Fidelity European Trust

Fidelity European Trust (FEV), formerly Fidelity European Values, offers investors a portfolio of large-cap European equities chosen for both capital and income growth. FEV has been run by lead portfolio manager Sam Morse since 2011, who has recently been joined by co-portfolio manager Marcel Stötzel, though Sam retains the final say.

As we outline in the Portfolio section, FEV follows a bottom-up approach to asset allocation and attempts to balance quality growth and valuation sensitivity, termed ‘growth at a reasonable price’. Sam looks for quality dividend-paying companies, as he believes long-term dividend growth is key to profitability, and he looks for four key characteristics. The resulting portfolio is intended to have a defensive tilt, one which can protect on the downside while still participating in a portion of the upside.

FEV’s performance has been strong over recent years, with the trust outperforming both its peer group (the AIC Europe sector) and benchmark (the FTSE World Europe ex UK Index) over a five-year period. FEV generated an NAV return of 83.9% over this period, in excess of its peer group’s 76.1% and its benchmark’s 66%. Much of this outperformance is a result of Sam’s growth bias and successful stock selection.

One of the unique aspects of FEV is its use of derivatives rather than debt to gear the trust, as discussed in the Gearing section. The use of contracts for difference (CFDs) allows FEV to gear at potentially lower cost, while also taking short positions on the market (albeit small ones). FEV currently trades at a 4.3% discount, with this discount having narrowed over the last two years and narrower than the peer group’s average.

It is our view that FEV offers investors a measured but ultimately straightforward way to access the European equity market while taking advantage of a closed-ended structure. The ‘growth at a reasonable price’ mantra Sam follows has prevented any major deviations from the benchmark’s regional or sectoral allocation. As a result, FEV could satisfy the needs of investors who are looking for exposure to Europe, but who are not comfortable with taking active positions in any one region or sector.

The active management component of FEV, often taking the form of stock selection, has in our opinion been successful. FEV has been able to outperform its peers and benchmark without having to sacrifice its progressive dividend, with the trust having the highest dividend growth rate of its peers. However, we believe that Sam’s disciplined investment process – which biases FEV towards growth stocks – may work against him in the near term, as renewed economic activity and the eventual resolution of the pandemic could disproportionately favour value names.

We view the use of options to be a key differentiator for FEV. While Sam has been successful in his use of contracts for difference , we remain cautious as history has shown that short sellers will on average lose money. Thankfully such positions make up only a sliver of FEV’s portfolio. While FEV currently trades at a discount, we foresee potential tailwinds for the European equity sector which could see both FEV’s and its peer group’s discount narrow.

Fidelity European Trust (FEV), formerly Fidelity European Values, aims to achieve long-term growth in both capital and income through a portfolio of predominantly large-cap continental European equities. FEV is run by lead portfolio manager Sam Morse, who is now supported by new co-manager Marcel Stötzel, who joined in mid-2020, though Sam will continue to have the final say on any investment decision made. The duo use Fidelity’s team of about 40 pan-European analysts to aid in company research and the identification of potential new investment ideas.

FEV follows a wholly bottom-up approach to stock selection, with great importance placed on face-to-face manager meetings. The team also take a long-term view on investing, typically aiming to take three- to five-year positions. They believe that doing this is conducive to long-term outperformance by creating exposure to the full effects of compounding growth, as well as lowering the overall cost of the strategy. When seeking to generate this long-term performance, the team typically err on the side of caution, preferring to mitigate downside risk at the cost of full upside participation. Sam believes that the avoided capital impairment should exceed the forgone return on the upside and thus be conducive to superior long-term performance.

FEV’s portfolio is ultimately a balance between growth and valuation. While there are key metrics that Sam looks for when identifying attractive companies (i.e. those which determine the growth potential of the companies’ capital and dividends), he is not prepared to pay any price for a company. This balance between growth quality and price is termed ‘growth at a reasonable price’ (GARP), a label which Sam is happy to have applied to his strategy. When identifying such companies there are four main characteristics the team look for:

• Positive fundamentals, e.g. structural growth, disciplined use of capital, a proven business model or strong barriers to entry.
• Cash generation, which the team see as a good indication of future dividend growth.
• A strong balance sheet, which ensures the ability to grow dividends over the long term.
• Attractive valuations, good-quality dividend growth at a reasonable price, the fundamental principle which underpins FEV’s GARP philosophy.

Beyond Sam’s own investment criteria outlined above, FEV’s dual objective of capital and dividend growth also drives the allocation. Sam will often only invest in dividend-paying companies, more specifically those which have the ability to generate competitive dividends which can be grown over the long term. Such a quality is often a result of the characteristics Sam looks for, as consistent dividend growth is indicative of a company’s quality and its ability to grow consistently over the long term. Nevertheless, Sam will occasionally invest in non-dividend-paying companies, so long as he is confident in management’s use of capital. However, he will not invest in companies which are aggressively reinvesting cash in search of growth, as he fears this may result in inefficient capital allocation.

Although FEV’s investment policy is a bottom-up one and its portfolio is constructed from analysis of companies rather than of macro trends, FEV’s sectoral and regional weightings deviate little from its benchmark (the FTSE World Europe ex UK Index). As a result, much of the risk attributed to FEV’s investment strategy comes from the team’s stock allocations, rather than from taking off-benchmark positions in regions or sectors. Given FEV’s long-term outperformance, outlined in the Performance section, we believe that the stock selection has been successful in adding alpha. FEV is permitted to invest up to 20% in UK-listed stocks or other stocks outside of continental Europe, with a current allocation of 6.5% to the UK.

Source: Fidelity International, as at 30/11/2020

The portfolio ranges from 50 to 60 holdings, though recently FEV has become more concentrated and typically operates at the lower end of the range, with a current portfolio of 50 stocks. It should be noted that FEV’s managers sometimes use derivatives to gear the portfolio, as discussed in more detail in the Gearing section, and also to take short positions in companies they deem to have an unfavourable outlook. We understand that the portfolio currently has a small short position in select mid-cap stocks.

FEV’s portfolio contains many of Europe’s largest and most recognisable names, such as LVMH, L’Oréal and Nestlé, which does much to explain the similarity between FEV’s stock allocation and its benchmark’s. In fact, FEV has a larger weighting to the mega-cap European names than its benchmark, with a 9% overweight to market caps in excess of €10bn (Source: Fidelity International, as at 30/11/2020). While Sam has a long time horizon, there have still been a number of changes to FEV’s portfolio over the last year. This includes new positions in: Enel, an Italian utility company which stands to benefit from the continued growth of renewable energy; SIG Combibloc, a Swiss packaging company; and Zurich Insurance, which should benefit from improved premium pricing after a difficult year for claims in 2020. The team have also seen fit to exit their position in Royal Dutch Shell after it published disappointing fourth-quarter results, indicating little prospect for future dividend growth. Iliad, the French telecoms company, was also sold, in part due to a tender offer by the majority share owner Xavier Niel. The current top ten holdings are as follows:

Source: Fidelity International, as at 30/11/2020

FEV has a clear large-cap growth bias (as determined by Morningstar) despite its valuation sensitivity, with a greater exposure to the more expensive large-cap names when compared to its benchmark’s large-cap core allocation (a core allocation indicates a balance between value and growth stocks). While FEV’s price ratios reflect its growth bias, indicating the team are paying more per unit of earnings or sales, they are thankfully accompanied by stronger quality factors than the benchmark, as can be seen in the table below. The higher ROA, ROE and ROIC indicate better financial strength, supporting Sam’s notion that companies with sustainable dividends are of a higher quality and thus better able to sustain a growth trajectory. However, the price to free cash flow (P/FCF) is also higher for FEV, implying there is a smaller underlying cash flow which may ultimately be paid out as dividends. Thankfully, the strong quality metrics should be supportive of capital growth which can offset any potential hindrance to dividend returns, but income-focussed investors should be conscious of the lower cash flow. Despite this, FEV has been able to generate the highest dividend growth of any trust in its sector, a reflection of the quality and growth potential of its investments.

Source: Morningstar, BlackRock, as at 30/12/2020
Note: iShares Continental European Equity Index is used as a proxy for the FTSE World Europe ex UK Index

Unlike most trusts FEV does not typically make use of bank or structural debt when gearing, instead using derivative contracts, specifically contracts for difference (CFDs). A CFD allows the holder to profit from the price movements of a security without having to own the underlying asset. CFDs are typically structured to benefit from either upward movements in price or downward movements. While CFDs are FEV’s primary mechanism for gearing, the team are also able to use other derivative instruments, including futures and covered calls and puts. The use of derivatives achieves a similar result as using debt-based gearing, increasing the overall exposure of the trust to the market but at a potentially lower cost. However, investors should be aware that using derivatives instead of debt adds additional complexity and risks.

The board’s normal policy is to be geared, with the belief that long-term investment returns will exceed the costs of gearing. The board is responsible for the order of magnitude of gearing in the trust, while the investment team decide gearing on a day-to-day basis within a range set by the board. Gearing is reviewed at each board meeting. The aggregate use of derivatives and borrowing will not exceed 30% of NAV, with short positions not exceeding 10% of NAV.

FEV currently operates with 12% gearing, the highest level of any trust in its peer group. At the time of the 2020 half-yearly report (30 June 2020), all gearing was being achieved through derivatives. There were no short CFD positions, only long CFDs and futures contracts with exposure split between two-thirds in CFDs and one-third in futures.

Considering the dual mandate of both income and capital growth, we see FEV’s outperformance over the last five years as being impressive, though not unexpected given its bias to large-cap growth. Over this five-year period FEV has produced an NAV return of 83.9%, more than the 76.1% return of its peer group (the AIC Europe sector) and the 66% return of its benchmark (the FTSE World Europe ex UK Index). This outperformance should not be surprising given the increasing outperformance of growth stocks globally, especially from 2018 onwards. What is more noteworthy is that it was achieved despite Sam’s dedication to downside protection while also predominantly holding major dividend growth names, a style which has often been out of favour. These factors should have been headwinds, yet FEV’s outperformance is evidence of the alpha generated through the team’s superior stock selection.

The discrete annual performance of FEV versus its peers and benchmark tells a similar story. As can be seen in the charts below, FEV managed to outperform its benchmark from 2017 onwards, which coincides with the beginning of the outperformance of growth stocks globally. Yet during periods where growth investing fell out of favour in Europe, such as in the latter half of 2020, FEV could not avoid underperformance. Such periods may not necessarily be the result of poor allocation decisions by the management team, but rather of their style of GARP investing being out of favour. It should also be noted that over the last ten years there have been two down markets in Europe – in 2011 and 2018 – during which FEV outperformed both its peer group and benchmark, fulfilling its promise of downside protection.

2020 was an excellent example of both the success and limitations of FEV’s strategy. The downside protection of FEV can be seen in the first four months of the year. While FEV was not able to avoid the COVID-19 crash, with losses equal to its benchmark’s during the initial market downturn, it was able to rebound much faster, having lost 8% by the end of April compared to the 13.7% loss of its benchmark. At a stock level its holding in Swedish Match, a tobacco company, was the standout performer during this period. Sam also enhanced FEV’s returns in the second quarter of 2020 through opportunistic use of gearing, by closing short positions at a profit and increasing overall market exposure through long positions.

Over the last quarter of 2020 FEV has been able to capitalise on the tailwinds from the euphoria around the COVID-19 vaccine approvals and the implementation of the European recovery fund, both of which should spur economic activity in the region. However, it has lagged many of its peers during this period, as can been be seen by the outperformance of the broader peer group over the last year. Many of the top-performing European companies over the last quarter have been value names which had lagged the broader market earlier in the year, a clear headwind for FEV given its growth bias. In broader terms FEV will also lag during sharp market rises, as its focus on downside protection limits its ability to participate in market upsides, especially during steep rises. At a stock level, FEV’s holdings in Nestlé and Symrise were among the key detractors over the last quarter.

The income objective of FEV is to increase its dividend each year, and it has done so in recent years, as can be seen in the chart below. The most recent full-year dividend was 6.47p per share, a 3% increase on the year before. This is equivalent to a current dividend yield of 2.2% and is in excess of the 1.4% of FEV’s peer group, with FEV being the second-highest-yielding trust in its sector. FEV also has the highest five-year dividend growth rate of any trust in its peer group, at 15.1% compared to the peer group’s 3.1% (Source: JPMorgan Cazenove, as at 30/12/2020).

While the board has not sought to influence the manager by imposing a specific income target in any particular year, the board wishes to maintain a focus on growing the underlying dividend, as outlined in the Portfolio section. The board’s present intention is to pay a nominal increase in total annual dividend, but given the impact of COVID-19 on the underlying companies’ ability to pay dividends, the board will utilise reserves as necessary. FEV has a current revenue reserve of 1.1x, based on the most recent full-year dividend. Due to the trust having a significant retail shareholder base, and in order to smooth dividend payments throughout the reporting year, in 2018 the board decided to pay both an interim and a final dividend as of 2019.

FEV is run by lead portfolio manager Sam Morse, who is supported by co-portfolio manager Marcel Stötzel. Sam took over leadership of FEV on 1 January 2011, having also run the Fidelity European Fund from January 2010. As lead portfolio manager Sam has the final say on any investment decisions made within FEV. Prior to becoming a portfolio manager, Sam spent two years as a research analyst within Fidelity, covering a range of sectors, then six years as an equity income fund manager. He also worked as head of equities and head of UK equities at M&G from 1997 to 2003.

Marcel joined Fidelity as an analyst in 2014. In addition to his analyst responsibilities, Marcel was also promoted to head of the cyclicals segment of the European analysts’ ‘best ideas’ fund in 2018. He joined FEV as co-manager in June 2020.

FEV currently trades at a 4.3% discount, in line with the 5.1% discount of its peer group, the AIC Europe sector. The board operates an active discount management policy by purchasing shares when they trade at a discount to NAV, and seeks to maintain the discount in single digits in normal market conditions. Additionally, the board has shareholder approval to hold repurchased shares rather than cancelling them. The intention behind this is to reissue these shares at NAV or a premium, thus facilitating the management of, and enhancing liquidity in, the trust’s shares. There have been no share repurchases or issuances over the 2020 period.

As can be seen from the graph below, FEV has continuously traded at a discount over the last five years. However, the difference in discount between FEV and the broader peer group has narrowed since 2019. We believe this increased demand to be a result of FEV’s four consecutive years of consistent outperformance against its benchmark, as outlined in the Performance section, and of the generally increased demand for growth stocks globally. There are also a number of tailwinds which may improve demand for the European equity sector, and might reduce the discount of FEV alongside that of its peers. Such tailwinds include the conclusion of Brexit negotiations, the roll-out of COVID-19 vaccinations, and the implementation of the European recovery fund.

FEV operates with a tiered management fee structure. An annual 0.85% fee is applied to net assets of up to £400m, and for net assets in excess of £400m a 0.75% management fee is applied. With a current NAV of £1.24bn, FEV has an OCF of 0.87%, in line with the average 0.85% OCF of its peer group.

FEV has a KID RIY of 1.09%, below the 1.23% average of the peer group; however, it should be noted that the calculation methods for the KID RIY can differ between trusts.

The team are aware of the impact that ESG is having on the investment space, with the increasing demand for ‘good’ practices being reflected in a company’s share price performance. As such Sam actively integrates ESG into FEV’s investment process, believing that investing in companies which operate with high standards of corporate responsibility is more likely to protect and enhance investment returns for shareholders. Fidelity continues to increase the integration of ESG into all its investment processes, with assessment of ESG factors being primarily done at an analyst level. Fidelity’s proprietary ESG analysis and ratings are provided by the analysts in each investment team, though the portfolio managers are active in analysing the potential effects of ESG factors when making investment decisions. Analysis is done at each level of the supply chain, with the team’s focus on company meetings allowing them to directly query companies on ESG issues. Fidelity also makes use of a number of external ESG data sources. ESG factors which the analysts assess include: corporate governance issues, supply chain management, work practices and physical threats from climate change.

FEV’s sustainability is rated as average by Morningstar when compared to Morningstar’s European equity large-cap peer group. It should be noted that European companies are often amongst the world’s most sustainable, given the drive for a more sustainable economy at both a consumer and a political level. Thus an investment strategy which ranks as average within the European equity sector could still be expected to rank as one of the most sustainable equity investment strategies of any other sector or region. Nevertheless, investors should be aware of FEV’s holdings in tobacco companies. While tobacco is strictly more of an ethical issue than an ESG one, it may be incompatible with certain investors’ beliefs.