European Equities

2018 review: what we got right and wrong

There is no way to sugar-coat 2018 – it was the worst year for equities since 2008
January 2019

Philip Webster

Director, Portfolio Manager, European Equities

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Risk Disclaimer

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested. 

Past performance should not be seen as an indication of future performance.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

 
 

There is no way to sugar-coat 2018 – it was the worst year for equities since 2008. While the sell-off was concentrated in the final quarter, the rapid derating shouldn’t have come as a huge surprise. The risks were visible for all to see, whether quantitative tightening, the China-US trade war, the Italian Budget, slowing growth (particularly in China) or valuations. The initial European derating of around 20% was followed by a sharp correction in analysts’ expectations in December. As night follows day, the pendulum of ‘fear and greed’ has, in parts of the market, swung very much towards fear or capitulation. This is not the time to panic or, as Warren Buffett put it, to be the “idiot”. This is the time to access the value that is on offer and focus on the fundamentals.

Risk Disclaimer

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested. 

Past performance should not be seen as an indication of future performance.

“First the innovator, then the imitator, then the idiot”

Warren Buffett, CEO of Berkshire Hathaway

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Buffett refers to the value-destroying downside of imitation. While we can never say anything with certainty, when everyone’s convinced things can only get better, or in this case worse, we see an opportunity.
 

Style matters, not the market (herd)

While we’ve talked generically about the market, it’s resemblance to the portfolio is limited. We run a concentrated 26-stock portfolio where performance is driven by stock selection. After a very strong 2017 when our style and selection was in favour, outperforming by over 6%, 2018 – or the final quarter – saw this reverse, despite the work we had done around valuation risk. As it transpires, this wasn’t the main contributor to our underperformance, although our skew towards disruptors and technology did in totality drag on performance.

Style has been an important part of this. We talked throughout 2018 about valuations being ignored, especially in relation to expensive quality. We wrote several articles on the subject around our exit of Unilever, Adidas and Givaudan. In hindsight, these were the sort of names that performed well in the final quarter, reflecting their defensive qualities, not a change in earnings. Valuations for expensive quality continue to look extended; will we finally see that rotation into value through 2019?

Defensives also significantly outperformed, with around half our underperformance driven by the mega-cap names we don’t own: Novartis, Nestle, Roche, Total and Sanofi. We have said consistently that our informational advantage in the diversified pharmaceutical sector is zero and we see these businesses as average at best. Oil & gas majors have almost without fail been serial destroyers of capital. Again, we are not saying you can’t make money owning these businesses in a rising oil price environment (good luck forecasting that) but we have no desire to own businesses that make returns below the cost of capital and where they pay dividends by leveraging their balance sheets. This isn’t about mega-caps – we own SAP, ASML and Air Liquide – it’s driven by the quality of the business models. We are comfortable with this strategy but from time to time these stocks will drag on performance.
 

Stock selection hurt in 2018

While the above is relevant, the main reason we underperformed was stock selection, or a small cohort of names that were sizeable positions in the fund. We touch on these in more detail below but also provide you with the full breakdown of the positive and negative contributors.

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Stocks – Top 10 contributors for the full year 2018
Stock Fund Weight Benchmark Weight Active Weight Contribution
Takeaway.com Holding BV 3.37 0.00 3.37 1.32
Wolters Kluwer NV 3.74 0.24 3.51 1.13
Deutsche Boerse AG 5.25 0.37 4.88 1.03
Bayer AG 0.00 1.38 -1.38 0.53
RELX PLC 1.42 0.00 1.42 0.53
Air Liquide SA 3.59 0.80 2.79 0.52
Smurfit Kappa Group Plc 0.37 0.00 0.37 0.49
Anheuser-Busch InBev SA/NV 0.00 1.10 -1.10 0.36
BASF SE 0.00 1.31 -1.31 0.35
Novo Nordisk A/S Class B 4.59 1.26 3.33 0.32

Source: BMO Global Asset Management as at 31-Dec-2018

Before focusing on the small cohort of stocks that detracted from performance, we saw particularly strong returns form Takeaway.com, Wolters Kluwer and Deutsche Boerse. Takeaway.com has risen nearly 100% since initiation, and post the recent acquisition in Germany we still see significant upside over the medium term. There has been a lot of noise around ‘tech’, especially in the recent risk-off environment, but when we look back over our positions most of these have been positive relative contributors. Don’t get me wrong – these have come back sharply from their highs – but we see this as a great opportunity to be adding to our positions, especially Zalando and Delivery Hero, which had a tough 2018.

Turning to the detractors, we are talking about 4 names in a portfolio of 26. They were mostly large positions, which didn’t help, but the thesis that drives these businesses hasn’t changed over the medium term.

Stocks – Bottom 10 contributors for the full year 2018
Stock Fund Weight Benchmark Weight Active Weight Contribution
Richemont SA 3.75 0.65 3.10 -0.55
Delivery Hero SE 0.97 0.07 0.90 -0.55
Novartis AG 0.00 2.74 -2.74 -0.58
Dufry AG 2.71 0.06 2.65 -0.61
ING Groep NV 3.14 0.88 2.25 -0.74
Neinor Homes SA 3.58 0.00 3.58 -0.78
Zalando SE 2.43 0.09 2.35 -0.86
Deutsche Post AG 3.83 0.56 3.28 -1.04
Ryanair Holdings Plc 4.58 0.00 4.58 -1.06
Cairn Homes PLC 3.93 0.00 3.93 -1.93

Source: BMO Global Asset Management as at 31-Dec-2018

Cairn Homes, an Irish housebuilder, was the largest negative contributor. Cairn gained first-mover advantage in the Irish residential property market, acquiring a land bank of over 14k units in some of the best locations in and around Dublin. Over the past few years they have added over 20% to the gross development value of the portfolio through planning, while also shifting from an acquisition phase to that of execution. Cairn has suffered from negative sentiment around Brexit, coupled with noise around house price and build cost inflation, which related more to the wider market than Cairn specifically. The recent fall in the share price, almost back to the initial public offering (IPO) price, significantly undervalues the business given the unparalleled quality of the land bank. We remain convinced of the economics and moat of the business and have consistently been increasing our weight throughout 2018 to benefit from the value inherent in this business.
 
Ryanair spent most of the year dealing with the fallout of their pilot rostering error, first highlighted in late 2017. This led to protracted and difficult negotiations with labour unions, which will be mostly completed by the end of the first quarter of 2019. While these issues have been unwelcome, they don’t detract from the fundamental strengths of the business model. The company has a structural competitive advantage as the lowest-cost operator in Europe, which will be enhanced over the coming years as they transition to a more fuel-efficient fleet. This has been a year of significant change, but the business still generates a 23% return on equity, has profit margins (earnings before interest and tax) of 16% and a very strong balance sheet. Again, we see significant value over the medium term, which is reflected in the 5% position we still hold in the portfolio.
 
Deutsche Post was the only negative contributor in 2018 that we decided to exit. They had a profit warning early in the year, which caused them to review the German postal business and announce a short-term restructuring. Deutsche Post has several growth engines, including their German and European parcels divisions, while DHL Express is the market leader in European and Asian logistics. When reviewing the thesis, it was clear that escalating US-China trade tensions and slowing global growth were going to be tougher to mitigate with wage and cost inflation in the system. Despite the recent pullback, we still felt the risk-reward was skewed to the downside.
 
Online clothing retailer Zalando was also a big detractor, even though we cut the position aggressively through 2018. Our decision to reduce the weight was driven by the share price decoupling from the fundamentals. While we expected a pullback, the response to the profit warning was surprising, with capitulation driving the share price near to the 2014 IPO price. There was a perfect storm of events facing the company in 2018, which was exacerbated by heavy discounting from a high street in terminal decline. They have also been transitioning through a period of very heavy investment in product, distribution, delivery and their partner programme, which is yet to be reflected in the margins they can deliver. Having reduced the weight at €47 and €49, we will look to add further to our position once the noise subsides.

Our reaction

These setbacks are part of what we face in the short term and while it’s always disappointing to underperform, our reaction to these setbacks is significantly more relevant. Ryanair, Cairn Homes, Neinor and Richemont are all top ten positions in the fund today, having been in the bottom ten performers over the previous 12 months. This is reflective of the value we see in the long term and our belief in the strength of these business models over the medium term.
 

The outlook

The simple answer is we’ve got no idea and, frankly, how the index performs is less relevant for the fund. Activity has been minimal, we are comfortable with the shape of the portfolio and will selectively be adding to some of the weaker names mentioned above over the coming months. As ever, only time will tell, but we see significant value in the fund over the medium term.