Steve Frost and Michael Browne quip that they have spent more time working together investing in European equities than most marriages last – 25 years. The duo have traded through the Single European Market in 1992, the Single European Currency in 1999, and the ongoing expansion of the European Union from 12 to 28 member states today. These developments are only just starting to bear fruit for some European equities, they contend. Their strategy track record has generated returns of 152% since 2000 – nearly quadruple the MSCI Europe index, yet with less than half the volatility. Historically, the pair have generated alpha on both sides of the book but right now their $650 million of assets (including $350 million in a UCITS) is positioned to profit from their unashamedly bullish stance on Europe in general – and in UK companies in particular.
Notwithstanding the steep rally, the twosome sees more upside. Browne explains that US normalised earnings per share have roughly sextupled since 1987, whereas the comparable measure in Europe has only done somewhat better than trebling, according to UBS data. Yet in 2000 and in 2008 Europe was nearly neck and neck with the US in terms of earnings per share (EPS) growth since 1987. So it is only post-crisis that this gaping gulf has opened up between US and European earnings growth. The managers see scope to close that gap, but already think investors are ascribing low valuations to apparently depressed corporate profits. The magnitude of the rally in European equities is, in fact, smaller than the average recovery rally seen since 1980. The PE ratio is still about onestandard deviation below its long-term level, as is the price to book value ratio. Even after last year’s rally the implied equity risk premium – at over 8% – is still almost the highest in 25 years.
Europe’s long-awaited single market
With their eyes and ears to the ground, Frost and Browne argue that the compelling valuations are ignoring the springboard for growth stories. They are particularly excited about intra-European trade. Germany still does more trade with Switzerland than with China. At the same time, intra-US trade is still far greater than intra-European trade. Browne’s vision is that different European regions can specialise in their strengths, and form a “cluster economy” with, for instance, a silicon glen akin to Silicon Valley in California. So Portugal might regain its status as a location for lower-cost manufacturing, with wages down 5%, while those in Asia are racing ahead. Witness Portugal has just lured a furniture factory away from China. This may mean that the great white hope of pan-European specialisation is finally beginning to take hold.
Labour mobility is also key to the single market story. In the US, moving thousands of miles for a job may have always been taken for granted, and Europeans are starting to think in the same way. Migration may arouse the ire of UKIP and other far-right political parties, but Browne views it as a “huge positive” for the economies of Europe. The UK and Germany are attracting a wealth of human capital including highly skilled workers, whilst the extended families of the newcomers benefit from remittances. But the recovery is not limited to Northern Europe. Even some of the most sclerotic economies are starting to show signs of life. Employment has risen in both Greece and Spain in recent months. Meanwhile mortgage lending by French banks steadily grows.
At Martin Currie they also think that the macroeconomic backdrop will be supportive. Their investment thesis is not predicated on negative interest rates for the Eurozone, but they do think that interest rates could stay at low levels for an extended period.
Britain’s growth oasis
While rate rises are a risk for the UK, the managers think that Bank of England governor Mark Carney could instead employ the types of microprudential measures that have been applied recently in Sweden, Norway and New Zealand. For instance, ceilings could be placed on multiples of salary that banks could lend, minimum deposits could be set for property purchase – and other measures could also be used without raising rates.
Edinburgh-headquartered Martin Currie are cheerleaders for the UK economy. Browne studied economic history at Durham University and he still seems to be something of a demographics buff, who is quick to dimiss the Malthusian spectre of resource constraints being raised by UKIP. “The UK has a unique demographic profile with an expanding population and a growing labour force,” he observes. If the US labour force is shrinking by 1% a year (despite population growth) the UK labour force is growing, partly from the over-50s returning to work but also from immigration – no less than 130,000 Spaniards have obtained a National Insurance number in 2012 alone. Going forward, female fecundity has caught Browne’s attention – “it has risen to 1.91 from 1.62, giving the UK the highest birth rate in the G20. Live births up to 900,000 from 600,000 are outweighing 500,000 deaths a year.” Browne even claims that such high yearly population growth has not been seen since the 13th century.
Steady growth stocks
Given this macro outlook, it is little surprise that consumer discretionary stocks are the largest long book sector position, though their 50 or so stocks come from many sectors and countries. For the long book, the duo are often attracted to long-term, steady, if unspectacular, growth stories with strong cash generation – as opposed to glamorous go-go stocks. Sweden’s Autoliv is an example: growing revenues in the mid single digits and earnings in the high single digits, it has made free cash flow every year, even in the downturn. This is one of many stocks that the two have followed for many years. Not only does Autoliv continue to innovate in airbags, but the company is at the forefront of developing active safety products to enable night vision, advanced braking and lane changing.
Clothing retailer Next has also been “a great momentum story,” says Frost, confounding the naysayers who deemed it overvalued year after year. Barriers to entry are high for internet retail – “it costs $600 million to set up a net retailer from scratch and John Lewis spends $50 million a year on its internet business.” This is a business they have investigated in detail – for instance, consumer rights are better for internet purchases as goods can be returned within seven days with no argument. The one exception to this rule is personalised goods, which is why retailers are offering them for free!
Elsewhere in retail, Danish jeweler Pandora has had a fillip from lower silver prices raising its margins by around 4% over the past few years. But irrespective of input prices, Pandora is growing in a healthy way that appeals to the duo. “The company is generating very high margins and free cash flow, and is, unusually, committed to returning all free cash flow to shareholders. Pandora is enhancing its product range and expanding its network of own-brand stories, whilst also managing inventories very efficiently,” says Frost. The end game here is that Pandora has set its sights on the huge US and Asian markets.
Yet some core holdings are selected precisely because they have no global ambitions at all. Domestically focused retail banks are being relegated to the status of regulated utilities, according to some investors. Browne admits that regulations requiring more capital to be held will probably stop such banks from getting back to the returns on equity of 20% that some of them boasted pre-crisis. But Browne views the profitability of more complex, global and universal banks as much more vulnerable to higher regulatory capital requirements than that of local retail banks where the main asset is domestic mortgages. So Browne still thinks a low to mid teens return on equity (ROE) could be attainable, and he also finds selected banks, such as Lloyds and Nordea, much more interesting than utilities. For Browne a growth stock does not have to be knocking out eye-popping rates of revenue growth in triple or even double digits. Simply growing the top line a few percent faster than the economy is sufficient to incrementally expand profits by double digits thanks to the effects of operational gearing, and over time this can compound up to substantial growth.
Low-cost air travel is another industry growing a few percent faster than the economy that has been a persistent theme in the portfolio. The fund has a long-term holding in leading low-cost carrier Ryanair, which is focused on enhancing customer service to attract traffic growth and boost revenue streams such as upgrades. For many years Ryanair only accepted bookings directly via its internet site, but now the airline has done a deal with Travelport to allow travel agencies to sell seats and packages for the first time. By selectively courting business travellers the low-cost airlines are starting to exert pricing power on some routes.
In contrast, Nokia is a stock that lost its pricing power in some areas, but not others. It is testimony to Frost and Browne’s longevity in European equities – spanning spells at BZW, Chase Asset Management, Sofaer and now Martin Currie – that they remember a time in the early ‘90s when Finland’s Nokia manufactured toilet paper, televisions and wellington boots. Fast forward to today and Nokia no longer even makes mobile phones. Frost and Browne have often, but not always, owned the stock over a generation. In the mid-1990s through to 2005 they recall how it became the leading handset maker, until this position was toppled by competition from Apple, Samsung and Blackberry. Today “Nokia is still full of hidden value,” says Browne. Many years ago it was Apple that bought some Nokia patents, including the touch-sensitive size-adjusting feature, but swap agreements with Apple and Samsung prevented Nokia from monetising its own patent portfolio when it made handsets.
It is only Nokia’s departure from manufacturing handsets that is now unleashing the full potential of the patents. Nokia has many thousands of its own patents – indeed, “Nokia owns one-third of all GSM patents and has 35,000 CDMA patents.” One of its units did half of all 4G installations, and this continues to drive infrastructure spending by telcos. Looking out to 2020, the standards for 5G are already being written now – and they still have to draw upon the foundations laid by GSM technology. Hence this patent business is becoming a research and development studio. Nokia’s Navteq maps GPS division could also be worth several billion based on comparable valuations, Frost reckons.
In its heyday the pair held Nokia for a decade; this is not unusual for core positions. Turkish retailer BIM Birlisk has been an investment for nine years and its growth prospects are still compelling. BIM employs the same business model as German discounter Aldi, which created one of Germany’s richest billionaires and which is currently causing headaches for UK supermarkets. The management of BIM are all ex Aldi and the formula is familiar – own-brand products, vertical integration, aggressive pricing promotions, and convenient locations. The model has been somewhat adapted to the Turkish market: for instance, avoiding alcohol makes it much easier to find sites that will be approved by local authorities. BIM has grown to 4,500 stores all over Turkey and continues to expand its profit margins in Turkey and elsewhere. A presence in Morocco has already been established, with Egypt the next market to enter. That said, the team are very unlikely to allocate more than 10% of the overall fund to emerging and eastern Europe.
Shorts may seem like something of a sideshow right now, but if we hark back a few years shorts have been very important. Shorts (and shrinking the book) helped to limit losses for the strategy to 5% in 2008 and the twosome started shorting in 1998 while at Chase Bank. They do not view shorts purely as a profit centre but also as a balance sheet instrument. Short sale proceeds release more funds for the long book, which tends to outperform their shorts. For instance, in 2006 the short book appreciated and hence lost 16%, but this was still 30% less than the long book which made 46%. So having shorts allowed them to size the long book larger.
Since inception, the Europe long/short strategy has generated alpha on both the long book and the short book and even during recent exuberant years there have been pockets of opportunity. A recent short was a UK transport franchise where “the leverage was way too high and Standard and Poors were threatening a downgrade that would double interest costs,” recalls Frost. The pair are disciplined about locking in profits on shorts after a fall – or when fundamentals change. The short in the transport stock was covered down 40%. The short in a now disgraced bank was put on at 11 and covered at 4. Having shorted another stock for a long time, they closed it when the CDS (credit default swap) spread hit a crazy level of 1,200, which implied the equity might be worthless. As the CDS collapsed the shares nearly tripled from 1.5 to 4. The duo did not instantly cut and reverse from short to long – they covered the short before they went long.
The housebuilders were another sector Martin Currie has traded from both sides. This was a beaten-down sector that the pair took advantage of after the crisis. “Builders had bought overpriced land in 2007, written it down, and then became very cash-generative. They were depressed but their cleansed balance sheets were appealing,” Frost recollects. UK housebuilders are far from the only industry where management is now treading more carefully.
The portfolio currently places less emphasis on the short book, perhaps because the managers hope the history of boom and bust has made companies – and economic policymakers – more cautious. Browne envisages a smoother macroeconomic cycle in future – “the amplitude of the economic cycle will be lower,” he opines, arguing that “banks are simply not able to overextend themselves and nor can consumers – so the seeds of the next recession cannot occur, absent some exogenous shock like oil, or a growth shock from China or the US.”
Companies are also much more cautious now. Pre-crisis the pressure was to lever up to five or 10 times EBITDA, but now this is seldom seen. “We look at metrics such as cash-flow return on investment and companies are also more focused on these measures,” says Frost, adding that he is prepared to pay fair value for these more conservatively managed companies. “The quality of management is the best we have seen, as a near-death experience does not hurt,” he stresses.
Browne reminisces how, mid-crisis, a major luxury goods company that he is not permitted to name was unsure if it would be able to pay its suppliers. Today, the CEO has learned his lesson and promises to keep at least £300 million of spare cash in the bank. Browne and Frost have always kept a decent chunk of their own spare cash invested in their strategy, which chimes very well with privately owned Martin Currie’s ethos of being managed by its owners.
So far, as of May, 2014 has seen violent reversals in some of the most over-crowded hedge fund stocks, on both the long and the short side, inflicting hefty losses on some funds. Frost and Browne are unfazed by this as they do not appear to be involved in the consensus hedge fund stock picks. Performance in 2014 has been unremarkable thus far, but after 25 solid years in the markets these two managers can afford to take a longer-term perspective.