JPMorgan European Smaller Companies (JESC) aims to provide capital growth from a portfolio of smaller companies in developed Europe, excluding the UK.
Francesco Conte and Edward Greaves run the £654m trust, searching for attractively valued, high-quality stocks with positive momentum which they believe can outperform the market. The managers believe that Europe offers a unique mix of companies, in particular a number which are disrupting industries with nimble business models. Three key themes are evident in the portfolio and typify the kind of opportunities the managers are seeking: sustainability, wellness and technology.
Supported by a team of 49 analysts, the investment process uses both qualitative and quantitative methods to narrow down a universe of more than 1000 companies. This detailed approach helps to identify and compare three key characteristics for new investment ideas: quality, momentum and value. The managers believe that their balanced approach improves risk-adjusted returns and enables them to outperform through the different stages of cycles (e.g. both during growth rallies and at times when value comes back into favour).
As we discuss in the Performance section, JESC has an excellent long-term track record of outperforming the benchmark and the peer group. Performance over the past year however has been slightly more subdued, largely due to the low exposure the trust has to the highest rated companies which have driven benchmark returns. This has resulted in JESC spending the last year trading at a double-digit discount, which currently sits at 17.1%, offering a potentially attractive entry point for investors looking to access some of the unique smaller companies in developed Europe.
Over the long term, European Smaller Companies has been one of the strongest performing sectors across the globe. The JESC managers believe this is because it represents a unique blend of sectors and companies which are less prominent in other regions. At the same time, since the 2016 Brexit referendum valuations across Europe have fallen considerably. So companies which would potentially command premium ratings in the US are considerably more attractively priced in Europe.
We think the managers’ balanced approach to style could be attractive given the current uncertainty around the macroeconomic environment. Currently economies are reopening, but the danger of a second wave of COVID-19 remains real, as does the continuing uncertainty surrounding Brexit and trade wars. As such, the trust’s balanced style exposure should make the portfolio less exposed to any one of the possible outcomes from the current situation; including a flight to quality, value outperforming in a cyclical rally, or growth stocks outperforming on low rate expectations.
Although the trust has struggled somewhat over the past year or so, causing the discount to widen, the managers have a very strong long-term track record and they are simply ‘sticking to their guns’. They take the view that it is highly rated companies, which they do not invest in, that have driven returns over the past few years. However, if valuations start getting taken into consideration and performance picks up again over time, we expect the discount to narrow.
|Unique investment approach, with a portfolio exposed to high-quality, market leading smaller companies||Often has high levels of gearing which can cause volatility|
|Strong long-term performance track record||Poor short-term performance as highly rated companies have driven market returns|
|Current wide discount potentially offers an attractive opportunity to invest||A high number of stocks can make it harder to generate alpha|
JPMorgan European Smaller Companies (JESC) offers investors a diversified portfolio of smaller companies in developed Europe, excluding the UK. Francesco Conte and Edward Greaves run the portfolio, believing that Europe offers the perfect hunting ground for stock pickers. This is largely due to the types of company that can be found in the region, many of which are innovators or disruptors with agile business models. Most of the companies in the portfolio sit within three categories; sustainability, wellness and technology. Sustainability is a consistent feature of almost all the trust’s holdings, as we discuss in the ESG section, while wellness and technology are rapidly growing markets which can be difficult to find in other areas, such as the UK.
Together the managers search for attractively valued, high-quality stocks which have positive momentum, with the aim of outperforming the market. They are supported by a further 49 investment professionals within the JPMorgan Behavioural Finance team, and use both qualitative and quantitative research to create a unique portfolio.
The focus of the initial quantitative research is to cover as much of the universe as possible; and this part of the process is objective, unemotional and repeatable. From there, the companies which pass initial screening will be analysed in more detail. This will include analysing forward-looking metrics, while also taking into account contextual factors, and can often involve dealing with poor or unstructured data. From this analysis, the managers are able to identify catalysts for outperformance in the future, which can be any one (or a combination) of momentum, value and quality.
Companies that fit the ‘momentum’ bill are normally in structurally growing end-markets, and many offer disruptive technologies. The rationale behind this style is that companies which have performed well historically tend to continue to perform well. The JESC managers believe that earnings estimates are informative because one revision to expected earnings tends to be followed by another revision in the same direction, which should then be followed by a second shift in stock value.
Francesco and Edward highlight Encavis, the largest renewable stock in Germany, as an example of a company in this category. Encavis is well diversified by technology, predominantly solar and wind, as well as by region. The managers are particularly bullish towards renewables, which is now both cheaper and more efficient than traditional energy alternatives. They believe progress in renewable energy generation will continue, and thus that the outlook will likely only improve. COVID-19 has also benefitted the company, as during the period the EU has announced its intention to become a global leader in the hydrogen power industry. Although the full strategy will not be announced by EU officials until later in July, the managers believe the early signs are positive, and will benefit some of the trust’s large holdings including ERG and Falck Renewables.
The value opportunities sought by the managers are typically stocks which are out of favour, but which have catalysts for growth. Normally, these will be companies which either generate high levels of cash or are in cyclically depressed markets that are recovering. To identify these opportunities, the managers will focus on metrics such as free cash flow yields and price to earnings. However, they also note that it is important to recognise that value alone can be deceptive, and that their consideration of quality and momentum helps them avoid value traps.
An example of a company in this category is Bravida, the second largest holding in the portfolio. Bravida is the leading servicing and installation company in the Nordic countries, focusing on electricity, heating and cooling, water, ventilation and security. Bravida helps companies to use the latest technology to reduce their environmental impact, for example through intelligent plumbing or smart lighting. The company is a market leader in the area, and the industry is widely seen as benefitting from long-term structural drivers. Alongside this, the managers like the fact that Bravida is involved in M&A activities to help grow its business, and that the shares are trading at an attractive free cash flow yield.
The managers prefer companies which are market leaders in whichever niche they operate. This enables high margins and returns on capital to be achieved over the long term, and this is an area that differentiates Europe from the rest of the world. Typically, the companies that Francesco and Edward consider to be ‘good quality’ show high levels of return on capital; resulting in substantial cash generation, conservative accounting policies and disciplined capital allocation. The managers highlight SIG Combibloc, a Swiss provider of aseptic carton packaging systems and solutions, as a good example of a company with these characteristics. The company is currently supporting the movement from plastics to environmentally friendly packaging, mainly in emerging markets. Recent performance has been strong, as the company has benefited from both continued strong end-market demand and market share gains.
The resulting portfolio has 93 holdings currently, considerably more than when we last met with the managers in December 2019, when there were just 69 holdings. As of 30 May 2020 the largest holding (SIG) represents 3.1% of the portfolio, with the top ten holdings making up around 25% of the total NAV. The trust also has over 60% in what Morningstar considers mid-cap companies, more than any other trust in the sector.
At a sectoral level, the largest allocations are towards industrials, information technology and utilities. These are also the largest overweight positions relative to the benchmark; in particular information technology which is 9.2% overweight, as shown in the graph below. At the other end of the spectrum, financials, real estate and consumer discretionary are the largest underweight positions.
sector exposure relative to benchmark
At a geographical level, the trust’s largest exposures are to Switzerland, Germany and Sweden, with Switzerland, Italy and France being the largest overweights. Given that the trust has a focus on smaller companies, investors might expect it to have high domestic European revenue exposure. The managers estimate, however, that, while the portfolio takes 57% of its revenue from Europe, emerging markets (21%) and North America (14%) also represent significant exposures. This helps to reduce Europe-specific risk.
JESC employs gearing tactically, usually based on stock specifics. As the availability of interesting opportunities increases the managers will tend to gear up; conversely gearing will reduce as they become more cautious about valuations.
Within this approach, the managers are more than happy to hold net cash at different points in the cycle. A good example of this was observed during 2018: the managers had de-geared the trust entirely by mid-summer 2018, and then bought back in as the market fell in Q4.
Since then, the trust spent a significant part of 2019 with little to no gearing before increasing it again in Q3 and Q4 2019. Unfortunately, this meant the trust was running at a gearing level of around 10% when the COVID-19 pandemic hit. Since then it has been reduced again, to the current level of 6%.
On 1 April 2020 the trust changed its benchmark from the EMIX Smaller European Companies index to the MSCI Europe ex UK Small Cap. The rationale for this change was that MSCI is a leading global index provider, with a strong product offering in European equities. MSCI has also been investing in its ESG capabilities, an increasingly important area of focus for investors.
JESC has a strong long-term track record and has outperformed in six of the past ten calendar years, as shown below. Over this period, the trust has NAV total returns of 207.9%, outperforming the new benchmark (198.9%) and the IA peer group (178.5%), but underperforming the AIC peer group (246.9%). The trust has marginally higher levels of volatility (22.9%) than the peer group (21.6%).
discrete calendar year nav returns
In recent years the trust has tended to perform better during rising markets, as shown in the calendar year graph above. For example in 2015 and 2017, the two largest rising markets of the past five years, the trust delivered NAV returns of 32.4% and 29.7%, eclipsing the benchmark returns of 18.7% and 25.1% respectively. At the same time, however, the trust’s performance tended to lag its benchmark and peers during falling markets. Recognising this, when we spoke to the managers last year they mentioned that they had started to increase their focus on risk; and as we discuss in the Portfolio section the trust is now more diversified.
Over the past year the trust’s return (-1.1%) has struggled relative to both the benchmark (1.4%) and the peer group (4.3%). The managers are not out-and-out value investors, as illustrated by their relatively limited exposure to value companies (10.4% according to Morningstar). Still, the fact that the managers are conscious of the price they are paying has hindered the trust’s performance, with many of the strongest performing stocks being highly rated. Alongside this, during the sharp downturn in March the trust was geared as much as 10%, and this factor also hurt JESC’s performance during that period.
one-year nav performance
Although JESC’s principal focus is on capital growth, the board does pay out the majority of the revenue that is available each year. This means that the managers are not constrained to deliver income in any one financial year.
The trust has paid a dividend in each of the last eight years and currently yields 2.0%. We note that the dividend has been held at the same level for the past three years, and that the most recent payment is covered 0.45x by revenue reserves. The board noted however, in the trust’s March 2020 annual report, that COVID-19 has caused uncertainty surrounding the levels of future dividends.
JESC is managed by Francesco Conte and Edward Greaves. Francesco represents a very high degree of continuity in the management of the trust. He is a senior portfolio manager for European smaller company funds within JPM Asset Management’s European Equity Group. He has worked at JPMorgan for 20 years, and prior to that was at Robert Fleming.
Edward has been at JPMorgan since 2011, having joined from Rothschild where he worked in an advisory role in M&A. The managers are supported by a broader team of 49 investment professionals.
Over the past year the trust has consistently traded on a double-digit discount. On average the discount has sat at 14.6%, although it has recently widened to the current level of 17.1%. In comparison, the rest of the sector is trading at an average discount of 14.0%.
It is not uncommon for JESC to trade at a wide discount and in recent years, as shown below, it has been subject to considerable volatility. Over the past five years, we have seen the trust trade at a discount as wide 26% and as narrow as 3%. However, these large shifts have been seen across the entire smaller companies sector, not just JESC, as sentiment towards smaller firms has been impacted by uncertainty due to Brexit and COVID-19.
The board has the capability to buy back shares; however no shares have been bought back since January 2019. The last time shares were bought back, the trust was trading at a discount of around 13%.
JESC has an ongoing charges figure (OCF) of 1.05%. Up until March 2020, the management fee was tiered, with 1% levied on the first £400m of NAV and a reduced rate of 0.85% charged on assets above this level. However, this has now been changed to an annual rate of 0.85% per annum.
The OCF compares with a weighted average for the European Smaller Companies sector of 0.99% (source: JPMorgan Cazenove), where the trust is the second cheapest in the four-strong sector. The weighted average in the broader AIC Europe sector is 0.88%.
The KID RIY is 2.0%, relative to a sector weighted average of 1.7%, although we note that methodologies across trusts and managers do vary.
We understand that environmental, social and governance (ESG) considerations have always been a part of the investment process at JESC. Nevertheless the past few years have seen greater emphasis placed on the topic. ESG issues are considered at every stage of the decision-making process, including in the early stages of new investment ideas. Francesco and Edward use company meetings with both potential and existing investments as an opportunity to discuss ESG, and to challenge management on their adherence to best practice. In-depth ESG analysis on a company-by-company basis results in an ESG ranking of ideas, taking into account both risks and opportunities. We understand that this process gives the managers an additional dimension to their investment decision-making.
Through bottom-up stock selection, the fund managers are finding an increasing number of companies which are directly benefitting from growing ESG awareness. This applies to a number of the companies discussed in the Portfolio section, including Encavis and Bravida. Both companies are benefitting from increasing demand for clean energy and rapidly falling technology costs.
The team’s active ESG approach means that, while JESC is not likely to fit within a narrow definition of an ‘ESG fund’, its ideas will be increasingly influenced by a recognition that sustainability is growing in importance in every aspect of business.