The team added exposure to the Lightman European fund during the first quarter of this year.

The reasoning behind this was due to the managers expertise and experience of investing in Europe; the funds value style bias within its investment process; and long-term opportunities that were being presented by having a more value tilt to our European exposure.

Our CIO Laurence Boyle had a meeting with Rob Burnett the fund manager this week to discuss the fund in more detail and how it is positioned for the changing economic backdrop in Europe. The Europe Central Bank (ECB) has updated its forward guidance to show that interest rate increases will be enacted over the coming months to tackle high inflation rates in Europe. This is a major economic event that could impact European equities and so Laurence & the team wanted to understand the impacts this will have and re-evaluate the investment case for European equities and more importantly the fund. Below is a transcript of the questions that were discussed in the meeting that provide part of our on-going research of the fund:

European banks have been an important allocation to the fund over the years. With the ECB looking to increase interest rates in the future is the positive or negative for European banks in general? Also does this change your thesis on any of the individual banks or financial stocks you invest in?

We look to minimise exposure to geographies with high exposure to Russian gas flows. It is likely that we see Russian gas switched off in Europe later this year. It has already started in some countries for isolated periods but there is a risk of a more comprehensive shut down in gas supply. We prefer Spain, Ireland, Denmark and Sweden because of their low/zero exposure to Russian gas. On the other side, Eastern Europe, Italy and Germany have some vulnerability. Germany and Italy will manage these risks over time successfully but there may be higher economic volatility in the short term.

Given the squeeze on the consumer we also minimise exposure to unsecured consumer lending, auto lending, and micro SME lending. We prefer banks with exposure to mortgages and medium to large sized corporates. Most banks have low loan-to-value ratios for mortgages. This means default risks are low. EU corporate balance sheets are strong and with higher inflation, collateral values ought to stay reasonably resilient.

In aggregate, banks remain extremely cheap with growing earnings. Year to date our banks have performed very well, with some up 30% in 2022 so far, despite the headwinds. We remain confident about the performance of our holdings irrespective of the economic outcome, or Russian behaviour.

Post the ECB’s meeting last week, there has been a widening of Peripheral Europe nations government bond spreads with yields rising very quickly. For investors, this is a major risk that a debt crisis could occur in Europe like what was seen in 2011. Do you believe that this could be the case again?

We do not believe the European Sovereign debt crisis is returning. Given the weakness in most asset prices, recession fears and the end of quantitative easing, it is not surprising that Italian bond spreads have widened. In the Sovereign debt crisis in 2011-12 spreads widened to 5%, today they are at 2%. This seems appropriate given what is going on.

Why no return to the prior crisis? There are three key reasons:

1. Fiscal transfers have begun. The German balance sheet is being used directly to support the rest of Europe, including Italy. Italian solvency and German solvency are now intertwined. Aggregate EU debt to GDP is 95%. Whilst this is neither low nor high, the Eurozone runs a current account surplus with the rest of the world of 2% of GDP. With EU GDP at c.$18tn, this annual surplus equates to c.$360bn. By shorting Italian debt you are in effect shorting aggregate EU Sovereign debt. The EU is one of the world’s strongest credits.

2. Whilst QE is ending, the ECB still has mechanisms to buy Italian bonds to contain spreads.

3. Italy itself runs a large current account surplus, of between 2-3% of GDP. Italy is a net creditor to the rest of the world. In simple terms Italy in aggregate is accumulating wealth by selling more than it is buying. In 2011 it was very different – at that time Italy ran a deficit of nearly 3% of GDP. Italy has low consumer and corporate debt to GDP and high net assets. Italian solvency is stronger than is understood by many investors, despite its high headline government debt to GDP ratio.

The fund has performed well in very volatile periods recently with your value style outperforming growth style funds. Has this more positive performance created less opportunity to outperform over time? Also has the recent performance been reflected in the underlying metrics of the fund and the stocks you are invested in?

Today the fund has a PE of 9.2, a price to book of 1.09, a price to sales of 0.87 and a dividend yield of 4.3%. For comparison, the MSCI European Growth index has a PE of 19, price to book of 3.4, price to sales of 2.1 and dividend yield of 2.1%.

European value equities remain cheap compared to European growth equities. Since 1995, value equities have traded at 51% of the price of growth equities on average. Today they are at 35% of the price. There is a further 40% outperformance of value simply to return to the average valuation spread, a level seen in 2017. If value was to return to +1 standard deviations from its post 1995 average, we could see a further re-rating of 74%. Today value companies are also growing earnings faster than growth companies and so both earnings and the multiple are in favour of value’s continued outperformance.

The fund will always have a value bias, but we moderate between deep value and a more core value approach dependent on the degree of valuation polarisation in the market. Today with value close to record discounts, we have a more deep value approach. If we were to return to 2007 levels where value traded at 70% of the price of growth, the case for an aggressive value bias would be weaker. In that circumstance the fund’s valuation discount to the market and to growth would be smaller.

Source: Lightman June 22

Downside protection and monitoring of the potential downside for holdings is key within your investment process. What would need to occur for the companies you are investing in to see significant downside within their share price over the longer term from their current prices?

In terms of possible downside, we see no absolute downside for our holdings, unless interest rates were to rise significantly more than already discounted. We would need to see US and German yields in the 4.5%-6% range to justify lower prices for the majority of our holdings.

For growth equities we see downside, even with bond yields where they are. This chart below summaries valuations compared to the post 1995 average in absolute terms.

Source: Lightman June 22

There is nervousness about the cyclicality of value today but this is unwarranted in the most part. Many cheap equities are in industries which have experienced years of underinvestment. This is leading to higher pricing power, even in an economic slowdown. Growth industries like Technology have seen overinvestment and so pricing power is deteriorating.

There are some pockets of apparent value where we are cautious. Consumer facing companies are facing deteriorating fundamentals and some do have not pricing power. We avoid these areas.

Aside from this example and speaking in broad terms, the most significant risk to portfolios remains that of excessive valuation. By owning cheap securities you and your clients can reduce overall portfolio risk. If you own cheap securities that also have stronger pricing power, you and your clients ought to be in excellent shape. This is our central approach in the LF Lightman European Fund. We own cheap stocks with strong balance sheets with both cyclical and secular drivers behind their earnings. This means the fund ought to be able to cope with most difficult scenarios, be it recession, or higher inflation and higher interest rates.