Buy world-class companies on the cheap with Fidelity European

Although positive vaccine news has led to a re-rating of many cyclical companies, investors might now benefit from turning to defensive growth stocks. And Fidelity European Trust (FEV), which is trading on a wider-than average discount to net asset value (NAV) of nearly 8 per cent, looks like a good way to get exposure to them. 

Continental European listed equities are often under-owned by UK investors. Economic growth has been uninspiring, politics can be fractious and fears of another debt crisis have put some people off. But encouraging developments are drawing institutional investors back to the region. Michel Perera, chief investment officer at Canaccord Genuity Wealth Management, for example, says that European equities “probably represent the best opportunity right now” for a number of reasons. 

The €750bn (£641.42bn) European recovery fund has shown encouraging signs of fiscal integration in Europe and should provide welcome stimulus. The European Commission has revised up its economic growth forecasts for the European Union, manufacturing data has been strong and companies have consistently beaten earnings expectations, following a rocky start to the year.

However, much good news is already been factored into stock prices. Some companies in certain cyclical sectors are now trading at their highest ever valuation multiples. But European equities in aggregate look better value than their US peers. 

For long-term investors, buying quality companies with solid fundamentals and reliable cash generation looks like a sensible approach, and this is exactly what Fidelity European Trust aims to do. The trust, which has been managed by Sam Morse since 2011, looks for companies able to grow dividends over a three to five-year time horizon - irrespective of the economic environment. 

The trust has not made the best share price total returns of Europe trusts over the past five years, but its 116 per cent return is still well ahead of FTSE World Europe ex UK Index's 76 per cent. Fidelity European also yields 2.1 per cent, a level not to be scoffed at in a yield-starved world. 

Broker Stifel says that the trust has outperformed its benchmark in eight of the past 10 years. One reason for this is because Fidelity European's manager focuses on companies which have attractively valued divided growth, giving the trust a defensive return profile, and it has tended to outperform in down markets.

The trust's bias to quality left it lagging in the value rally in late 2020 and early 2021, but Morse shrewdly doubled leverage which boosted its performance. Morse commented earlier this year that he has been “too timid” with gearing over the past decade, which has averaged about 6 per cent, so he plans to keep it elevated to boost long-term returns.  

The trust's fee was reduced earlier this year to 0.85 per cent on the first £400m of its assets and 0.65 per cent on assets above that. Previously, it had charged 0.75 per cent on assets over £400m.

While not an income fund, Fidelity European has a progressive dividend policy and has increased its payouts every year for the past decade. But any strengthening in sterling will reduce the amount UK investors will receive.  

It is also the only European trust on investment platform AJ Bell’s select list. Ryan Hughes, head of active portfolios at AJ Bell, describes Morse as “hugely experienced and a safe pair of hands” supported by a well-resourced pool of analysts at Fidelity. 

Morse is supported Marcel Stotzel who joined Fidelity in 2014 and became co-manager of the trust last year. 

Fidelity European Trust's board tries to keep the discount to NAV in single digits. So the 7.4 per cent discount is less likely to widen much.  

Under the bonnet

The trust is well diversified across sectors and geographies which Morse says helps to balance macro risks. The sectors in which it is the most overweight compared to FTSE World Europe ex-UK Index are financials and technology, which accounted for 21 per cent and 14 per cent of its assets, respectively, at the end of May. The trust also has significant exposure to healthcare with 17 per cent of its assets in this area.

The trust's largest country weightings are France which accounts for 29 per cent of its assets, followed by Switzerland at 25 per cent, Germany at 11 per cent and the Netherlands at 8 per cent. This helps to diversify geographic risk, as does the trust's focus on larger companies which derive the majority of their earnings from other countries. Some 95 per cent of the trust was invested in companies with market capitalisations of over £10bn at the end of May.

A recent addition to the trust's holdings is Bankiter (SP:BKT). The Spanish banking market is experiencing a lot of consolidation so Morse hopes that this company will be able to take advantage of customer attrition and grow organically. More broadly, European banks, which have been out of favour for years as interest rates have been negative, should do well if there is economic tightening.   

The trust’s largest holding is Nestle (SWX:NESN), the world’s largest food company. A significant proportion of Nestlé’s business is in areas with strong growth and high emotional engagement, meaning it could potentially increase the prices of its products. Morse expects Nestle’s management to further streamline its portfolio and exit less profitable businesses, which should help drive efficiencies.

Fidelity European Trust’s second largest holding is lithography tool manufacturer ASML (NL:ASML), a semiconductor firm. Also read ASML is a hidden tech gem (IC, 11.01.21).

The trust's 10 largest holdings include LVMH (FR:MC), the world’s largest luxury conglomerate. Its portfolio of luxury brands has tended to be less cyclical than those of other luxury goods companies and could be well positioned for a slower growth environment. LVMH and L’Oreal (FR:OR), also a top 10 holding, benefit from selling to Asia’s growing middle classes.  

Risks 

Recent strength in markets suggests that much of the recovery may already be factored into share prices which Morse says “prompts a degree of caution.” Any disappointment in earnings or dividend growth could leave the market vulnerable to a correction. And a shift in policy by European central banks, which have been very accommodative over the past 18 months, could also hit equity markets. 

Fidelity European Trust's balanced asset allocation and focus on reasonably priced cash generative companies should stand it in good stead. But the trust’s elevated gearing levels are likely to amplify losses in down markets.  

Persistent inflation could hinder longer duration growth companies if a rise in interest rates follows suit. There are some signs of rising inflation such as a rise in input prices which poses a challenge for companies which can't pass increasing costs onto their customers and may face a margin squeeze.

However, Morse believes that a number of the trust's largest holdings, such as Nestle and pharmaceutical company Roche (SW:ROG), have attractive pricing power and should be able to maintain their competitive advantages.