European Opportunities

A torrid 2020 for JEO means it is on an attractive discount...

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Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by European Opportunities. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

European Opportunities

Summary

European Opportunities Trust (JEO) has been managed by Alexander Darwall since launch in 2000. In late 2019, JEO followed Alexander to his new fund-management company – Devon Equity Management. The same bottom-up, fundamental investment strategy is applied as has always been. Alexander looks to identify companies that retain high-growth characteristics and profitability longer than the market expects and to hold them for the long term.

Another characteristic of JEO has meant that 2020 has been a standout year for all the wrong reasons. Alexander manages high-conviction, concentrated portfolios. Over the long term this has meant he has delivered strong returns relative to the benchmark and his peer group. However, during 2020 Wirecard (now sold, but until relatively recently JEO’s largest holding) has had a significant negative impact on recent performance.

As we discuss in the Portfolio section, Alexander’s lessons learnt include the recognition that the sizing of the position had clearly been too big given the complex nature of the business, but also that he had placed too much trust in the wrong people in his due-diligence process. Nevertheless, if Alexander had not followed his investment process so rigorously (by selling immediately when the facts as he knew them changed), the impact on performance would have been significantly worse.

Over the long term JEO typically employs gearing. However, as we show in Gearing, it was taken down to zero in May. This represented an overall market de-risking exercise, and indirectly helped mitigate the damage from Wirecard.

The discount has widened to c.10% since June and both the board of JEO and Alexander himself have recently bought in shares at these levels.

Kepler View

We believe the lessons learnt from the painful Wirecard episode should not obscure the strengths of a strategy which has delivered over the long term. Up until the start of 2020, JEO was far ahead of peers on an NAV total return basis over most time frames.

As we illustrate in the Performance section, Alexander’s stock selection for the rest of the portfolio has been strong over the short and medium term, which means that we believe that the mistakes made over a single stock do not mean that his long-term track record is in any way invalid.

JEO has been de-rated relative to peers which means that, for the first time since 2009, the trust stands on a slightly wider discount than the weighted average for its peer group. This discount has not gone unnoticed by Alexander (who recently invested c. £700k), with the trust’s board subsequently buying shares back for the first time since 2011.

Alexander has a long and consistent track record and he has a very meaningful personal stake in the trust himself. It is our view that Alexander’s investment process (which remains unchanged at Devon) should, over the medium to long term, deliver attractive returns – as it has so clearly done in the past. The discount to peers is therefore unwarranted, and with the board now making purchases of the trust’s own shares, we believe this could be an opportune moment in discount terms for long-term investors.

bull bear
Strong long-term track record Wirecard demonstrates the downside risks of having a highly concentrated portfolio
High-conviction, stock-picking manager who has delivered alpha year in, year out Short-term performance has lagged the benchmark (over one year) due to Wirecard
Pragmatic mandate enables manager to look for best 'European' opportunities Devon Equity Management is a young company

Portfolio

European Opportunities Trust (JEO) has been managed by Alexander Darwall since launch in 2000. The same investment style has been consistently applied over this time. The style can be described as ‘bottom-up’. Using rigorous fundamental analysis, the strategy seeks to generate value for investors by successfully identifying companies that retain their high-growth characteristics and profitability for longer than the market expects. Alexander prefers companies that have less capital intensity, use ‘digital’ and have a large amount of intellectual property. These companies typically operate worldwide, and in this respect are not so much plays on the European economy, as plays on these European companies to operate globally. All his companies are well established and profitable; there are no start-ups or ‘pre-profitability’ companies.

In 2019, along with Richard Pavry and Luca Emo, Alexander left Jupiter to set up Devon Equity Management. The trust followed them with modified fee arrangements, notably the abandonment of the performance fee. The rationale for the move was that the ‘platform’ at Devon, where the focus for now at least is on institutional mandates, would give Alexander and the team more time to concentrate on investing without any of the administrative distractions that can result at a larger investment house. Alexander’s investment philosophy has always been to try to stay away from the ‘noise’ and focus only on fundamentals.

We last wrote on JEO in October 2019, just before the transition to Devon. We met up with Alexander recently to get an update on how the new set-up Devon is working, and to review the portfolio in the light of the Wirecard news. As regards Devon, we understand the move went smoothly. Every attempt has been made to replicate those elements that made the strategy successful historically. With offices in Victoria in London, many long-standing clients have followed. Due to the same investment process and the three principals having worked together for many years, the key elements certainly seem the same as before. As we discuss in the Management section, the investment team have been strengthened with the appointment of Charlie Southern, who joined Devon in February. Charlie brings with him extensive experience in Asian markets and expertise in sectors including technology. Other hires include experienced people from major investment houses who were taken on for dealing, back-office and compliance functions.

The portfolio has not fared well since the news that Wirecard’s auditors refused to sign off the accounts on 18 June. EY, the auditor, says that there appeared to have been “an elaborate and sophisticated fraud”. Wirecard was the largest position in the portfolio at the time at c. 10%. During our conversation, Alexander made no attempt to excuse the serious loss of value caused by the demise of Wirecard, crystallised by selling the entire position immediately when the company announced the accounting problems: it was a serious error. However, we believe it is instructive to understand why this was a big holding but also what lessons Alexander feels he has learnt from this unfortunate experience.

Alexander believes that a key part of the historical success of JEO has been the ability to run winners and have concentrated positions in what the team view as the most exceptional companies that they can find. Typically, positions in the fund start small, at around 0.5% of the portfolio. With good results, and supporting evidence from peers, customers and suppliers, Alexander is likely to add to the position as his confidence in the investment thesis increases. Until he believes that the growth ‘runway’ has shortened or expired, Alexander will continue to hold the position.

Since 2007, when shares in Wirecard were first purchased, the audited results appeared to corroborate the company’s strong growth credentials. Through a mixture of price appreciation and further purchases, Wirecard became the largest holding in the portfolio. Alexander sold down a significant proportion of this holding in 2017 and 2018 at a profit, when price appreciation resulted in the holding touching 17% of total assets at one point. No new shares were added after January 2019.

This holding should be seen in the wider context of what has always been a concentrated portfolio. The top ten holdings currently represent about 75% of the portfolio, but it is nonetheless important to recognise that there is little systemic portfolio risk given the drivers for each holding are very different.

top ten holdings

Company % of total assets
EXPERIAN PLC 10.4
NOVO NORDISK A/S 10.1
DEUTSCHE BOERSE AG 9.8
RELX PLC 8.2
BIOMERIEUX 7.2
DASSAULT SYSTEMES SE 7.0
GRIFOLS SA 6.4
GRENKE AG 5.6
INTERMEDIATE CAPITAL GROUP PLC 5.4
GENUS PLC 4.0
Total 74.2

Source: Devon Equity Management Limited

When we asked Alexander what lessons he had learnt from the experience, his first observation was that the sizing of the position had clearly been too big. Aside from trusting the wrong people in the due-diligence process, he accepts that the nature of Wirecard’s business should also have been a factor restricting the size of the holding. A digital-payments business, he notes, is, almost by definition, more opaque than most, and the worldwide scope of operations makes it more vulnerable to the problem of agency.

The JEO board introduced firmer restrictions on sizing in 2019 (precluding purchases for the portfolio that result in individual holdings representing more than 10% of net assets). Nonetheless, the board and manager are determined that the trust should continue to be invested in the same way, enjoying the benefits of the investment-trust structure, which permits gearing and a concentrated portfolio. In our view, this seems eminently sensible. As we discuss in the Performance section, over medium and longer periods JEO has outperformed and added value – even if one removes the influence of Wirecard. We believe that the lessons from the painful Wirecard episode should not obscure the strengths of a strategy which has delivered over the long term.

Gearing

JEO’s gearing is managed flexibly, with the aim that Alexander can increase gearing at times of low valuations and decrease it in stronger markets. To support this, he has permission from the board to vary the level of gearing up to 20% of total assets through a flexible revolving credit facility for amounts of up to £100m.

According to Alexander, gearing has averaged 15% over the longer term but recently it has generally been lower (perhaps reflecting fuller valuations at the end of what has been a ten-year-plus bull market). Gearing was taken down to zero in May. This represented an overall de-risking exercise in response to broader market conditions. When we met up with Alexander recently, he noted that this was the first time since launch that the trust has been ungeared. As such, we might reasonably expect that gearing will once again rise over the medium term.

gearing

Source: Morningstar

Returns

The graph below shows what a traumatic year 2020 has so far proven for JEO. In absolute terms, the NAV and share price fell thanks to the COVID-19 market ructions. However, the trust was broadly in line with the index and peers until 18 June. It was then (as we discuss in the Portfolio section) that Wirecard negatively affected performance, although it is worth noting that if Alexander had not followed his investment process so rigorously (by selling immediately when the information changed), the absolute loss would have been significantly worse. Needless to say, with Wirecard the largest position in the trust at the time, the NAV performance relative to that of peers and the index has been poor and as a result the discount has widened considerably.

ytd performancei

Source: Morningstar

We believe that, whilst unfortunate, over the medium to long term a single event needn’t define a manager or trust. As we discuss in the Discount section, the current discount may represent an opportunity. Certainly, the longer-term track record of JEO has been very strong – even including the recent travails. As the graph below shows, up until the start of 2020 JEO was very far ahead of peers on an NAV basis. Over the ten years to 20/07/2020, JEO is +250% in NAV terms, c. 45% ahead of the average for the peer group.

five-year performancei

Source: Morningstar

Since 2001, the first full calendar year in which Alexander ran JEO, he has only underperformed the benchmark in two years – 2008 and 2016 – both of which were rather momentous and challenging years for active management. He has also outperformed the average open-ended European equities fund in every calendar year except the two years mentioned. This year he has plenty of ground to make up, but with six months to go, there is all to play for.

The Wirecard allegations have been long running, which has meant that (as the largest holding in the trust for quite some time) the NAV has seen some extra volatility. That said, with volatility of 20% over one year, it is in line with the average for the peer group. Before its problems, Wirecard had been a significant contributor to returns over the years. Devon provided performance statistics which take out the effect of Wirecard, which we summarise in the table below. We believe that this shows that Alexander’s stock selection for the rest of the portfolio has been strong over the short and medium term, hence why we believe that the mistakes made over a single stock do not mean that his long-term track record is in any way invalid. This is also why we believe that, over the medium term, the previous experience that shareholders have had of outperforming should revert.

performance excluding contribution from wirecard


one year (%) THree years (%) Five years (%) ten years (%)
NAV 2.9 15.5 54.2 242.1
Benchmark 0.6 11.7 52.1 139.1
Alpha 6.4 8.5 13.8 120.7

Source: Devon Equity Management

Dividend

JEO’s strategy is focussed on capital growth. Any dividends it has paid historically have come solely from the need to distribute 85% of the distributable income it receives in order to maintain investment-trust status with HMRC. As such, the dividend is unlikely to be a meaningful contributor to returns. At the current level the shares yield 0.8%.

Management

Alexander Darwall has been manager of JEO since 2000. For the past 13 years Alexander has been supported by fund manager Luca Emo. Together they ran a number of funds at Jupiter Asset Management, including a UK unit trust and a Luxembourg SICAV.

In 2019, Alexander announced he would be leaving Jupiter to launch his own fund-management business, Devon Equity Management. The JEO board consulted with major shareholders and appointed a firm of specialist compliance and risk advisers to consider both Devon and the proposed new Alternative Investment Fund Manager, FundRock Management Company. These appointments and the move from Jupiter to follow Alexander to Devon were subsequently confirmed by the JEO board, whose decision took effect on 15 November 2019.

As we discuss in the Portfolio section, Devon represents a ‘back to basics’ approach for Alexander, Luca and their new senior analyst Charlie, enabling them to focus on companies and not be distracted by non-fund-management activities. Alexander’s investment philosophy has always been to stay away from the ‘noise’, instead focussing on fundamentals, which one might argue suits being part of a lean, focussed organisation such as Devon. As part of its FCA application process, Devon prohibited itself from investing in unlisted companies and using derivatives.

Discount

As we show in the graph below, over the past five years (and until June) JEO has traded at a premium rating when compared to the European investment-trust peer group, and at times at a premium in absolute terms. As such, the trust has been able to issue shares historically and grow. More recently JEO has been de-rated relative to peers, which means that for the first time since 2009 the trust stands on a wider discount than the weighted average for its peer group.

discount

Source: Morningstar

This discount has not gone unnoticed by some investors. Alexander announced that he had bought a further 100,000 shares (representing consideration of c. £700k) on 8 July, taking his holding to 3.3% of the trust. Subsequent to this, the board has announced the first buybacks since 2011, at a discount which we estimate to be around 10%. As we noted in our previous note on JEO, the ordeal with Wirecard (and risks of investing in a highly concentrated portfolio) has been exacerbated for any investors who previously bought in at a significant premium to NAV. JEO serves to illustrate the risk that a relatively poor period of NAV performance can be compounded by a simultaneous widening of the discount.

Alexander has a long and consistent track record, and he has a very meaningful personal stake in the trust himself. It is our view that Alexander’s investment process (which remains unchanged at Devon) should over the medium to long term deliver attractive returns – as it has so clearly done in the past. The discount to peers is therefore unwarranted in our opinion, and with the board now making purchases of the trust’s own shares, we believe this could be an opportune moment in discount terms for long-term investors.

Charges

Under JEO’s new management arrangements which came into effect from 1 June 2020, management fees of 0.9% per annum of net assets (i.e. excluding drawn-down bank debt) will be paid up to £1 billion, and 0.8% per annum will be paid on net assets over this amount. No performance fee will be payable.

Jupiter Asset Management had previously charged a fee of 0.75% of gross assets, i.e. including any drawn-down bank debt of up to 20% of total assets. Additionally, Jupiter had been entitled to a performance fee of 15% of NAV outperformance of the benchmark. This performance fee equated to 0.8% of net assets over the financial year to 31 May 2019. As such, investors now have a simpler and potentially significantly lower fee structure under Devon.

The historic OCF of the trust stands at 0.9% (excluding the performance fee), relative to a sector weighted average of 0.88%. We expect the OCF might rise slightly under the new arrangements, but we’d expect JEO to be broadly in line with the peer-group average. The KID RIY is 1.04%.

ESG

Devon’s investment decisions are primarily driven by business and financial considerations. Alexander is looking for companies with distinctive characteristics which he expects to yield substantial benefits to shareholders over the long term. As such, he necessarily takes political, environmental and social issues into account, since they are likely to have a material impact on future financial performance.

We understand that Devon will soon publish an update to its ESG policy which will illustrate how ESG considerations are integral to its investment process and reflect an enhanced role for its investment-oversight committee in engagement with investee companies on ESG issues. Devon believes that companies with good practices are better placed to achieve good investment outcomes over the long term.

Fund History

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