European Equities Q4 investment update

As with any investment, your capital is at risk. Past performance is not a guide to future returns.

Tom Hodges (TH): Welcome to this quarterly update video covering the European Equity Strategy. My name is Tom Hodges, I'm the investment specialist on the strategy. And today we're going to cover performance, the portfolio and give you a bit of an outlook going forward.

It's been a tough quarter. It's been a tough year for the European growth investor. And indeed, we have underperformed both over the quarter and the calendar year of 2024. And to discuss this with me today, I have Christopher Howarth, who is an investment manager on the European Equity Strategy.

So Christopher, let's dive in by covering the drivers of performance.

Christopher Howarth (CH): Yes, you're right. So this has been a tough quarter for European growth investors and indeed a tough year. And I think one of the main contributors to that that we've been talking about around the desk has been various cyclical headwinds which have impacted the fundamental performance of several stocks in the portfolio.

Often these cyclical headwinds have had their origins in the pandemic and in their responses to the pandemic. And one of the most important of these has been the de-stocking effect. This is when customers that have built up large excess inventories during periods of uncertainty, so for example, during the supply chain blockages over the pandemic, then have to then burn through this excess inventory before placing new orders.

And this creates a headwind to companies like, for example, Sartorius Stedim, which makes bioreactors. Soitec, which makes the materials that go into semiconductors or building materials companies like Kingspan. So, that's had a notably negative effect over the past year on several of the stocks in the portfolio and in some cases that's been accompanied by derating as well.

TH: And interestingly in Europe, compared to the US at least, value has actually outperformed growth, whereas in the US we've seen growth outperform value quite handily from a style-based perspective.

CH: That's right. I think one of the headwinds that we have faced as growth investors has been the fact that growth itself has been out of favour, so it's not just a question of the companies that we're investing in struggling with various cyclical headwinds, their valuation multiples have in many cases also come down.

But the optimistic side of this is that actually it creates more of a potential for rebound. Once those fundamentals start to come back, then you potentially have those valuations reverting to levels that might be more comparable to peers in other continents.

TH: And there have been some notable positives in 2024. And the standouts would be the likes of DSV, which made an acquisition earlier in the year, which we discussed in previous videos.

And really, I guess most particularly, has been Spotify. And that's an interesting one, because it could provide a bit of a blueprint for other companies in the portfolio.

CH: That's right. Spotify has been a standout performer in the portfolio, delivering well over 100 per cent total return over the past year. And this is an interesting one because for a long time, Spotify has been delivering impressive top-line growth and also growth in monthly active users, but for a long period of time this hadn't translated into profit growth. Spotify had been continually reinvesting in top-line effectively.

This has all changed. Spotify has made considerable cost reductions and this has translated into not just profitability but also free cash flow profitability. This has been received extremely positively by the market with a significant valuation uplift. We believe that this could potentially shed light on what could happen to other companies in the portfolio once those fundamentals return and you get that valuation uplift on top.

TH: Yeah, and it's really what's been quite notable, I guess, for Spotify has been that revenue growth, as you said, has been decent, it's been good. But profitability, the profit increase has been really, really strong as it's seen or as it's exhibited some operating leverage.

Is that something that we could start to see with some of those underperformers that you mentioned earlier, the likes of Sartorius Stedim and the likes of the Soitec?

CH: That's right. So, several of these companies have relatively fixed cost bases, and this means that when sales decline, this translates into a significantly greater decline in earnings, but the reverse is also true.

So, once we start to see that growth returning, we could actually see much faster EPS growth, free cash flow growth, and this operating leverage could generate significant returns from there.

TH: And turning to the portfolio, turnover is quite elevated compared to history. What's the thinking there and what have we been doing?

CH: So, yes, portfolio turnover has been higher and of course there will be periods of time in which it's very low and then periods of time in which we make several changes. The past few quarters has been one of consolidating the portfolio around more higher conviction ideas.

So, as part of that, we've sold companies like Mettler-Toledo, which we've owned for many years. We decided to sell this business eventually on valuation grounds, having made reductions in the past.

We also sold businesses like Vitec, Wizz Air, CRISPR, Eurofins, basically just consolidating the portfolio around what we believe are the highest conviction opportunities over the next few years.

TH: And in terms of an outlook, what would you say to clients in terms of giving them a message of positivity, I guess, for the coming years?

CH: So I think one of the challenges with investing over long periods of time is that it's often at the points when it feels the most painful that you have the potential for the greatest future returns.

And I think that's particularly true when you've seen cyclical weakness compounded by valuation weakness. Because while that's very painful to go through as an investor, and I think even more so when you see index concentration around large caps, it actually creates almost ideal opportunities for returns in the future. Because once you have that fundamental growth coming back and you have that operating leverage, and you have the valuations on top, then that can potentially create a really powerful cocktail of total return in the future.

So, I think I would certainly have a positive view of the next few years and we are now starting to see some indications that some of these cyclical headwinds are now abating and potentially even turning into tailwinds in the near future.

TH: Well, I think that's a really bullish message to end on. Europe and European growth really has two of the sort of powerful engines blowing in its favour for returns in terms of the ability to see fundamental growth return, but also that valuation support.

So, thank you very much for your time and we hope to see you next time.

Annual past performance to 31 December each year (net%)

Annualised returns to 31 December 2024 (net%)

Source: Revolution, MSCI. US dollars. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised.

Past performance is not a guide to future returns.

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