The fund sector that’s on the up, but investors are not buying

Stock market indices are rising, but investors remain lukewarm to funds investing in this region.

Europe is not just a conundrum for UK tourists trying to figure out where they can show off their new swimming trunks this Covid summer. The continent is also proving to be quite a puzzle for investors.

In recent weeks, buoyed by confidence about a eurozone economic recovery as Covid restrictions ease, indices such as the STOXX 600 and German DAX have surged to record highs.

In addition, European funds have seen a performance upturn. Figures from FE Analytics show that the average Europe ex-UK fund is up 28.9% between 1 November 2020 and 1 July 2021.

In a note in May, Frédérique Carrier, head of investment strategy at RBC Wealth Management, said that the European economy was reviving faster than most observers expected with the European Commission upgrading its economic forecast for the EU to 4.2% GDP growth in 2021 and 4.4% in 2022. “Europe is finally emerging from a long economic winter thanks to lower infection rates and an accelerating vaccine roll-out,” Carrier wrote.

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More outflows than inflows over past year

However, this European bullishness has failed to bring investors on board. Figures from the Investment Association (IA) show over the past year £431 million was withdrawn from the Europe ex UK sector.

Daniel Lockyer, senior fund manager at Hawksmoor Fund Managers, believes that outflows could be as a result of the swing to value stocks from growth as economic recovery takes hold.

“There are not that many value European funds remaining. Over the last 10 years they have underperformed, shrunk or simply been closed,” he says. “Maybe European growth investors looking to switch to value have gone to the UK.”

Rupert Thompson, chief investment officer at Kingswood, is one who favours the red, white and blue. Although stating that Europe is benefiting from the value rotation into sectors such as financial and industrials and has “further to go”, it pales in comparison with the UK.

“We are lukewarm on Europe. We prefer to play this move to value via the UK. It is a lot cheaper than normal trading at a 25% to 30% discount to the rest of the world in price earnings terms,” Thompson states. “Europe ex-UK trades at a PE discount of around 5%. We think the UK’s recovery will be stronger than the eurozone giving it a distinct value advantage.”

Detlef Glow, Head of EMEA Research at Thomson Reuters, says outflows are simply following a long-term trend. “We’ve witnessed a lot of Europe outflows over the past few years,” he says. “Investors believed that Europe had weaker economic growth prospects than other regions such as the US [tech] and China [economic growth].”

It’s partly the reason why, according to David Lewis, co-head of strategy of Jupiter’s Merlin Portfolios fund range, does not invest in a dedicated Europe ex-UK fund.

“Our global funds have a reasonable exposure to some European companies,” he says. “But we believe the euro is a bit of a weight around the necks of EU nations. Europe does not have the structural advantages and it is not as attractively priced as other regions. Its strongest economic growth years are in the past,” says Lewis.

Reasons for optimism  

Lockyer remains optimistic. He favours River & Mercantile European in its MI Hawksmoor Global Opportunities fund. River & Mercantile European, which launched last September, has a philosophy of avoiding highly valued growth stocks but also structurally challenged deep value.  

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Lockyer explains: “It is a pragmatic fund on the value end of the spectrum. It is looking for those companies set to do well in the recovery, and since November it is the cyclical stocks which have performed.” Current holdings include Banco Santander (LSE:BNC) and Dometic Group, a Swedish manufacturer that supplies mobile leisure products for recreational vehicles.

Funds like these, Lockyer argues, can take advantage of Europe’s depth and size. “The European market is so much broader than the UK. Even a passive Europe ETF index tracker will give you a wider and more diversified exposure. A UK ETF would be dominated by banks,” he says. “It is not cheap on the continent at an aggregate level, but an active fund can go across the sectors and get attractively priced companies without sacrificing growth.”

Stefan Gries, co-manager of the BlackRock Greater European (LSE:BRGE) Investment Trust, also emphasises the breadth of stock opportunity. “You don’t need to have a positive view on European economic growth to buy a trust,” he says. “Europe is home to some fantastic companies with developed corporate governance and innovation. You just have to go out and find them.”

The trust focuses on companies with long-term wealth creation. “They will be market dominant with pricing power in their fields,” he says. “We want best-in-class culture. There is always a new narrative and pressure to change, change, change your composition. Earlier this year, many sold off semi-conductor stocks. We stayed with their growth story and now they are seeing huge demand.”

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Jamie Ross, fund manager of Janus Henderson’s Henderson EuroTrust (LSE:HNE), believes Europe can be a value leader. “Europe is more associated with interest rate sensitivity, so we have seen flow improvement. The sentiment around Europe is improving,” he states.

Ross believes there are opportunities in ‘compounder’ and ‘improver’ stocks. “A compounder has a strong current market position, high returns on investor capital and an expectation that they will remain high going forward,” says Ross. “We look to avoid those companies that although high returning now, will fade because of industry dynamics or product failure. An improver’s business model suggests that returns are going to go up over time.”

He says the fund is keen on consumer discretionary such as Adidas (XETRA:ADS), luxury goods in the form of Hermes (EURONEXT:RMS), auto companies such as Stellantis (EURONEXT:STLA) and communications such as Telecom Italia (MTA:TIT).

“An improver we like is Delivery Hero (XETRA:DHER) with the payments process businesses also looking good for growth,” he says. “We are aware that valuations are higher than normal in the payments sector, but we like it. It is a question of which individual business we find attractive.”

In fact, even the valuation picture isn’t as gloomy as first painted, argues RBC Wealth Management’s Carrier.

“Valuations for European equities do not seem unduly stretched, in our view. On 16x the 2022 consensus earnings estimate, the Euro STOXX Index trades at a 20% discount to the S&P 500. It also trades at a wider-than-average discount to its US counterpart on a sector-neutral basis,” she wrote.

Stephane Levy, strategist at Chahine Capital, which runs the Digital Stars Europe Ex-UK fund, believes it is very attractive to invest in Europe just now.

“Europe is a value market. The US is a growth market. We will see higher inflation over the next 10 years and that means lots of opportunities. We are now overweight in value and cyclical stocks and have reduced allocations to defensive stocks, food and healthcare. We also look at growth stocks such as digital gaming,” he says.

Sustainability will be a key driver of returns for Europe

One sector of European growth all the experts agree on is sustainability.

The European Green Deal, the European Commission's roadmap to make Europe the first climate neutral continent by 2050, will lead the way. Its €800 billion pandemic recovery fund will also focus heavily on energy transition.

Ross says: “There is a very good chance that sustainability becomes the next dominant investment theme. It could mean the decade of US tech giving way to the decade of European sustainability.”

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He says that European governments, investors and corporates are far more forward-thinking on sustainability than the US.

“The biggest renewable energy firms and wind turbine manufacturers are in Europe. As investors green up their portfolios, higher European allocations makes sense,” he states.

Europe may not want your bucket and spades but its value opportunities, broad range of well-governed corporates, edgy innovators and green leaders could book a place on your portfolio.