TR European Growth Trust review

TR European Growth Trust (TRG), launched in 1990, invests for long-term capital growth in a diversified portfolio of smaller European (ex-UK) companies that its managers believe are good value.

 TR Europe

Lead manager Ollie Beckett of Janus Henderson Investors has run the fund since 2011 and is assisted by Rory Stokes and Julia Scheufler, who joined the team in 2013 and 2018, respectively. The managers have an unconstrained, bottom- up approach to portfolio construction.

TRG measures its performance against the EMIX Smaller Europe ex-UK index (in sterling terms) and is a member of the Association of Investment Companies’ European Smaller Companies sector.

The portfolio is biased towards the smaller end of the small-cap universe, with ca 65% of TRG’s assets invested in companies with a market capitalisation below £1bn. Because smaller companies may carry a higher risk of failure and can be illiquid, TRG’s managers prefer to hold a relatively long list of stocks (circa 120–150) to mitigate stock- specific risk. There is a maximum individual position size of 7%, although in practice few holdings exceed 2% of the total.

The trust is permitted to hold unquoted investments (prior board approval is required), but currently has no such positions following the sale of longstanding unlisted holding Brainlab towards the end of 2018.

Gearing of up to 30% of net assets is permitted (with a normal working range of up to 15%) and is used flexibly in response to investment opportunities.

The trust may also hold up to 20% in cash and/or fixed income. While TRG’s main aim is to achieve capital growth, it also has a long record of year-on-year dividend growth and since FY 2018 has paid an interim as well as a final dividend to spread income more evenly through the year.

Performance

TRG has posted negative sterling returns over one and 12 months to 30 April 2019, underperforming the benchmark EMIX Smaller Europe ex-UK index in both NAV and share price total return terms. However, year-to-date (to 14 June), TRG has outperformed the benchmark, producing a respectable NAV total return of ca 14.2%, versus 13.3% for the index.

Its longer-term performance record remains compelling, with annualised absolute returns of circa 10-13% over three, five and 10 years. It has also outperformed the benchmark in both share price and NAV total return terms over five and 10 years. Longer-term returns have also been strong versus European large-cap stocks and the broad UK equity markets.

Beckett says that any stabilisation in economic data, with an associated reduction in investor risk aversion, would be a positive support for TRG’s performance.

TR European Growth Trust

Price875.0p
Market cap£429.4m
NAV*987.4p
Discount to NAV13.2%
NAV†1,003.5p
Discount to NAV14.6%
Yield2.5%
*Excluding income. †Including income. As at 14 June 2019.
Source: Edison

Investment strategy – Diversified and valuation aware

TR European Growth Trust‘s investment universe covers circa 2,000 small- and mid-cap companies across Europe with a market capitalisation below €4bn, from which the managers build a diversified portfolio of circa 120-150 stocks. Managers Ollie Beckett, Rory Stokes and Julia Scheufler begin by using quantitative screens to help identify attractive companies whose valuations do not reflect their long-term growth prospects. Each year they meet hundreds of companies to assess the durability of their business models, quality of management, drivers of growth and catalysts for revaluation. They also take account of in-house and external company research. The managers build financial models for potential investee companies, using a range of valuation metrics to gain an understanding of the relationship between a company’s current valuation and its growth potential. The portfolio is built on a bottom-up basis, with no constraints on country or sector weighting, and position sizes are based on the managers’ degree of conviction, although they rarely exceed circa 2%. Beckett, Stokes and Scheufler view their investment universe in terms of a company lifecycle with four stages:

  • Early cycle – the managers look for young companies with growing returns on capital, a clear strategy and operating leverage. The key valuation metric is enterprise value to sales (EV/sales).
  • Quality growth – companies with high returns on capital, growing revenues, sustainable margins and strong competitive positions. The team uses valuation metrics including p/e multiples, EV/EBIT (earnings before interest and tax) and EV to invested capital (EV/IC).
  • Mature – cash-generative companies with steady returns on capital, whose shares are trading cheaply versus the value of their assets. Valuation metrics include EV/IC, EV/EBIT and free cash flow (FCF) yield.
  • Turnarounds – companies that may have suffered declining growth or a specific setback, but where management cost cutting or asset disposals may spark an improvement in margins. Companies are valued on EV/IC, EV/EBIT and FCF yield.

Beckett said most investors concentrate on the quality growth and mature segments of the market and are not willing to go down the market cap scale to the ‘early cycle’ companies such as ‘internet of things’ solutions provider S&T, or to consider turnaround situations such as Puma, which was transformed following the appointment of ex-Pandora CEO Bjørn Gulden in 2013.

TRG’s holdings on average trade at lower forward p/e valuations than the benchmark average, with higher prospective dividend yields, higher returns on equity, and higher historical and projected earnings growth.

Portfolio turnover averages ca 50% a year (53.8% in FY 2018), implying a holding period of around two years, although many companies are held for much longer than this. Stocks may be sold when they reach the managers’ assessment of fair value (as with Carl Zeiss Meditec in FY 2018), if worsening fundamentals call the original investment thesis into question (as with Swedish online retailer Boozt), or where the managers see better value opportunities elsewhere.

The manager’s view – Opportunities in mispriced securities

After a difficult period of performance for TRG following an exceptionally strong FY 2017, with NAV and share price total returns of 54.0% and 75.5%, respectively, compared with 35.8% for the benchmark, lead manager Ollie Beckett said he is finding many opportunities in attractively valued, under-researched small-cap stocks across Europe.

Although a value-oriented investment approach has outperformed over the long term, Beckett pointed out that during the decade since the global financial crisis, investors have favoured highly valued ‘quality’ stocks, continuing to back those companies that have already performed strongly, even at forward p/e valuations that suggest severe limitations on future appreciation. From January 2018 to May 2019, small-cap stocks in Europe have underperformed large- and mid-caps, with small-cap value underperforming by more than small-cap growth. The manager explained that in a climate of uncertainty such as that surrounding the US trade dispute with the rest of the world, investors have become more risk averse, which tends to translate into a preference for larger stocks that are perceived to be safer.

Beckett admitted the TRG team was too early in moving further into low-valued stocks at the end of 2017, as expensive names continued to perform better for the first three quarters of 2018; however, from a style perspective, quality and momentum both underperformed in the Q4 2018 sell-off, with value stocks falling by less than the broad MSCI Europe Index.

The manager said that the climate of volatility, together with ongoing concerns over the impact of Brexit on the rest of Europe, has led to a number of attractive smaller stocks, in which he and the team have a high level of conviction, trading at levels “where the price is just wrong”. He gave the example of Paris-listed Nexans, a top 10 holding, which makes cables for construction, telecoms and high-voltage power lines. Following the sudden departure of its CEO and delays to several high-voltage cable projects, its share price fell sharply; with a new CEO in place, it has rallied by circa 23 per cent since its low point in November 2018, yet still trades on a forward p/e valuation of less than 10x. Beckett said the team significantly increased TRG’s position in the stock in October and November to reflect a high level of conviction. “All these projects will come good, but they are on a different cycle to the rest of the economy,” he added.

The team actively manages the portfolio, a strategy illustrated by the holding in Danish ferry and shipping company DFDS, TRG’s third-largest position. Having previously owned and sold the holding, Beckett and the team have been building the stake back up at a single-digit forward p/e valuation, despite the company generating a more than 20% return on equity.

The manager said being one of two Dover-Calais ferry operators means DFDS is seen as “the ultimate Brexit stock”, although it also has routes in the Mediterranean, the Baltic and the North Sea, which will be less exposed to the UK’s future trading relationship with the EU, whatever form that takes. Even in the most extreme no-deal Brexit scenario, which would adversely affect the English Channel route because of a lack of space for carrying out customs checks in Kent, the impact on DFDS could be lessened by a switch in shipping routes to the North Sea coast, where ports have more storage capacity. Beckett said that even if there were a Brexit-induced reduction in UK GDP of a similar magnitude to that of the global financial crisis (approx. 5%), which could hit shipping demand and reduce DFDS’s EBITDA profits by circa DKK400m (circa 15%), the stock would still be undervalued.

Gearing is also managed actively in response to available investment opportunities. Beckett raised TRG’s gearing close to the maximum 15% working level in the Q4 2018 sell-off, as he felt valuations were attractive, further deterioration in the political situation was unlikely and a recession was not inevitable. Along with not being a forced seller in a falling market because of redemptions, the manager says the ability to use gearing to buy stocks at depressed levels is a key advantage of TRG’s closed-ended structure. The level of gearing was reduced to 8% at end-February after the market rallied, before increasing again to 11% at 31 March 2019. At 31 May, net gearing was 9%.

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