Why investors should consider European equities today

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There’s obviously been quite a lot of negative sentiment towards Europe, recently. A lot of talk about gas prices, inflation, and a potential recession, but earnings have held up relatively well. So, can you help give us a feel for sort of the on the ground picture at the moment? What the reality of the situation?

[00:35] So, the reality, actually surprisingly for now, is that it’s business as usual for most companies. So, for the most part – especially in the portfolio – the companies that continue to deliver very good numbers and first half results for the portfolio have seen earnings grow 20% this year over the last year. So, fundamentals remain very strong.

Of course, share prices tend to move before the fundamentals and the share prices, as you mentioned, so far this year are down quite substantially. And that’s of course in anticipation of what is likely to be a recession at the tail end of this year or the beginning of next year; rising, very high levels of inflation; and of course, all of that compounded by tightening credit conditions.

So, I think it is quite reasonable and most companies on the ground are expecting much tougher conditions in the second half of the year and into next year. And they are preparing their businesses for that  environment.

And are there any countries or sectors which you particularly like or dislike at the moment?

[1:39] I think, especially as we enter what is likely to be a recession, I think there are certain characteristics that are going to become very important. The first is going to be the defensiveness of the company’s revenue streams. And there are of course revenue streams out there, which are far more defensive than others. Think of healthcare, for example, healthcare spending in US records has never fallen. And that includes of course, multiple financial crisis, including of course, a health crisis in the form of COVID. So, we think that is a space that will continue to be defensive.

But of course there are other defenses spaces – staples companies tend to be more defensive in recessionary environments. But then there are some sectors that might surprise you as being defensive. Luxury goods is actually a quite defensive sector, particularly the most desirable brands like LVMH, who even in the financial crisis of 2008/2009 was able to generate revenue growth. So, I think defensive revenue streams is going to be very important.

The second is going to be within those markets, which are slightly less defensive, people tend to concentrate their purchases and they concentrate them towards the stronger brands. So, we are already seeing that so far this year. Look at the difference in, for example, the performance between L’Oréal and Unilever, both of which have had to push through big price increases, but Unilever is seeing their volumes decline by a couple of percent. L’Oréal is generating close to 7% growth in their volumes. So, people tend to concentrate their purchase. And of course it’s much easier when you’re selling a dream in the case of L’Oréal than when you’re selling soap in the case of Unilever. So, I think we’re going to see the strong get stronger in that sense.

And I think a third area which will be important, are companies who have idiosyncratic growth. Remember we’re buying businesses, we’re not buying the market. And of course there are businesses that have growth drivers that are quite irrelevant to the broader economy. Take a company like Straumann. It’s a dental implants leader. There is no doubt that there is a certain consumer sensitivity to the purchase of a dental implant, but they have a very important driver of growth in the form of their clear aligner business, which they’re currently rolling out across their dental network. So, even if there is a certain weakness in consumer spending, that growth driver is in many ways, idiosyncratic, it is somewhat irrelevant to the macro environment and will drive growth for the company. So, I’d say those are three areas which are going to be quite important in the months to come.

And how dependent on China are European companies at the moment? I think you recently mentioned Adidas sales have been hit due to their Chinese exposure. But as you say, luxury brands seem to be holding up better.

[4:21] So, surprisingly, maybe China, isn’t actually an enormous part of the European market nor indeed of the portfolio that we’re talking about today. So, it constitutes around 6%, 7% of sales for the MSCI Europe [index] and for the portfolio. And to give you an idea it’s smaller than for example, the UK or Germany as an end market. So, it’s not irrelevant, but I wouldn’t want to overstate the importance of China.

Now, where China has been a challenge for some Western companies and for companies in general, is in two forms. First regulatory pressure, particularly in the internet and tech space. And secondly, through increasing nationalistic spending patterns. So, moving away from international brands towards local brands, and this is of course, in the wake of the Xinjiang controversy where a number of Western brands said they were going to stop sourcing their cotton from that region, which created a boycott on the part of Chinese consumers of those brands. And Adidas was in the middle of that maelstrom and suffered from that.

That being said, the majority of our exposure to China actually comes from the luxury space, as you mentioned, and these luxury brands continue to be highly desirable in China. And it also comes from the healthcare space where these are businesses selling proprietary and patent-protected either drugs or medical equipment and there that continues to be an attractive market. So, I’d say for the most part in the portfolio context, China actually remains an attractive and exciting growth opportunity with the odd pocket of difficulty in the case of Adidas, as you mentioned.

And what changes have you been making in the portfolio recently?

[6:08] So, we are long term investors. Our investment time horizon is five years and more, and we’ve held companies for 20-30 years in our pan European strategy. And we tend to take advantage of these market sell-offs to buy into or to increase our exposure to some of the best long term companies in the portfolio. And so, we’ve been doing that since the start of the year. We’ve been adding to some fast-growing companies like Adyen in the payment space – a very high quality and fast-growing Dutch payments processor. We’ve also been adding to a company called Sartorius Stedim, which is a provider of medical devices or medical equipment to the pharmaceutical industry. That has also been a fast-growing company and one which we had unfortunately not been able to own as much as we would’ve liked because the valuation was too high. And the sell-off since the start of the year has created a buying opportunity there. So, where we see opportunities in this sell-off, we’ve been adding to those names.

And why should investors be considering European equities today? Why not invest elsewhere in the US or UK or Asia?

[7:19] I wouldn’t necessarily make an argument for owning Europe in general. I’m sure there are other people much better placed to comment on whether that’s a good region to have exposure to. I would argue get exposure to some brilliant European companies – and Europe does hold some of the best companies in the world. We have excellent expertise in brands. We have some of the strongest in particularly in the premium space brands like LVMH, like Louis Vuitton, like L’Oréal, with an amazing heritage in those brands and a knowledge of how to manage those brands. So, I would say that’s one area where we have some great businesses in Europe.

We also have some of the best innovation in Europe, especially in the medical space. We have great pharmaceutical companies. We have the leaders in the oncology space in the case of Roche, in the diabetes space in the case of Novo Nordisk. It’s no coincidence I would say that the first two vaccines to be discovered were European companies. So, we have a great expertise in Europe there.

And then the third space is software. Europe is, of course, where SAP was born – one of the first and largest software companies in the world. And we have a culture. We have a great number of great software companies in Europe, whether that be in the 3D design space in the form of Dassault Systemes, in the asset management space in the form of SimCorp. So, I think that’s another space where we have some great businesses. So, I would say there are some great businesses in Europe, and I would look to get exposure to those, rather than saying, get exposure to Europe as an economy.