Rich pickings

Undoubtedly, this was a tough semester for European equities, finishing on a very bearish note. The Strategic European Silver Stars Fund’s benchmark was down 10.61% in June and 22.28% in H1 2022.

June has typically been the worst month of the year for European stocks, and this year was no exception. Short-lived bounces have failed to hold, with traders sitting on the sidelines waiting for real capitulation, or any positive signal, before being willing to step in.

The month was characterised by a sharp retreat in commodity prices; interest-rate cut expectations, already priced in for 2023 in the US; and a stock sector rotation away from growth-sensitive cyclicals. All of these send a clear signal: investors are increasingly evaluating recession risks when picking stocks. Market commentaries have included phrases such as “the macro environment is especially complex right now, making it hard to separate the signal from the noise”.

Today, we see a big disconnect between the micro perception of the world from companies and the macro view of investors. At the BNP Paribas Exane CEO Conference held in mid-June, the message was that corporates remain confident they can navigate the inflationary environment well, with customer demand still buoyant and strong pricing power. While a handful of corporates were seeing early signs of a rough ride ahead, across all sectors the outlook was generally positive. Of those attending 65 (79%) were upbeat, with 13 (16%) neutral and only four (5%) cautious.

While we have seen such disconnects before, our sense is that the gap between top-down macro and bottom-up company views is unusually wide this time around, blurring the picture even further. Experience from 2008-2009, unfortunately, tells us that if today’s dislocations were to deteriorate further, the bottom-up view could rapidly converge with the top-down.

Since the beginning of the year, equity markets have had to face three major dislocations:

1. Repeated COVID-related lockdowns in China with supply chain and logistics implications;
2. Russia’s invasion of Ukraine;
3. Persistently high headline inflation in the US and now also in Europe.

Of those three factors, only one, Russia’s invasion, has the potential to deteriorate further. It could however have ripple effects on the two others.

From a market perspective, however, there are indeed some positive points to be noticed:

• We should not be far from the peak of pessimism and even more so with regards to European equities. The Bank of America Bull & Bear indicator has been stuck at zero since 16th June;

• Valuations in some segments of the markets (e.g. Consumer Discretionary) have reached levels rarely or never seen before. We will discuss this further in the context of Trigano’s valuation later in this commentary;

• Contrary to the sell side, the buy side has already incorporated sizeable EPS cuts for 2022 and even more in 2023;

• Corporate balance sheets in Europe are extremely healthy post two years of strong cash generation;

• June showed the first signs of what looked like a capitulation, finally!

The flip side of the coin is the following:

• The Central Banks put option is no longer there in our opinion, as “whatever it takes” is focused on controlling inflation. In that sense, the situation differs a lot from the bottom of March 2009;

• The capitulation in June took place without significant market volumes and panic, given what appear still to be limited outflows from investment funds. Quality companies are still priced 20% above March 2020 levels. In March 2020 we found some opportunities to deploy capital in names that normally do not match the strict 10% minimum FCF threshold we impose on ourselves;

• There is no visibility of where and when inflation, and hence interest rates, should stabilise. A scenario like the 1970s is clearly not priced in at this point;

• Second-round inflation effects are already driving salary inflation initially in the US, but also now in Europe;

• Interest rate levels have an immediate impact on equity valuations; paying 100x PE could be justified, or at least explained in a 1% interest environment. This is no longer the case today. This impact is felt in all asset classes with the end of the 60/40 model. It is intriguing to see that no one cared about the model misfunctioning on the way up;

• Finally, as already mentioned in the previous commentaries, since Q3 2021, the rosy P&L picture is far from being translated into the cash flow statements for companies, with working capital (especially inventories) eating away at the reported earnings improvement.

As this brief summary suggests, our belief is that the next quarters may remain choppy and volatile. As such, we will continue to remain prudent given the absence of visibility. The H1 results season, which is opening in the coming weeks, will be scrutinised to capture potential trends and patterns, notably around the inventories’ level and their impact on cash generation.

As a truly active and fundamental manager, the Strategic European Silver Stars Fund’s goal is not to buy the market as a whole, or a representative basket of stocks from it, but to carefully select 25 companies in a universe of 2,000 companies in Europe that we believe are able to manoeuvre in the current environment, minimise the crisis impact from a cash perspective and benefit from the situation in either the short or long-term.

Whilst this summary may come across as negative and bearish this is not at all how we as an investment team feel. Any time that there is fear and panic in the markets it results in massive mispricing opportunities for those investors that are willing to do their own fundamental analysis. During those times, we feel like kids in a candy store.

The last months have been spent looking for names that we feel will be able to take advantage of the current situation. Similar to previous crisis periods, an extensive shopping list of companies was built that we are ready to pull the trigger on if they trade at the levels we hope to see although we are not completely there yet.

The Fund was down 10.40% last month and 16.97% over H1 2022, outperforming the benchmark by 5.31%. The outperformance can broadly be attributed to three specific items:

1. Strong resilience in January 2022, when growth / quality stocks with unjustifiable valuation levels were heavily sold by markets;
2. Prudent positioning in the absence of visibility with a higher than usual cash portion in the Fund; and
3. The takeover by KKR of Albioma, one of the Fund’s top positions.

The largest contributors to June’s performance were: Albioma (+0.14%), Nordic Paper (+0.07%) and Ipsos (+0.03%). RVRC was the largest detractor (-1.29%) during the month, followed by Trigano (-1.17%) and Befesa (-0.95%).

Albioma’s tender offer period by KKR opened on 23rd June. All suspensive conditions have been lifted. This position can be considered as cash.

Nordic Paper is an example of a company that strongly benefits from the current environment. They posted a strong Q1 print where they beat consensus expectations by 30%. The underlying margins will improve in Q2 vs Q1 as prices have been raised for both main grades (greaseproof and kraft papers) amid strong demand.

The same can apply to Ipsos, as market research companies strongly benefit from uncertainty and limited visibility. At their Capital Market Day on the 14th of June, Ipsos confirmed its 2022 guidance and unveiled a very encouraging 2025 plan with an acceleration compared to the targets in the previous plan and objectives higher than consensus expectations.

If one must highlight only one objective given by the company that day, it would be the €900m cumulative Free Cash Flow over the 2022-2025 period vs. a market cap. of approx. €2bn. This is an 11%+ FCF yield for the next four years.

Capitulation has already taken place in some segments of the market and Consumer Discretionary is clearly one of them. The inflationary environment is severely impacting consumer confidence. Investors appear not to be willing to be invested anymore, whatever the price. But everything has a price. RVRC and Trigano fall into that category. Both stocks have been strongly penalised in June.

RVRC’s investment case was described in detail in our October and November 2021 commentary. The stock price dropped 40% in June given weak consumer confidence numbers and several profit warnings in the European fashion retail space.

Valuation multiples stand at 10x calendarised 2023 net income with a 10% Free Cash Flow Yield. Even in a depressed environment, RVRC should be able to grow earnings by more than 20% annually for the years to come, due to: online penetration; openings of new countries; and enlargement of the assortment.

Trigano’s valuation is even more intriguing as it trades at less than 4x August 2023 net income with a cash-adjusted FCF yield of more than 20%. The stock price currently implies an implosion of the European motorhome market. We believe this is completely wrong because:

• Demand for motor homes remains strong, keeping order books historically high and saturating production capacity for the next 18 months;

• The chassis shortfall will ease from the end of 2022 or early 2023, allowing production to be increased;

• Targeted customers are senior people, who are impacted less by inflation, with pensions often indexed. People in this category are not willing to wait 5 years to enjoy their retirement.

Befesa was the third detractor of the month as it was trapped in the decline of commodity prices even though more than 70% of its production is hedged up to early 2025. It is an overly attractive proposal at this level.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio. Download the latest factsheet. 

Please do not hesitate to contact us or visit the Strategic European Silver Stars Fund Page.

Adam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

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The views and statements contained herein, including those pertaining to contribution analysis, are those of Pascal Investment Advisers SA in their capacity as Investment Adviser to the Fund as of 08/07/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.

Morningstar™ Ratings Disclaimer
The Strategic European Silver Stars Fund – A EUR share class has a Morningstar rating of 4 stars overall and 5 stars over 3 Years. Morningstar Rating™ as of 31/05/2022. Past performance may not be a reliable guide to future performance. Returns could be reduced, or losses incurred, due to currency fluctuations. The Strategic European Silver Stars Fund received a Morningstar 3 Globe Sustainability Award. Sustainability Rating as of 30/04/2022. Out of 789 Europe Equity Mid/Small Cap funds as of 30/04/2022. Based on 98.92% of AUM.  Historical Sustainability Score as of 31/03/2022. Sustainalytics provides company-level analysis used in the calculation of Morningstar’s Historical Sustainability Score. Data is based on long positions only.