Focused European Equity Strategy Commentary: March 2022

With the conflict in Ukraine dominating headlines, many have begun to speculate on both the near- and long-term implications this situation may have for global growth, as well as the path of Europe’s major economies. Major bourses on the Continent have clearly reflected this, underperforming their U.S. peers, and moving, sometimes quite violently, downward year-to-date. At the same time, volatility in the Euro versus the Dollar has risen significantly as of late, placing further pressure on U.S.-based owners of European assets. With these factors in mind, we felt it appropriate to provide an update on our Focused European Value Strategy. Despite the aforementioned headwinds, we see several factors which may well mitigate risk and widen the opportunity set for the Strategy, especially in the long term.

First off, we feel it is important to note that none of our portfolio companies currently have major operations in Ukraine or Russia. To be clear, this does not mean that our businesses have NO exposure to the region: for example, Hamburger Hafen und Logsitik operates Ukraine’s largest container terminal at the Port of Odesa, but these operations do not represent a meaningful portion of the business’ revenue. Similarly, some of our portfolio companies may serve industries which are exposed to this conflict. Many have noted, for example, the impact of this conflict on the German automotive industry, with sanctions (or self-sanctions) effectively cutting off the Russian market, and the effective shutdown of Ukrainian manufacturing facilities resulting in supply shortages at German automotive plants. With Russia representing roughly 2% of German auto exports, the former issue is likely less concerning than some may believe. As for the latter, the disruptions to Ukrainian facilities only further exacerbate the supply chain issues that have impacted the global auto industry in the past year. While this remains a challenge for the industry, it has also led to changes in price/mix that, over the long term, may lead the industry to become more profitable. As such, we remain quite constructive on the businesses we own in this space, whether they are suppliers like Continental or Duerr, or OEMs like Volkswagen (owned through Porsche Automobil Holding). We will likely continue adding to these positions where appropriate and remain vigilant for further opportunities in the space. Regardless of what the economic outlook may look like for the region, as with much of the Strategy’s portfolio, our automobile exposure is geared not just towards European, but rather global markets, making the businesses we own that much more compelling at this juncture.

To that end, thinking more about the long term, we believe it is also an important time to address the path forward for the Strategy. Since inception in early 2019, performance has lagged what have been quite buoyant markets. Though this has certainly been a source of frustration for us, as we are sure it has been for some of you, we continue to firmly believe in our methodology and process. As we discussed in our recent update on the Strategy, we believe that the market may come to place a higher premium on the current cash flows of the businesses we own, as compared to the highly uncertain future cash flows of the oft-discussed (yet frequently profitless) businesses that seem to be driving indices higher in recent years. For reference, we’d like to include an updated version of the data we shared back at the beginning of the year:

Source: Bloomberg

While markets themselves have gotten somewhat cheaper, so too has our portfolio, often by a relatively greater amount. While in December the strategy had an earnings yield of 11.0% to the 3.8% yield of the S&P 500 (7.2% greater), by the end of last month this difference had widened to 8%. While some may argue that the businesses we own may be “cheap for a reason”, we would question this assertion. Using the S&P 500 and MSCI EAFE for comparison:

Source: Bloomberg

Though businesses in the S&P 500 indeed have higher returns on equity on average (20.7% versus the Strategy’s 13.8%) they achieve this through notably higher debt levels. Looking to peers in other developed markets, though the companies in the MSCI EAFE achieve similar returns on equity to those of the Strategy, they do so with levels of leverage similar to that of U.S. businesses. In our eyes, this would seem to suggest that the valuation discrepancy between the Strategy and larger, more well-known businesses in developed markets is not as much a question of quality or operational performance as some might believe.

Speaking of valuation discrepancy, we would like to provide you one last data point, which some of you may have seen in the past. For some time now, we have tracked the discount between small cap European equities versus that of the S&P 500 versus their 5-year forward performance. Below is the latest iteration of that study:

Source: Bloomberg

As one can see, generally speaking, when there is a significant discount in the long-term valuation of small cap European equities versus their larger U.S. peers, these businesses have a strong tendency to outperform the S&P 500 in the subsequent 5-year period. While past performance is, as always, no indication of future results, we do find this data to be compelling. With the current discount sitting at about 40%, we have good reason to be constructive on the path for our Strategy from here.

With that being said, we would note that the outperformance in this study is measured on a 5-year (annualized) basis, suggesting that taking advantage of any potential valuation discrepancy may take time. Though there have been signs the investing public may be beginning to look further afield for bargains in a world where rising inflation and rates make expensive U.S. equities less attractive, the fact is that we cannot say definitively when this regime shift may occur (if ever). However, we believe that regardless of what may lie ahead, the Focused European Value Strategy continues to own high quality businesses at quite compelling valuations. Though it may require patience, we are of the belief that owning such businesses will prove rewarding over the course of a market cycle.

Despite a decidedly challenging environment, we greatly appreciate the trust you have put in us as investors in this Strategy. Should you have questions about our methodology and process, our views on markets or a specific holding in the Strategy, please feel free to reach out to discuss further.