Fund in Focus: European Special Situations October 2024

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Transcript:

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[00:00:00] Nick Peters: Hello, my name's Nick Peters, investment advisor at Marlborough, and for this week's podcast, I'm joined by David Walton, the lead manager of Marlborough's European Special Situations Fund. Hi, David.

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[00:00:20] David Walton: Hello, Nick.

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[00:00:21] Nick Peters: Okay. So, let's get straight into it, so obviously the ECB cut rates very recently, but in your latest or your last monthly commentary, you mentioned that the investors are having to balance the optimism from the impact of falling interest rates with pessimism from a spate of downgrades, company and earnings downgrades.

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[00:00:42] Nick Peters: Can you maybe just expand on that, please?

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[00:00:44] David Walton: Yes, I mean, what's happening, Nick, is that the effect of the previous rate rises is now being felt in the European economies.

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[00:00:53] David Walton: So that's why you're seeing downgrades by companies like BMW or Stellantis in the carmaker sector where this fund doesn't have any holdings.

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[00:01:03] David Walton: But nevertheless, it's an example of a wider phenomenon of industrial companies, other companies which are also cyclical are experiencing the effects of slower economic growth as a result of previous rate hikes. So therefore, now investors are aware of these earnings downgrades by such companies.

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[00:01:26] David Walton: At the same time, they're also aware that next year they may well be then a similar lagged but positive impact from the current rate rises. So that's why there's this balance between optimism and pessimism.

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[00:01:39] Nick Peters: So, I'm guessing that the meetings that you have with companies are even more important now than they are usually. Are there any sort of messages that are coming out from those meetings that you can share with us?

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[00:01:50] David Walton: You know, I was recently meeting companies in Finland for a couple of days and the message there really is that this recovery in economic growth, which has been hoped for by these industrial companies, has been further postponed from this year, second half, into next year.

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[00:02:09] David Walton: Nevertheless, I did meet a number of companies who were saying that whilst that is, let's say, a disappointment, at the same time, the projects which they're working on to win orders from are not being cancelled.

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[00:02:21] David Walton: It's really a case of customers are being more cautious and are waiting before they press the button to approve a new project, a new factory, etc. But these projects are not being abandoned.

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[00:02:33] David Walton: So in that respect, I think there are, you know, good grounds to be hopeful that next year with lower cost of borrowing, you may well see some uptick in industrial activity as projects, which after all, have got a, you know, a good basis for going ahead, will be given the green light.

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[00:02:53] Nick Peters: So generally speaking, you invest in smaller companies that should do better in falling interest rate environments. Is that the case?

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[00:03:01] David Walton: We don't really make predictions about when the small companies do well or badly because I think when one makes predictions obviously you get them wrong most of the time so I think we're just focusing on small companies which we think can get through any unexpected economic slowdown because they have not too much borrowing on their balance sheets, they have good business models.

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[00:03:22] David Walton: So, currently, I think, on aggregate, the fund is experiencing a slowdown in earnings across its various holdings, because of the factors I mentioned to you just now, which you described. This lagged effect really of previous interest rate rises around the world, but at the same time, I think that the outlook is better because borrowing costs are now beginning to fall for small companies.

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[00:03:48] David Walton: And at the same time, you're seeing signs that there may be a small improvement in China, or at least that the deterioration there is not worsening. For example, I saw this morning results from another company in the the car sector, quite a big supply in France, Forvia, they are expecting growth in the Chinese automotive market next year.

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[00:04:11] David Walton: So that would be a clear improvement from the situation this year.

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[00:04:16] Nick Peters: I suppose with such a sort of unsettled environment, that's why it makes diversification so important. I think, you know, you've said before you have holdings, some who are perhaps more sensitive to economic growth. and others perhaps less sensitive to those sort of conditions.

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[00:04:34] Nick Peters: Can you give us an example of each of those that you've currently got in the portfolio?

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[00:04:38] David Walton: I think on the one hand we hold shares in the Danish pharma company Lundbeck. Which is focused on neurology, so pharmaceuticals to treat depression, other conditions such as PTSD, and also Alzheimer's agitation. They have recently made a accretive acquisition of a company with a late stage molecule which should be approved next year.

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[00:05:04] David Walton: So that company obviously is not sensitive to the economic cycle, rather it has its own cycles within its product groups and product life cycles.

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[00:05:14] David Walton: So they're on a different trend compared to a company like Ipsos, which the fund holds as well, which is in the consumer sector. So Ipsos is selling market research to bigger groups like Procter and Gamble or Nestle.

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[00:05:28] David Walton: And they have experienced a slowdown this year, more so actually in America, strangely than Europe. Nevertheless, they've experienced a slowdown simply due to greater caution also by consumers as well as by industry.

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[00:05:43] Nick Peters: You mentioned Lumbeck, but also I've noticed that a lot of the successful holdings that you have are quoted in the Nordic, so Proact, VBG, Pandora.

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[00:05:55] Nick Peters: Is that regional success just a coincidence?

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[00:05:58] David Walton: I think it's probably a function of, in the past, we've had higher weightings in that region. So I guess if we have a higher weighting, then there's more probability of getting some big winners from that region. But we've also had a good performance from SAP, which is a large cap in the portfolio in Germany.

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[00:06:14] David Walton: That's been a good performer over the last two years. And going back before that time, we had big success in Italy with the IT services company, SeSa, which we've since sold. So, it really just depends on partly the portfolio country weightings, which do vary over time. They're driven by stock selection, we aren't taking any top down views here on country weightings.

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[00:06:37] Nick Peters: I guess what we should point out though, it's, it's not coincidence that these are higher weightings, because if I remember rightly, part of your process is to hold higher positions in the stocks that you're most optimistic about.

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[00:06:50] David Walton: I think we just take a sort of simple buy and hold approach. And We actually don't know which holdings are going to do the best over time, despite our research efforts.

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[00:07:00] David Walton: So, we tend to have portfolio weightings are set really by partly the size of the company, so we don't own too much of particularly small companies. So, they would have a low weighting in the portfolio, whereas the companies with a larger market cap would have a higher weighting. And then we simply try to run those holdings as long as the company's performing well and our investment case is making sense, then we'll run that holding.

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[00:07:27] David Walton: We do take profits, but we try not to take profits too much because sometimes we can be a little bit hasty in doing that and not fully appreciate the longer term growth potential still to come through. So, Pandora would be an example there where the company still has really quite a low market share in what is a very fragmented retail jewellery markets.

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[00:07:50] Nick Peters: Okay, thank you. And we obviously can't go through a podcast without talking about valuations and price earnings. And you mentioned earlier that, you know, in this sort of environment it is difficult to forecast the earnings. Can you give us a flavour of the work that you do just to sort of firm up in your mind what earnings could be for a company over, say, this year and the following year?

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[00:08:13] David Walton: I think what we are doing really is trying to select the companies for the portfolio based on their characteristics, such as a good business model, a good management team. And I wouldn't say that we are any better than anybody else in actually forecasting the short term earnings development of those companies.

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[00:08:30] David Walton: So, yes, we have our spreadsheets and models to analyze the companies, really to do a sense check on whether the consensus analyst estimates are reasonable in our opinion or not. But I think we are simply performing the same function there as the analysts are. So perhaps we are being a bit more conservative with our assumptions.

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[00:08:52] David Walton: But yeah, otherwise we're performing a very similar function. And I think that it's actually quite difficult to make a prediction about when an earnings trend will either slow down or speed up.

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[00:09:05] David Walton: Pandora, which you mentioned, is a good example because some analysts have been forecasting a material slowdown in the company's earnings this year. Turned out that they were wrong, and they've actually had earnings upgrades this year. So equally, we didn't see that either. So it's quite hard to predict these short term directions.

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[00:09:24] Nick Peters: What is the valuation of the fund at the moment?

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[00:09:27] David Walton: The weighted average PE for this year is 13.6x.

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[00:09:32] Nick Peters: Thank you, and then lastly, just going back to something you were saying earlier, with such an uncertain outlook, why do you think investors should look at the fund now rather than wait until the clouds have cleared, so to speak?

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[00:09:45] David Walton: Well, timing is always difficult to get right, and I wouldn't claim to be able to call the bottom of this particular market cycle. All I'd say is that the companies are proving fairly resilient, and what we're going through now is a slowdown, I think, rather than a major recession touch wood.

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[00:10:07] David Walton: So in that respect small company share prices have lagged large cap share prices again this year for the third year in succession and small caps do trade at a double digit discount to large caps on their current year P/E ratios.

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[00:10:23] David Walton: So in that respect, there is a reasonable chance in my opinion of a good share price performance from smaller companies in the years to come, because we're not starting from a particularly high base or a level where small companies are valued more highly than large companies. It's the other way around.

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[00:10:43] David Walton: And also, as I said before to you, there is, I think, some reasonable chance that the economic conditions for small companies will be a little better next year, if these rate cuts by the ECB and the other central banks around the world begin to have their effect on economic activity because we're still seeing declines in housing starts.

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[00:11:04] David Walton: For example, in Germany, each month, the permissions for new housing are still declining, albeit the decline rate is now reducing. But it will take more, I think, to begin to see those sort of indicators begin to improve. And that would then show that the real economy is actually picking up speed again. And that's really, I think, what we're waiting for.

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[00:11:25] Nick Peters: David, thank you very much for your time.

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[00:11:28] David Walton: Thank you, Nick.

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[00:11:29] Nick Peters: That was David Walton, Lead Manager of the European Special Situations Fund. If you'd like to find out more information about the fund, then please go to our website. Thank you very much for joining us, and goodbye.

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Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.‍‍