Five years ago, European funds took regular beatings in the performance league tables. Nowadays, however, some of the best-performing funds anywhere have a European prefix attached to their title. Mark Hargraves, fund manager of Axa Framlington’s £95 mn ($190 mn) European Fund – up more than 75 percent since 2002, well ahead of the Msci benchmark – says the change has been driven by continental companies adopting more aggressive Anglo-Saxon working practices, and the growing presence of a new breed of shareholder.
‘There’s been a huge change in the shareholder base of a lot of European companies,’ Hargraves points out. ‘They used to be very domestic, with a lot of passive local insurance companies. Now it’s become much more international, with owners who are also a lot more demanding.’
So does this mean goodbye to that bewildering patchwork of stubborn national identities, strong union power and generous pay and working conditions – and hello to the new seamless economy of New Europe, aided by a tighter rein on costs, a surging M&A pipeline and a growing tranche of demanding and performance-focused owners?
also been very good at shifting their cost bases to Eastern Europe.’ The quality of European IR has made big progress in the last few years, too – but Hargraves is not a fund manager who sets much store by locking eyes directly with management and Iros. ‘Quite a few investors say they like to see a company eye to eye,’ he comments.
‘Personally, I think that’s a load of rubbish. Most companies suffer from over-confidence. Regulations are now very tight – you used to get lots of extra information at a meeting, but now you tend to get highly scripted lines. I’ve done a number of meetings where the management assures you all is well, and the next day you hear of a profit warning.’
Return to returns
What Hargraves puts greater emphasis on is getting companies to shift the chat away from margins, market share and growth to capital expenditure and what return it’s making – these factors are far more relevant for him.
‘Often, that will tell you a lot about the capacity of an industry, and management usually doesn’t put enough emphasis on it,’ Hargraves complains. He says all the emphasis on market share and growth is a habit Iros have picked up from continual exposure to analysts, ‘though it can give you a sense of where they’re coming from.’
Hargraves also needs a solid sense that an Iro has a defined function inside a company and can give a confident explanation
Hargraves says the truth sits somewhere in the middle, although if the ex-Bristol University geography graduate was to plump for a country that was reforming its act fast, he would pick Germany, where more than 20 percent of his fund is concentrated. ‘The German market generally was moribund for a long time,’ he says. ‘But in corporate Germany there’s been a revolution in terms of profitability, a shift from gaining market share and bigger sales to making profits. German companies have of its business mechanics: what’s driving it, how sustainable it is and what the competition is. For now, Irish and Scandinavian IR comes closest in quality to the UK and the US, he says, although Italy – unsurprisingly – remains weak. ‘Spain is very different,’ Hargraves adds. ‘Firms there are quite good at corporate governance, but you still have to be aware there are often core groups of shareholders who pull the strings, especially with family-owned companies.’
Hargraves typically holds 55 to 70 stocks within a pretty promiscuous brief, and is able to pick and choose from a wide range of market caps. He describes himself as a mediumterm investor, with an average holding period of one and a half years. There are substantial variations within these parameters, however.
‘Some companies I’ve held for five years,’ Hargraves explains. ‘Like Anglo Irish, a specialist bank focusing on commercial property – a fantastic bank that’s grown at a rate of 20 percent a year for 10 years. For most companies, that sort of growth is very difficult, but it can be done. What Anglo Irish has done is be very focused on what it does, very niche-focused with great service.’ Compare that growth with Royal Bank of Scotland, which has thousands of divisions, he adds.
Another operation Hargraves rates highly is German tire-maker Continental. ‘Both high-quality tires and anti-lock braking are big growth areas for Continental,’ he notes. ‘It’s a mid-sized company, the classic sort of firm that supports the Germany economy. Many people thought it would be wiped out years ago, but it has thrived by offering premium-rate products. It has also managed to address its cost base; more than 50 percent of its workforce comes from Eastern Europe. As it’s a niche player, it’s also been able to retain its pricing – its return on equity has soared from 10 percent to 20 percent.’
Old habits
On the other hand, Hargraves’ relationship with Deutsche Post – ‘a classic German restructuring story with some terrific turnaround opportunities’ – hasn’t flourished in the same fashion. ‘The stock has performed OK, but the returns are still poor and the firm is still too focused on size rather than profitability,’ he explains. Recently the company downgraded its numbers, so Hargraves sold.
European companies that fail to shrug off die-hard habits of the past – bloated workforces and lack of shareholder accountability, to name but two – look increasingly vulnerable, warns Hargraves, especially given the increasing international ownership base offered by hedge funds and private equity. ‘Laggard companies are no longer safe,’ Hargraves says. ‘Look at Abn Amro – badly managed for over a decade.’
The European market still looks attractive, with a p/e average of 14, but investors have got used to robust returns. So what of the future? Hargraves thinks the bull run is past its best for now. ‘The driver behind European markets has been earnings growth, which is now starting to slow, although it still remains positive,’ he points out. But strong cash flow, positive earnings and ongoing acquisition activity means European equities will still deliver 6 percent to 8 percent gains for investors this year, he adds.
Unfortunately, there are few obvious valuation anomalies remaining in most sectors, according to Hargraves. ‘The pharmaceutical sector looks increasingly cheap relative to its long-term history,’ he says. ‘However, rising political risk with the upcoming US presidential election and disappointments with new drug launches mean the sector may remain a value trap in the near term.’
Similarly, large caps increasingly look good relative to mid-caps, although Hargraves points out that mid-caps continue to benefit from high levels of M&A. His portfolio is now weighted in favor of major blue chips, which soak up almost 80 percent of his fund.
Some nervousness in the US economy and its impact on the rest of the world remains. A slump in US real estate, for example, could trash consumer spending, inevitably hitting Europe. European and US consumers have endured a record rise in domestic energy prices recently, as well as interest rate rises.
Hargraves remains unperturbed, however. ‘The US housing downturn is confined mostly to the sub-prime market,’ he explains, ‘but there will be a moderation, not a crash. What the world really needs is a much more balanced economy. We need the tiger economies to spend more and save less. Yes, it is tougher out there, but it’s not Armageddon.’
