Within the IA Europe ex UK sector, a number of managers have tilted their portfolios towards financials on the back of the attractive valuations that can still be found in the space. The average fund in the peer group is underweight financials, with a 16% allocation against the MSCI Europe ex UK index’s 19.7% weighting, although some members have much more than this.
Rob Burnett, manager of the £242.4m Neptune European Opportunities fund, says: “The banks present investors with the biggest opportunity in our view. At trough margins and tough earnings, we believe banks are one of the few sectors that could experience both an earnings expansion and a re-rating as the cost of capital rises.
“It is not uncommon to find well capitalised European banks paying dividends yielding more than 5%, trading on price-to-book multiples of 0.5-0.7x, and price-to-earnings ratios of under 10x. BNP Paribas and Société Générale are good examples.”
Burnett, who has 36.8% of his fund in financials and counts BNP Paribas, Banco Santander, KBC Bank, Société Générale, DNB ASA and ING Group as top-10 holdings, describes the gains since February as “relatively modest”. “We expect further upside from here,” he adds.
According to FE data, Neptune European Opportunities has the second-highest allocation to financials in the IA Europe ex UK sector. The fund with the highest is Schroder European Alpha Income, which is headed by James Sym and has 41.6% of its portfolio in financials (its benchmark has a 21.7% weighting to financials).
Sym’s approach is based on the business cycle and the type of company the fund owns depends on where the manager thinks the cycle has reached. As the moment, he has an overweight to higher-quality financials and has not largely stayed away from lower-quality names in the sector.
In terms of future positioning, the manager believes investors will have to increasingly look outside the quality-growth stocks that have rallied hard since the financial crisis. They may look to value areas such as financials as the economic environment moves into a reflationary phase.
Sym explains: “This means we want to own very different assets than the ones that have served so well since 2008. Bond markets, as the biggest beneficiary of these policies, look especially vulnerable. Although fully valued, fortunately the European stock market does not appear egregiously manipulated in aggregate.”
“However, equity markets are also likely to see a massive rotation. A focus on valuation will be a much more important determinant of future share price direction, whereas any company which has directly benefited from the low inflation world is at risk.”
Pursuing performance
More than a dozen members of the sector have over one-quarter of their portfolio in financials. Joining the Schroder and Neptune funds are Jeffrey Taylor’s Invesco Perpetual European Equity, Olly Russ’s Liontrust European Income and John Bennett’s Henderson European Focus funds.
Given the strong run in quality growth stocks and the significant underperformance of financials over recent years, many of the IA Europe ex UK sector’s top performers are those funds that have stayed away from the likes of banks.
The Man GLG Continental European Growth fund (Chart 2), which has been headed by European equity veteran Rory Powe since October 2014, has one of the peer group’s lowest allocations to financials at 2.4% of assets. The fund focuses on quality businesses – among its biggest overweights are the consumer durables and healthcare sectors – and is running a 9.9 percentage point underweight to European banks.
The fund was the sector’s best performer over the five years to the end of November 2016, after making a 157.2% total return. Its average peer was up by 81% over the same period while its FTSE Europe ex UK benchmark gained 68%.
Likewise, funds such as David Dudding’s Threadneedle European Select, Alister Hibbert’s BlackRock European Dynamic and Alexander Darwall’s Jupiter European are topping the sector’s five-year performance table and have a low weighting to financials.
Some of the funds overweight the financials space have struggled during the past five years because of their value approach. Neptune European Opportunities sits in the bottom quartile after making 62.8%, for example, where it is joined by Allianz European Equity Income, which has 25.4% in financials, and its 67.3% gain.
But not all have underperformed. Invesco Perpetual European Equity, Henderson European Focus and SVM Continental Europe, managed by Hugh Cuthbert, are examples of funds with high financials weightings and top-quartile numbers on a five-year view, up by 110.5%, 103.4% and 98.6%, respectively.
During 2016, however, some of the sector’s highest returners have been those with the most exposure to financials.
Schroder European Alpha Income, the fund with the largest allocation to financials, made 14.9% in the year to November 2016. The average fund in the peer group was up by 9.9% and the MSCI Europe ex UK index climbed 11%.
Neptune European Opportunities made 18%, the eighth-highest return in the sector. Other European funds with over a quarter of their portfolio in financials, as well as top-quartile 2016 total returns, include Schroder European Alpha Plus, up 17%, Invesco Perpetual European Equity, up 15.5%, and Allianz European Equity Income, up by 13.7%.
Split decision
Given the mixed outlook for European banks, as investors are split on whether the sector represents a value opportunity or a value trap, those funds running an underweight to the sector should not be forgotten.
Other funds with good long-term track records and low financials exposure already noted include Jupiter European and Threadneedle European Select.