite the fact that the macro has changed somewhat.

JY: And why should investors consider this fund over a more standard, long-only European equity fund? And what role does it play in a wider portfolio?

SB: So, this fund does have a number of attributes which perhaps are not so usual, that you would get with a typical European equity fund.

The first one would be diversification. The fund does have a low correlation with other asset classes, which really can bring portfolio diversification benefits. In the long run, it has had a low correlation with both equity indices, but also with government and corporate bonds.

The second point is really around volatility. So, you know, for those that want to manage volatility within a portfolio, this fund has historically had a lower volatility versus the market over time.

The third point I would make is really around alpha-driven returns with limited market exposure. So, if I think about the fund beta, since its inception, it’s really been around negative 0.04. So, again, not taking a lot of market exposure, but you know, generating positive returns on both the long and the short side.

And I think the final point is really around capital preservation. So, when market conditions tend to become more challenging, I think this fund tends to perform very well in terms of its resilience and its ability to preserve capital.

JY: Fantastic. Well, that’s been very interesting, Stephanie. Thank you very much for sharing your thoughts with us today.

SB: Thank you.

SW: The BlackRock European Absolute Alpha fund is a multi-cap fund, using both long and short equity positions. A combination of a concentrated list of long positions to capture upside potential and a diverse range of short ideas aim to generate returns through various strategies while managing risk effectively. For more information on the BlackRock European Absolute Alpha fund 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.