09 Sep 2021
Sam Morse and Marcel Stötzel, portfolio managers of the Fidelity European Fund and Fidelity European Trust PLC, review the outlook for continental European equity markets. Following a period of strong returns, they discuss why a focus on attractively valued dividend paying stocks is well placed to navigate a backdrop where aggregate valuations are starting to look stretched.
The global economy has recovered more quickly and more strongly, following the pandemic, than many commentators had expected. As a result, earnings and dividend expectations for continental European companies have continued to be upgraded. This may carry on, given pent-up savings among consumers and with many services still due to reopen fully. However, much of this optimism is already discounted in share prices that are at elevated levels compared to history.
Indeed, Continental European equity markets have continued to rise over recent months, supported by continued support from the European Central Bank (ECB). Whilst we have seen strong earnings and record upgrades to guidance, it is notable that further share price responses to Q2 results have been relatively muted.
Encouragingly, the ECB has indicated that it will continue to provide stimulus, despite the recent surge in inflation, which the central bank has labelled transitory. There does appear to be more evidence that some of the dramatic price increases seen earlier in the year will indeed pass (for example, US lumber prices which had doubled in a few months have dropped back again to their starting level). However, if we do experience a period of inflation, it is strong companies with pricing power, like portfolio stalwarts Nestle and Roche, that will be best positioned as they are able to pass any increases onto their customers and avoid a margin squeeze.
Stock market leadership will continue to evolve but we will stick to our investment philosophy of investing in attractively valued dividend growers. As always, we will ask ourselves if that rate of dividend growth is already discounted in the share price.
The good news is that we continue to identify companies with positive fundamentals, strong balance sheets and an ability to generate cash flow to sustain dividend growth over time. In this regard, we’ve recently found an exciting opportunity within Spanish financials, Bankinter. This small, but best in class bank is well positioned to exploit any customer attrition caused by consolidation elsewhere in the sector. Through its spin-off from Bankinter we also inherited and have been growing a position in insurance business Linea Directa, a quality asset with around 7% of the Spanish motor insurance market. This business offers really attractive growth with strong and maintainable margins.
Elsewhere, we also maintain exposure to the luxury goods sector and these holdings have been key contributors over recent months. Hermes and LVMH, for example, outperformed on strong results and in recognition that their improved online offerings are allowing access to new customers, especially in China. L’Oréal has also proven resilient, with its fragrance business benefitting from positive read across on the sector’s outlook following a bullish update from competitor Estee Lauder’s CEO. L’Oréal has just acquired several prestige luxury fragrances, which positions it well for any surge in demand.
On the flip side, we recently moved to sell out of a Spanish utility, following a disappointing update to the company’s dividend policy. The company has been a positive long-term holding for both portfolios, but is no longer growing its dividend. Furthermore, changing regulation means that it offers no inflation protection in the current environment.
At the sector level, our largest underweight continues to be within industrials. Whilst we see a number of very good businesses in the sector, we feel many names that fit our investment criteria are trading on expensive multiples for the growth and dividends on offer.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. The Fidelity European Fund and Fidelity European Trust PLC can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.