Fidelity European Values Investment Trust Plc (FEV.L) – 24th March 2014
Fidelity European Values Plc (FEV) is an investment trust listed in London. The trust’s objective is to achieve capital growth by investing in the equity markets of continental Europe. The trust’s mandate requires that the investment manager concentrates 80% of assets in companies that are listed on exchanges included in the benchmark FTSE World Ex UK Index.
The investment manager can invest up to 5% of the portfolio in non-European listed entities which have a significant exposure to the continent. Up to a further 5% of the portfolio may also be invested in unquoted companies.
The investment mandate also encourages the use of leverage within the portfolio, out of the belief that long term investment returns resulting from this will outweigh the costs of any borrowing. Gross gearing is capped at a maximum of 30% of assets.
|Benchmark||FTSE World (Ex UK) Index||Ticker||FEV.L||Latest Close||1513.00|
|52 Week High||1572.00||52 Week Low||1361.00||Exchange||London Stock Exchange|
|Dividend Yield %||1.96||Dividend (Pence)||29.75||Discount to NAV %||10.47|
|NAV (30th April 2014) (Ex income)||1690.09|
European Equity Markets Set to Continue with Strong Performance of Recent Years
While the valuation gap that was once present between equity markets of continental Europe and those of healthier economies has now diminished, there are a number of fundamental influences at play that suggest the bloc’s positive performance since 2012 may have further to run.
Today’s report illustrates in greater detail what are likely to be some of the key drivers behind continental equity market returns, while providing a price target for FEV.L, along with an overview of why we prefer the trust as a means of exposure when compared with individual shares.
Drivers: Signs of a Nascent Recovery in Play
While the central bank policies of non-European nations helped to lift continental stock markets throughout 2013, the key drivers of EU equity returns going forward are expected to come from much closer to home.
Although the road ahead is not without challenges for European policy makers, there has been a gentle persistence in improvements over the last 18 months, indicating that an economic recovery may be taking hold on the continent.
Of greater interest to some investors will be the observation that many of the key milestones to have been reached here have emerged from the once crisis ridden peripheral nations.
Some of the achievements of 2013 have included the stabilisation of peripheral governments, a deceleration in the pace of unemployment growth across the continent, a reduction in the severity of economic contractions and a notable decline in budget deficits across some of the more problematic nations.
During the year, Greece announced that it was on track to reach a primary budget surplus by 2014 while Ireland announced in December 2013 that it expected to make a long awaited exit from its bailout programme. In addition to this, Spain saw a return to growth in the latter half of the year following two years of severe recession.
The year also saw noteworthy steps taken to improve longer term financial stability, beginning with the recapitalisation of Europe’s most troubled banks. Following several years of bailouts, restructuring and deleveraging, capital adequacy among EU banks is now greater than it was before the global financial crisis.
This has brought the financial sector closer to a position where it can resume normal levels of lending while improving overall confidence in the deposit taking institutions which underpin the foundations of Europe’s economies. Policymakers have not failed to capitalise upon the momentum behind the return of this confidence and, as a result, have continued to drive progress throughout the opening of 2014.
This has seen Greece take advantage of lower borrowing costs among the higher risk peripheral economies by announcing a return to the bond market during April. After nearly plunging the world into a period of economic instability three years ago that, at times, was tipped as the beginning of some form of financial Armageddon, Greece raised nearly 3 billion Euros in exchange for a coupon rate of interest that was below 5%.
The positive developments on the periphery for April have now been swiftly followed in May by an announcement from Portugal that the nation also expects to exit its own bailout programme this year.
Although there are risks to the recovery that remain, and the existing improvements have largely been derived from efforts in fiscal consolidation not output growth, the bloc as a whole has made notable progress and, we believe, now has the potential to sustain the fledgling recovery that is beginning to take hold.
The below chart (1st – Daily time frame) illustrates the performance of French, German and Spanish benchmark equity indices between 2012 and the present day. The second graphic provides an illustration.
EU Indices Between 2012 – 2014
EU Economic Indicators
Driver: Recovery has the Potential to Drive Valuations in the Opposite Direction
As crisis era risks have receded, and global equities continued their northward march in response to central bank policies, investors have begun to test the waters again in Europe as part of a worldwide search for yield and value.
This has led the once present valuation gap between continental markets and their other developed nation counterparts to reverse and now many EU indices trade at a premium to their peer groups on a price to earnings basis. As a result, voices have begun to emerge which indicate that some observers believe European equities are no longer undervalued.
Something we feel has been overlooked in all of this is that both earnings, as well as margins for European companies, are, on average, still falling. This, we believe, has magnified the valuation impact of investor inflows into continental stock markets over the course of 2013, hence the rapid acceleration in price/earnings ratios over the period.
Although by traditional standards this should lead to a revaluation of European shares, we do not feel that this will be the case. Our expectation is that the near term prospect of stimulus from the ECB will continue to support markets near to their current levels. This is while the growth outlook for the other major developed economies over 2014 remains bright, which supports anticipations of stable, or higher, levels in equities.
With this taken into account, and given that the continental recovery remains much younger than those elsewhere across the globe, we see the Euro area as offering the greatest degree of upside for investors when compared with other markets.
In addition, with European growth forecast to accelerate, consumer confidence trending higher and inflation remaining significantly below its long term average, we believe an improvement in earnings among European companies may not be far off in the cycle.
Should this be the case, earnings multiples will either reduce, or remain flat in the event of further inflows. As a result, we feel it is most likely that positive EPS (earnings per share) growth will be a bigger driver of equity valuations throughout 2014, not a market correction.
Q2 2014 Price to Earnings Valuation of MSCI Europe Index (Ex UK) Relative to Long Term Averages
Driver: Unconventional Policy Measures to Drive Continued Search for Yield
While Euro area governments have made substantial progress in reducing deficits, recapitalising banks and repositioning their economies to capitalise upon an improving global growth environment, the bloc still has challenges to face.
The most notable of these is the persistent decline in inflation which has unnerved policymakers across the continent since early 2012. This is as CPI has now fallen from 3% in November 2011 to 0.5% at its lowest point in February 2014. If left unchecked, the consequences could see the Euro area plunged into a Japan-like era of deflation, which would have negative implications for the economy throughout many years to come.
Conscious of this, the ECB has reversed its 2011 hawkish stance toward monetary policy and progressively reduced the minimum bid rate (base/bank rate) from 1.5% down to the current level of 0.25%. So far, this has failed to halt the deceleration in price pressures within European economies and the central bank is now believed to be actively exploring the possibility of embarking upon an asset purchase programme (QE) similar to those seen in the UK, US and Japan.
In addition to facing legal hurdles under the EU constitution, the ECB will also have to overcome the technical challenges inherent in the task of providing monetary stimulus to the European economies. This is because of the differences between the capital market structures of continental economies and those of the West. Further from here, the finer details relating to whose bonds would be purchased, and in what quantity, would need to be established before the ECB could go ahead in this manner.
These challenges are likely to require time to overcome and as a result, we believe the next policy step will be a further reduction to the minimum bid rate, most likely next week (Thursday 08 May). If the bank wishes to avoid negative deposit rates, the anticipated reduction in rates will only be minor, most likely in the region of 10-15 basis points.
Should this be the case, and the ECB does cut rates, then the implications for continental equities would be highly positive, particularly for large caps with attractive and stable dividends.
The below graphics illustrate the European disinflation trend and the behaviour in rates of output between the continental core and periphery.
FEV Lags the Benchmark in 2013
After a positive performance which spanned a number of years FEV fell down in the face of its benchmark during 2013 as returns on riskier areas of the market outpaced those of the higher quality dividend income stocks listed in Europe.
While investor appetite for risk returned during the year, driven by improvements on the continent and a strengthening recovery elsewhere, the investment manager continued to follow the trust’s traditional strategy un-distracted.
This is to invest in high quality companies, with strong balance sheets, where business models and macroeconomic positioning offers the potential for sustainable levels of dividend growth over time.
Although the strategy was not as successful as it has proved in past years, we do feel that the manager’s persistence with it positions FEV well to exploit a monetary policy environment which is likely to see rates fall further, as well as the eventual return of earnings growth for European companies. As a result, we remain undeterred by the 2013 outcome with performance.
Board Plans Share Split to Boost Attractiveness to Retail Investors
In a positive development for retail investors seeking exposure in European companies, the board of FEV announced in early 2014 that it would use the annual general meeting this May as an opportunity to consult with shareholders over the potential to carry out a share split.
The purpose of this is to reduce the individual cost per share for FEV and thus make the trust more attractive to smaller retail investors. The proposed split will see every share (1,513.00) exchanged for ten new shares priced at 1/10 of the current value.
This should help to increase the volume of shares traded and could provide support for further gains over the coming months if the split has the desired effect of making the trust more attractive to retail investors.
FEV.L, 8 Hourly Chart
Valuation and Risks
FEV currently trades at a discount to NAV of 10.4% which is below the long term average of just over 12 % but, in our view, is attractive given the positive fundamental support for European equities and the manager’s lengthy track record of generating above average returns.
This is while European price to earnings valuations on average have risen from between 11 and 12 X earnings in late 2012, to just over 14 X earnings today. This means that by traditional metrics, continental stocks are no longer cheap. However, present day valuations remain below their 12 month highs, just above 16 X and still enjoy the support of a positive outlook for earnings growth and stimulus driven inflows.
On the other side of the same coin, concerns over valuations, earnings, and the tightening of monetary policy all have the potential to create adverse conditions for investors in developed market equities going forward, including those of Europe.
Were a sustained period of weakness to ensue across the world’s more prosperous markets such as the US and the UK, then European indices could also face the prospect of giving back much of the last 24 month’s gains.
Geopolitical conflict also represents a risk in the current environment, most notably where Russia and Ukraine are concerned. If this conflict results in some form of economic warfare, via trade sanctions, this could have a severe impact upon confidence, while adding to existing uncertainties surrounding the likely future health of continental economies.
Further, while consumer, business and investor confidence levels have all improved, growth still remains weak at the core and negative on the periphery of Europe. This is as persistently declining prices on the periphery have diluted already meagre inflation across healthier parts of the continent. If left unchecked, this could slow down or derail the recovery altogether.
If the ECB was to continue to refrain from providing stimulus then the above scenario could become a reality. This could ultimately lead to further pressure upon corporate earnings which would be bad for the equity outlook overall.
In addition to this, considering that at least part of the investment case for European shares over the short term is based upon the likelihood of ECB easing, there is a risk of some level of Euro weakness over the coming months. This could have an erosive effect upon the amount the trust is able to pay in dividends, which may, in turn, reduce the appeal to existing investors of continuing to hold the shares.
In response to these risks, while there is little that can be done to reduce the risk presented by geopolitical conflict and concerns over valuations in other parts of the globe, FEV does have a hedge against the other two primary risks.
This is that, should the ECB opt not to provide further stimulus to the European economies, it will most likely be because price pressures have shown signs of increasing and growth remains on track. While the lack of stimulus could dent investor confidence in the near term, it could be positive over a more extended period. This is because sufficient enough progress in the European recovery to avoid such measures would most likely bring forward the time at which earnings for EZ businesses are likely to improve.
On the other hand, should the ECB go ahead with additional forms of stimulus while the recovery falters, the effects for continental indices, particularly dividend income stocks, would be positive. This would be because investors would then be facing a greater length of time having to contend with lower interest rates and poor returns upon cash and bonds. For those investors who are restricted to buying mostly European assets, continental stock markets could begin to look far more appealing in such a situation.
The trust has performed well, in line with momentum, behind the steady flow of positive news relating to the European recovery, over the last 18 months.
While this is positive, it does leave FEV.L prone to a correction should the news flow turn sour or slow altogether. In addition, were the ECB to decide not to go ahead in providing a further lifeline to the European economies, then this could also act as a catalyst for a correction.
Despite this, and on the whole, we still see the European recovery play as valid and feel that earnings momentum for continental companies is likely to follow further developments in the global recovery while, whether now or further into the summertime, persistently weak inflation is likely to force the ECB’s hand, leading to lower rates and potentially monetary stimulus.
Each of these events will be positive for European shares and the Fidelity European Values Trust and, as a result, we remain undeterred by the potential for near term headwinds to impact upon the shares.
Our outlook for the shares sees strong support at, and around, the 1,460.00 pence level in response to any market weakness. This is while our medium term expectations see further upside for European share over the coming months, which we feel will be likely to drive FEV.L toward new highs, and our price target of 1,720.00 pence.
The contents of this report and the Stockatonia website (https://www.stockatonia.co.uk/