Focused European Equity Strategy H2 2021 Commentary



As we approach the third anniversary since the inception of our Focused European Equity Strategy, we feel now is as good a time as any to begin providing more regular updates on this offering. While we have been providing a quarterly factsheet on the strategy for some time, it is our intention to now begin sharing a brief commentary similar to our (typically) biannual Reviews. Regardless of whether one is an investor in the strategy or not, we hope that you find this to be yet another useful set of insights from our team.


While European equity markets generally ended 2021 in the black, their performance certainly lagged that of the (continued) runaway growth of U.S. equities, especially larger cap growth businesses. Though these highfliers have taken somewhat of a hit in the face of higher inflation and demanding valuations, the fact remains that markets globally have favored those willing to pay up for outsized growth, or at least, the possibility thereof. As one might imagine, this has made for a challenging environment for us: the businesses we own, despite their generally high earnings yields and solid balance sheets, have often failed to attract much investor attention. At the same time, though we continue to find bargains on this side of the Atlantic, the fact is valuations remain stretched globally, leading us to hold more dry powder than would be ideal. In some ways these circumstances have persisted for the entirety of the short life of the strategy, but their ongoing impact on performance makes them no less frustrating, even with the passing of time.


While we feel there is no shortage of evidence to suggest that markets have been behaving irrationally for some time, perhaps one from the portfolio may be most instructive: Leoni AG is a German automotive supplier we owned when the strategy launched. After meeting with the management team in Nürnberg in late 2018, we came away with the view that the business was well positioned not only to refocus on margins over revenue growth, but also to enjoy tailwinds from the rise of electric and autonomous vehicles. While progress was slow in coming on both fronts, we remained patient given our confidence in the management team to bring the business back to what we saw as its true (and significantly higher) earnings potential. Unfortunately, the onset of the COVID-19 pandemic called into serious question the viability of this turnaround in our eyes, leading us to exit the position in early March 2020. From that time to November 2020, shares fell another ~35%, marking a 20-year low for the company, and we felt somewhat vindicated. However, since that time, shares have risen 130%+, or ~50% higher from where we sold! While some may attribute this to poor market timing on our part- we also feel it important to consider the state of the business as of Q4 2019 versus today: Revenues have shown minimal growth and operating margins, though positive again, remain in the low single digits. While this could reflect a nascent recovery, this only occurred with a 35% increase in net debt, making this turnaround significantly less compelling for equity owners. While those willing to speculate may have been able to make a tidy return from this situation, fundamentally oriented investors like ourselves have seen little reward for our prudence. With Leoni representing one of the major detractors from portfolio performance over the life of the strategy, we see it as quite representative of the challenges faced thus far.


To be clear, it is not as though every company with which we have gotten involved has encountered the same issues. During the same diligence visit in which we met with the team at Leoni, we also had the opportunity to visit the headquarters of another portfolio company- JOST Werke AG. At the time, JOST traded at less than 6x EBITDA, despite double digit operating margins and a global market share of >50% in its core products. Our discussions with the team there reinforced our views that JOST understood the demands of its customer base, which consisted not only of commercial truck manufacturers, but the fleets they sold to, and ultimately, the truck drivers themselves. As demand for trucking has risen with the explosive growth in e-commerce, safety and convenience have become increasingly important, and JOST has sought to iterate on its products accordingly. This has resulted in solid revenue growth, stable margins, and the ability to leverage its technology to move into new markets, namely the agricultural space. All of this has made JOST a top contributor to the portfolio’s performance thus far, and though the company is not as cheap as when we initially got involved, it remains attractive relative to history, and we have resized the position accordingly.


While we have begun to see investments made early in the strategy’s life begin to “bear fruit”, we are also constantly working to find new opportunities to deploy capital. As we have mentioned, this has been an increasingly difficult proposition, but we nevertheless did manage to identify several businesses this year that we felt possessed compelling fundamentals at attractive valuations. One of these was Vivo Energy plc. The result of a move by Royal Dutch Shell to divest from certain downstream operations a decade ago, Vivo is the leading retailer and distributor of Shell-branded fuels and lubricants in Africa. With a network of over 2,300 service stations across 23 countries, it is frequently the #1 or #2 retail fuel provider in the markets in which it operates using the Shell brand. We viewed the business as an excellent play on the emerging consumer in Africa, a region where EV adoption will likely take longer than in the West. Despite this, the business traded at a discount to many fuel retailers in developed markets, offering what we saw to be a margin of safety. Clearly, others recognized the value of this business, and in November the company received a takeover offer from Vitol, a major energy trading house and a significant shareholder in Vivo since the business’ inception. While we would have preferred to remain involved with this business for much longer, a successful acquisition by Vitol would represent a successful “exit” from this investment in our eyes.


It is our hope that these few case studies offer some insight into our methodology and process when it comes to investing the Focused European Equity Strategy. As we look towards the year ahead, we see no shortage of risks to the global economic recovery: ongoing pandemic-related disruptions (both social and economic), elevated inflation numbers and decidedly frothy asset valuations. We believe all these factors have the potential to make markets more volatile which, though unnerving, would likely create further opportunities in risk assets, especially in the small and mid-cap European equities space. Whether this will indeed come to fruition is impossible to say, but we will remain vigilant, and be clear on our intentions if the opportunity set should widen dramatically.


While that would certainly be a welcome development, it is no secret that equities around the world remain richly valued. Despite this, we believe that we have identified a number of quality businesses whose valuations remain relatively undemanding. Comparing our portfolio to that of major European and developed market indices, we feel there is a good deal to like:


Source: Bloomberg


As one can see, our portfolio has a relatively higher “earnings yield” versus major indices, suggesting a more attractive valuation. However, we also feel that our strategy’s relatively higher dividend yield is important to note as well. On the most basic level, this higher yield means investors in our strategy are receiving more current income than investors in most equity indices at the moment. While that is interesting in and of itself in this yield-starved environment, we are of the view that this may become an increasingly attractive quality in the years to come. Though global investors have lately been willing to assign massive valuations to businesses whose (uncertain) cash flows are predominantly expected far out in the future, the prospect of rising prices (and interest rates) may cause an increasing attraction to immediate, assured income. This would create yet another tailwind for a portfolio that, in our eyes, offers a compelling combination of quality and “margin of safety”.


Overall, we feel our current portfolio is well-positioned for whatever may lie ahead, and we are quite optimistic about the prospects for the types of businesses in which we invest in Europe. If you are interested in learning more about our views on this space, the strategy, or specific opportunities we are seeing, we strongly encourage you to reach out to us to learn more. As we begin this new year, we look forward to providing you with more updates about the strategy and wish you all the best for 2022.