277. Investing through the recession that hasn’t come… yet

21 September 2023 (pre-recorded 12 September 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. This week we’re discussing the economic challenges in Europe – de-stocking, inflation, and supply chain disruptions – and the opportunities in this type of environment.

Chris Salih (CS): I’m Chris Salih, and today we are joined by Tom Lemaigre, who’s one of the managers on the Elite Rated Janus Henderson European Selected Opportunities fund. Tom, thank you for joining us today.

Tom Lemaigre (TL): Good to see you, Chris.

CS: And you.

[INTERVIEW]

CS: Let’s obviously start and go straight into it. I mean, you’ve co-managed this fund for a couple of years now, but John Bennett, who is well known to our listeners, one of the most veteran European managers, he’s obviously retiring next year, and he is doing more with his beloved Rangers [Football Club]; will the investment process change? Does the longstanding tenets of what makes this fund work continue? Maybe just talk us through that and will there be any sort of change over as well?

TL: Yeah, sure. So, in a word no. Investment process, the philosophy is absolutely not going to change, and there’s a couple of reasons for that. So, number one, you know, essentially John, as you said, veteran fund manager, he hired myself and Tom O’Hara back in 2018 as analysts and kind of formed us not in his own image as such, because that’s dangerous, but definitely to have the same kind of process. And we had the same philosophy to begin with. And, therefore, this has been sort of a well-thought-out plan by John, in his older age, in terms of what succession planning looks like for the funds that we manage. So, as a consequence, no, the philosophy, the process is not going to change. And just to remind the listeners of your podcast, what our philosophy is, there’s six key strands of DNA that sort of make us up as investors.

The first one is ‘follow the cash’, which was unpopular for the last decade or so, but actually what we mean by follow the cash is, we like businesses that generate free cash flow and we love businesses that can take that cash flow and invest it at higher rates of return on investment. And so, what it actually means is, we like businesses that are valued on that cash flow. So, we have a valuation sort of consciousness, because we believe that the price you pay today determines your future returns.

The second key strand of our DNA is that we like to avoid excessive leverage. So, very simply, if a company has too much debt on its balance sheet, we don’t like that because if there’s an operational change, or if the interest rate regime changes, then they can be caught, you know, with their trousers down as the tide goes out very quickly. So, it’s something that we worry about, and so we keep away from those kind sof companies.

If I take number three and four together, ‘believe in cycles’ and ‘believe in change’; we are mean reversionists. We believe that everything comes back to the mean, we believe that everything is cyclical, and therefore it gives us an interesting lens to look at every company through. We think that sort of over the last 10 years, it’s all been about extrapolation – and you would’ve seen that with hyper-growth companies, thinking that food delivery could continue to grow in the high twenties rate forever, just isn’t the way that works. You know, companies will come in and compete away returns and growth.

The last two strands; ‘give yourself time’ – clients’ willing – and ‘be ready to be wrong’. Those are very important to us too. And once again, are not going to change.

We invest in large capitalisation, European equities where an investment thesis takes a long time to play out and we have to be patient investors, but we can only be as patient as the investors that put money in our fund.

And our last round, I said it there, ‘be ready to be wrong’. That is about our pragmatism. We are pragmatic investors and we have this saying – Tom, myself and John – which is ‘When the facts change, we reserve the right to change our mind;’. We never want the investors in our fund to be in a situation where if they look at their performance over the last three to five years, and we’ve underperformed, that we blame it on any market regime. We are an all-weather fund. We’re core, we’re agnostic, we’re flexible, and we always want to be making and generating alpha for our clients over the long-term.

CS: You mentioned there, let’s obviously go into the market a bit deeper. Obviously with Europe there’s always something happening, something good, something bad, something in between. But maybe just talk us through the environment for companies in Europe at the moment. You know, you talked recently about short-term and illogical reactions to earnings results. Maybe go into that of a bit of detail and just give us a snapshot of things in Europe if possible?

TL: Yeah, so, if I take the first question, it’s something that I find absolutely fascinating, especially when talking to clients more directly, is there’s this understanding that when you invest in our fund – or sorry, misunderstanding, I should say – that you’re investing in domestic European companies. That’s absolutely not the case. So, what I want to do is sort of disaggregate that immediately, which is because we deal with big, big European companies, actually, their revenue bases are very diversified. So if I look, you know, at one of our funds that we run – our pan-European fund, it’ll be very similar names for [Janus Henderson] European Focus – the revenue exposure, when you add up all the companies in the fund, to Asia and emerging markets, about 40%,  developed Europe is about 33% and North America it’s about 26%. And actually, we’re underweight revenue exposure versus the benchmark in developed Europe and overweight Asia and emerging markets and North America.

And the reason why I’m sort of labouring this point is because it is very important for us, for people to understand that investing in our fund, you’re investing in large European companies that are global champions in what they do, and they just happen to have been born and founded and are now listed in Europe. So, that’s just one thing I want to say on our fund.

But you know, you’re right, there are always things happening in Europe – t’was ever thus. I mean, I, myself am Belgian – I’m from Belgium – and I can tell you that there’s complicated political and social situations out there as there are in other European countries. But the reality is I think at the moment, companies are finding it tough because they don’t really know when their end demand is going to pick up. For instance, I had a meeting with a CEO of a chemicals company that operates globally, yesterday. Volumes are down 13% in Q2, and it’s because there’s this word that’s being uttered or has been uttered since December nonstop, which is de-stocking. So, their customers are getting rid of inventories ahead of an anticipated recession, but this recession hasn’t come yet, and we keep waiting. It’s the recession that people keep pushing out further and further.

Likewise, companies have got to deal with inflation, be it at the raw material level in terms of when they make their goods you know, all the input costs into those goods going up. Likewise in services, you know, labour rates are going up, and so inflation is an issue that they have to deal with. And there have been also supply chain issues. So, you know, supply chains have been fragmented because of Covid and I’m sure we’ll talk about it later in terms of what companies are doing to respond to that.

So, the environment hasn’t been easy, I think, for any big companies for a while, but what we focus on, as an investment team, is buying companies that have very good management, that are great operationally, and that can deal with any kind of macro headwinds and operational difficulties that are caused by the macro.

And then, in terms of the last question, which is short-term and illogical reactions to earnings results, what I would say is the beauty of being a long-term investor is the fact that when there are these reactions, or share price reactions to company results, we can take advantage of them. And the reason why we’re seeing more of this now, is the investor, the market, has become increasingly short-term in nature. And that’s partially due to the rise of shorter-term platform hedge funds, as well as quant-type funds. And so there will be this issue where, going into a company results, positioning will really matter to these people who have very short-term time horizons. Whereas if there is an illogical reaction to a company earnings release – say, the stock is down 5% on pretty much no news, just because the earnings number didn’t realise exactly the expectations of investors – and if you’ve got a long-term time horizon, like ourselves of three to five years, we can take that opportunity and add some more or find an entry point to a stock.

CS: Are you finding quite a lot of opportunity in that sense then, given the short-term nature sentiment perhaps with Europe? You know, the nature of your companies perhaps makes greater opportunities because they’re so global and they’re quite core in their focus?

TL: Yeah, absolutely, I mean, to the extent actually you know, recently I talked about de-stocking and there’s a number of industries where de-stocking has been harsh, and demand has also been a bit of a struggle. But if we take one of our largest positions in the fund which is UPM-Kymmene [UPM-Kymmene Oyj] , which you might ask me about later, that’s one where it had to cut its profit guidance for this year between 30% and 40%. And actually, on the day of results, it was down 2[%], and it’s kind of like the last cut, and actually ended up plus 6[%.] And we were buying when it was far down below that because we could see that the trough in earnings because of the markets that it operates in, was ahead of us. And the market needs to be a forecasting mechanism at all times. And sometimes things just become really quite overdone and throws up opportunities for us. And we’ve seen it specifically actually in the cyclical space, where recessionary fears have gotten so bad, valuations were running way ahead of those fears and therefore, share prices were down and created opportunities for us to be able to buy and increase our exposure to certain companies in anticipation of when volumes and end demand will turn.

CS: You mentioned UPM now, I was going to ask you about that later, but I feel like now might be the best time to ask you. So, obviously climate change is at the front and foremost in the news at the moment with high temperatures and flash flooding; UPM is looking at a future beyond fossil fuels. Maybe just give us a bit of an insight into that company and maybe the attraction and the investment case in your eyes for that holding.

TL: Yeah, I mean, UPM is sort of a complicated business in so far as it actually has six different, separate business units, but they all can talk to each other in various ways and complement each other. But ,ultimately, the best way to try and understand it is, it tries to combine bio and forest value chain together. Something they call BioFore [UPM BioFore – Beyond Fossils], but they traditionally were a pulp and paper producer and they’re one of the largest communication paper sellers here in Europe. So that’s to say, you know, newspaper, magazine paper, etc. etc. And they realised that that business was declining, I’m not going to say rapidly, but slow and gradual decline. And they used the cash from that business to invest in other areas. And the other areas they have invested in, where they see growth, are in bio-refining and biochemicals.

So, to your point about sort of looking at a future beyond fossil fuels and what it is that UPM, is trying to do is, it’s trying to use its value chain –  so the natural products that grows because it owns forests – and from there, create renewable solutions to the problems that the world sees. So, for instance, it’s investing in creating a plant in Germany in a place called Leuna. And what you’ll find with that plant is the product that’s coming out of it is going to try and replace PET bottles, say for Coca-Cola. Coca-Cola is actually going to be one of their first customers. Likewise, it’s looking at building a bio-refinery plant in Rotterdam and what that will be, it’ll be taking wood and essentially trying to make a diesel equivalent from it to be able to put into trucks. And obviously the beauty of wood is that you can keep growing it out of the ground.

So, the way in which UPM has changed over the last 10 years – and actually I had a meeting with the CEO a week and a half ago, who, unfortunately, is going to be retiring in the next 18 months because he is very much been the leader in all of this – is taking cash flow from mature and potentially declining businesses and finding growth avenues in sustainable and growing businesses. And that is the beauty of that business, is the reason why it has six separate business units is because some of them mature and they are feeding the growth of other businesses.

CS: Maybe just on the portfolio in general now. Obviously, very long-term [inaudible], you’ve got a few long-term themes in the portfolio: deglobalisation, onshoring of supply chains, electrification, we’ve already talked about some of the stuff regarding energy efficiency, automation, digitalization, … I mean the list goes on … AI …  maybe let’s just highlight and give an example of each of how they are implemented in the portfolio and perhaps a stock example as well?

TL: Yeah, I mean, the beauty of all those thematics that you just pointed out, that play in the portfolio, is that they’re sort of interlinked. Because if I take the energy efficiency / electrification theme, that one is not mutually exclusive from say, automation or AI or the onshoring of supply chains because companies which we’re invested in like people at home will probably know Siemens [AG] quite well, they might know Schneider [Electric SE] as well, but we own both of those in the portfolio. And they are essentially electrical capital goods companies. So, they make stuff like circuit breakers, they make low voltage stuff like switches, but they also make things that go in factories, drives motors and they make uninterruptible power supplies. So, if the power goes off in a building, the backup power is them who have installed it, that comes on immediately.

And I guess the important thing for these guys is, that given the war in Ukraine and how it’s focused people’s minds on having energy efficiency in any building that is run by a company or even in your own home, quite frankly, I mean we all remember the gas crisis and electricity prices going up. It’s uncomfortable for everyone. The CEOs and CFOs of big companies are no different. So, they are investing in making sure that their buildings are more electrified, more energy efficient. Because energy prices went up so high, the payback on those investments in terms of the number of years to get back your money came down fairly quickly.

And then on the other side of that, in terms of playing into the other themes you’ve talked about is, because of the Covid supply chain disruption I mentioned earlier, a lot of companies – [there’s] nothing more annoying for a company than to have the demand for a product or a service, but not being able to fulfill that demand and book the revenue. And that was what was happening in Covid with supply chains being broken, is somebody wanted a product but couldn’t get their hands on it because that last little piece was missing because it was stuck on a boat somewhere in Asia. And so, what we’re seeing now is a lot of companies are bringing back their supply chains closer to home. In fact, we call it friend-shoring here, or near-shoring to friendlier countries, so that they have easier access to it. What does that mean? Well, it means a factory needs to be built, so you need to have steel that’s put in there, you need cement, and then you’ve got to fill the factory and actually, you should probably insulate it and put some walls in it and a roof on it too. But then you’ve got to fill the factory with equipment to be able to process whatever goods it is that you produce.

And going back to the global champions in Europe argument I was making earlier, we have a number of them in our fund, so Siemens, Schneider, and there’s others that are based in Europe also that are listed in Europe that we can also talk to and potentially invest in like ABB [Ltd.] and Legrand [Legrand Electric Limited].

So, I don’t want to say, this thematic is mutually exclusive from any other, because actually the way the world is going and where fiscal stimulus is going too – if you think about the amount of money that the US alone – so if you take the IRA, the Inflation Reduction Act, the IIJA [Infrastructure Investment and Jobs Act] and the CHIPS and Science Act, there’s a trillion [dollars] of fiscal stimulus going into trying to improve the grid infrastructure in the US alone, and these companies are going to sell into that. And we haven’t even talked about the amount of stimulus coming out of Europe. So, these thematics for us are very much driven, 1) by corporate’s desires to invest, but also [2) by] the government backing up the need to sort of upgrade the grid.

And then lastly, I’ll just say something quickly on automation and AI. In automation, what you’ll find is companies, because they’re struggling with the increase in wage costs, where they try and find productivity is by automating processes. So, once again, they’ve got to go to the Siemens and the Schneiders of this world who sell the equipment that go into these factories to be able to further automate and find those efficiency gains. And sorry, I know I’ve been talking for a while now, but AI is the buzzword of this year for sure. And what you see with AI is actually you need more compute power, you need more data centre power. And once again, if you think about the power management of these places, Schneider and Siemens are the ones who do the power management systems in data centres, and therefore they’re also exposed to that theme and should see good growth.

CS: Let’s just finish with a couple of holdings. So, both Airbus [SE] and Safran [S.A.], they’re sort of both, I mean these are backing sort of travel and transport sector. Maybe just talk us through that. Is that a support for that sector or more sort of a defensive position in general? Maybe just give us a bit of an insight into both.

TL: Yeah, I mean it is a fantastic question because I suppose it’s another thematic at play. During Covid we sat down thinking, is the world really never going to get on a plane again? Well, after being locked in my house for months on end, my desire to travel was completely unbridled, I wanted to get out and travel again. And I think that’s the thing is even business meetings, you know, we still are travelling now and going to see people, so our view was that air traffic growth would return to pre-pandemic kind of levels and it is moving in that direction. The other interesting thing is, so, in developed markets, we all know that we have a desire to travel more, and we’re still going to be doing business face-to-face and flying to different countries to see people, but actually in emerging markets, there’s so many people that haven’t yet got on the plane. And this was kind of borne out by the recent Paris Air show earlier this summer where two Indian airlines, so Indigo and Air India respectively, ordered 500 and 250 aircraft from Airbus. That takes Airbus’s backlog to 8,000 planes. So, [at] the current rate of production that they do every year, that’s a 10-year backlog. So, they have visibility on the amount of planes they need to produce for the next 10 years, so we know what their growth is going to look like.

And likewise, Safran, which is the other holding you mentioned Chris, is an engine manufacturer and their engines go on Airbus planes. And so, they’re sort of directly linked and the beauty of Safran is, because once Airbus ships a plane, it doesn’t really have an aftermarket service business. Whereas with an engine, what you end up finding is that in five to eight years after it’s first put into to a plane and flown, is it needs to go back into the garage or the workshop and have an engine overhaul.

And so, as you’ll probably know Chris, the last BA 747s were retired, I think it was in 2020, and they were flying something like 40 years. Aircraft engines last a long time, and they go through various workshop cycles. Safran also has great visibility on 1) selling the original engine to the airframe manufacturers, ie. Airbus, and then [2)] they have visibility on when those, depending on the number of flight hours – which we think are increasing because obviously air traffic is increasing – they have visibility on when those engines need to come into the workshop, and they charge for that too. So, in many ways it’s backing into the travel and transport sector, like you said, but it also feels fairly defensive because, barring any other further pandemics, we are fairly sure that air traffic growth should continue and the companies that you want to invest in to be able to take advantage of that, once again are global champions based in Europe. And that is Airbus and Saffron., and there’s a couple of others too that you have mentioned.

CS: Tom thanks for joining us today and talking us through all things Europe and beyond.

TL: Thanks very much Chris. It was a pleasure.

SW: The Janus Henderson European Selected Opportunities fund is a high conviction portfolio of 40-50 mega and large-cap stocks. To learn more about the Janus Henderson European Selected Opportunities fund, visit FundCalibre.com – and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.