Fidelity European Values PLC A difficult year for equities

Fidelity European Values PLC

Fidelity European Values PLC (LON:FEV) today provided final results for the year ended 31st December 2018.

Financial Highlights:

  • Fidelity European Values PLC recorded a net asset value (“NAV) per share total return of -4.8% for the year ended 31 December 2018, while the Benchmark Index, the FTSE World Europe (ex UK) Index, returned -9.5%.
  • The discount widened from 8.6% to 10.7%, as a result of the share price total return of -6.8%.
  • The Board recommends a final dividend of 6.28 pence per share for approval by shareholders at the AGM on 13 May 2019. In addition, the Board has decided from the 2019 financial year to pay both an interim and a final dividend.
  • In a difficult year for equities, the Portfolio Manager’s strong stock selection capabilities were once again the significant drivers of performance with several high-conviction holdings contributing positively to returns.

Chairman’s Statement

Fidelity European Values PLC aims to be the cornerstone long term investment of choice for those seeking European exposure across market cycles.

The Portfolio Manager, Sam Morse’s, approach in managing the Company’s portfolio is to look beyond the economic and political noise and concentrate on the real-life progress of listed businesses across this large and diverse region. In running the portfolio, he focuses on researching and investing in stocks he believes can grow their dividends consistently, irrespective of the prevailing backdrop. Companies with the cushion of a healthy and growing dividend also tend to be resilient during periods of macroeconomic uncertainty. By investing in solid and sustainable dividend-paying companies, Sam believes that the Company provides core defensive exposure to European equities with the potential to outperform indices over the long term.

The Company recorded a net asset value (“NAV”) per share total return of -4.8% for the year ended 31 December 2018, while the Benchmark Index, the FTSE World Europe (ex UK) Index, returned -9.5%. The share price total return over this period was -6.8%. In a difficult year for equities, Sam’s strong stock selection capabilities were once again the significant drivers of performance with several of our high-conviction holdings contributing positively to returns. In addition, the Company’s NAV total return performance over three and five years remains ahead of the Benchmark.

Investor sentiment took a turn for the worse last year, particularly in the second half, as markets faced twin headwinds of trade tensions and rising interest rates. The market movements in Europe were in line with larger global trends in general, but the environment was further aggravated by the chronic government budget deficit in Italy and political unrest in Spain, while the possibility of a disorderly Brexit and its implication for the European economy remains a concern. As the Company is a UK business with predominantly UK investors and no overseas suppliers, the Board’s focus is on the impact of market and investment risk. At the time that this statement was written, it was still not clear whether the Prime Minister’s proposed Brexit agreement would eventually be ratified by Parliament, whether there might be an exit without any form of agreement or whether Brexit might be delayed by way of an extension to Article 50, which governs secession by individual states. How markets will react depends largely on what they have already discounted, and in the Portfolio Manager’s Review, Sam gives a more detailed view on which European sectors and stocks held in the portfolio might prove vulnerable in those circumstances. The outlook in this respect is still finely balanced. This is why Sam looks beyond these shorter term uncertainties and positions the portfolio for the longer term, by which time Brexit will be history, for better or worse.

These factors coupled with rising borrowing costs owing to normalisation of monetary policy by various central banks, most notably in the US, resulted in a sharp sell-off towards the end of the year. It was also a contrast to the relative calm which had prevailed over the last few years. Underlying the market movements was an increased number of earnings downgrades given slowing global growth. Europe has many of the world’s biggest exporters and the economy is particularly exposed to global trade. This also resulted in a significant de-rating of equities in Europe.

Lead indicators for the global economy have slowed, prompting investors to become more cautious. While the region’s economic expansion is expected to be supported by favourable domestic demand, the pace of expansion is likely to be moderate. Equity markets are set to face some challenges due to ongoing trade concerns between the US and its trading partners. Concerns around the fiscal challenges in Italy, continuing uncertainty over Brexit and the current slowdown in global economic growth, may negatively impact investors’ preference for risk assets. Nonetheless, an uncertain market environment is likely to create buying opportunities for long term investors, and in these circumstances your Portfolio Manager’s concentration on fundamentally strong businesses should continue to help performance.

Management Fees
With a view to reducing costs for our shareholders, the Board agreed a new tiered fee structure which was effective on 1 April 2018. The previous fee of 0.85 per cent per annum only applies to the first £400 million of the Company’s net assets and a lower rate of 0.75 per cent per annum applies to net assets in excess of £400 million. Given the value of shareholders’ funds of £955.3m as at 31 December 2018, this represents an important saving for shareholders.

Allocation of Fees and Finance Costs
As mentioned in last year’s Annual Report, and effective from 1 January 2018, 75% of the Company’s management fees and finance costs are now charged to capital and 25% to revenue. This better reflects the balance of the capital and revenue elements of total return experienced historically over the longer term. Previously, these costs were charged in their entirety to revenue. The change does not affect the total return although relative rates of taxation of income and capital gains may be a consideration for some investors. As a result of this change, the revenue return for this reporting year is higher than in prior years and this is reflected in the final dividend proposed.

The Board recommends a final dividend of 6.28 pence per share for the year ended 31 December 2018 for approval by shareholders at the AGM on 13 May 2019. The dividend will be payable on 17 May 2019 to those shareholders who appear on the share register at close of business on 29 March 2019 (the ex-dividend date will be 28 March 2019). 1.79 pence per share of the recommended dividend represents the increased revenue generated from the change in the allocation of the management fees and finance costs as mentioned above. If this element is excluded, the underlying 4.49 pence represents an increase of 3.2 per cent year on year.

While the Board has not sought to influence the Portfolio Manager by imposing any income objective in any particular year – and this remains the case – the investment focus on companies capable of growing their dividend has seen the Company’s dividend payments rise over time. Because the Board acknowledges that both capital and income growth are components of performance, as reflected in the change of investment objective approved by shareholders at the Annual General Meeting last year, it considers that this is an appropriate time to move to a more clearly defined progressive dividend practice.

The aim therefore will be to increase the dividend each year. The exceptional circumstances in which this might not prove possible include, first, if sterling were to rise substantially against the euro; secondly, if economic trends prove to be unusually adverse; and thirdly, if the Portfolio Manager shifts the emphasis of companies held to ones with a materially lower overall yield than hitherto.

In order to help realise its aim, the Board has decided gradually to augment revenue reserves by retaining a minor proportion of earnings from year to year. By law this proportion is not permitted to exceed 15 per cent. By way of example, for the 2018 financial year the dividend of 6.28 pence is being paid from earnings of 6.94 pence per share, a retention rate of about 9 per cent. The Board expects that as revenue reserves build up, they will assist, if necessary, in smoothing dividend growth year on year, in the event of the sorts of exceptional circumstances outlined above.

Finally, as the Company has a significant retail shareholder base and in order to smooth the dividend payments throughout the year, the Board has decided from the 2019 financial year to pay both an interim and a final dividend, which it is hoped will be welcomed by shareholders. It is expected that in normal circumstances the interim dividend will represent somewhat under half the total dividend for the financial year, and will be paid in November 2019, following the interim results.

Discount Management and Treasury Shares
The Board operates an active discount management policy, the primary purpose of which is to reduce discount volatility. As of this year, the Board is seeking to maintain the discount in single digits in normal market conditions. Buying shares at a discount also results in an enhancement to the NAV per share. The Board has shareholder approval to hold in Treasury shares repurchased by the Company, rather than cancelling them, and these shares are then available to be sold at a premium to NAV, facilitating the management of, and potentially enhancing, liquidity in the Company’s shares. The Board is seeking shareholder approval to renew this authority at the forthcoming AGM.

As a result of the widening of the discount during the year, the Company repurchased 3,029,351 ordinary shares into Treasury. Since the beginning of the year and as at the date of this report, the Company has not repurchased any further ordinary shares.

The Company continues to gear through the use of derivative instruments, primarily contracts for difference (“CFDs”), and the Manager has flexibility to gear within the parameters set by the Board. As at 31 December 2018, the Company’s gross gearing was 10.1% (2017: 13.2%) whilst net gearing was 6.1% (2017: 3.6%). In the reporting year, gearing made a small negative contribution to performance, as can be seen from the attribution analysis table in the Annual Report.

The Board monitors the level of gearing and the use of derivative instruments carefully and has defined a risk control framework for this purpose which is reviewed at each Board meeting.

Board of Directors
After serving on the Board for over ten years as a non-executive Director and nearly eight years as Senior Independent Director and Chairman of the Audit Committee, James Robinson stepped down from the Board at the conclusion of the AGM on 14 May 2018. At the same time, James was succeeded as Audit Committee Chair by Fleur Meijs and as Senior Independent Director by Marion Sears.

We continue to review Board composition and Directors’ succession on a regular basis to ensure that we have a Board with a mix of tenures and one which provides diversity of perspective together with the range of appropriate skills and experience for your Company. In accordance with the UK Corporate Governance Code, and being a FTSE 350 Company, all Directors are subject to annual re-election by shareholders and put themselves forward for re-election at the forthcoming AGM. Biographical details of each Director are shown in the Annual Report.

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Annual General Meeting
The AGM of the Company will be held at midday on Monday 13 May 2019 at Fidelity’s offices at25 Cannon Street, London EC4M 5TA (nearest tube stations are St Paul’s and Mansion House). Full details of the meeting are given in the Annual Report.

This is our opportunity to meet as many shareholders as possible, and I hope therefore that you are able to join us. In addition to the formal business of the meeting, Sam Morse, your Portfolio Manager, will be making a presentation on the year’s results and the outlook for 2019.

Vivian Bazalgette
14 March 2019

Portfolio Manager’s Review

Sam Morse was appointed as Portfolio Manager of Fidelity European Values PLC on 1 January 2011. He has also managed the Fidelity European Fund since 1 January 2010. He first joined Fidelity as a research analyst and covered a range of sectors before becoming an equity income fund manager. He also worked as Head of Equities at M&G.


How has the Company performed in the year under review?


The Company had a disappointing year in absolute terms with the NAV total return falling by 4.8% and the share price total return falling by 6.8% as the discount widened. I hope it will be some consolation to shareholders that the Company’s NAV and share price both fell less than the Benchmark Index which was down by 9.5%.


And what has the market environment been like in the year under review?


2018 was a year of growing uncertainty, which is never good for stock market returns. As in a suspense movie, investors spent much of the year fearing what might come next. When the year began, the global economy was humming, earnings estimates were rising and there appeared to be few clouds on the horizon. Within a few weeks, however, and just as the ink dried on endless optimistic projections by strategy teams around the City, the angst began. Investors started to worry: ‘is this as good as it gets’? Then as the year progressed, ‘events’ provided more reasons to fear what might come next. We ended the year almost at the other end of the spectrum: fearing the impact of trade wars, higher interest rates in the US, the unpredictability of populist political agendas, etc., and all this just as the European Central Bank (“ECB”) finally ended its programme of quantitative easing! December saw a dramatic sell-off and what was touted, at the outset, to be a banner year for stock market investors, turned into a very disappointing year with only cash providing a positive return.


What have been the key contributors to performance? And detractors?


The focus on reliable dividend growers often means that the Company holds up relatively well when investors grow more nervous and when equity markets struggle and this was the case in 2018. Other factors contributed positively too, such as sector positioning, e.g. being overweight in technology and underweight in automobiles, and the focus on strong balance sheets as investors became increasingly concerned about financial leverage. Stock-picking, however was, as usual, the main determinant of relative performance. The financial sector provided the greatest boost, in aggregate, to relative performance. Deutsche Boerse was a strong individual contributor, as detailed in the interim report, but more generally, avoiding low-return banks, seen early in the year as recovery plays on the back of rising interest rates, helped when it turned out that interest rates in Europe were, as the President of the ECB Mario Draghi confirmed, going nowhere until at least after the summer of 2019. The top individual contributor for the year was Edenred – the global leader in managing employee benefit programs for corporates (remember luncheon vouchers?) – which saw an acceleration in organic and inorganic growth under the stewardship of a relatively new management team. Brazil is the single biggest area for Edenred so optimism about the prospects for that country, following the election of Bolsonaro, gave the stock an extra lift too. As always, there were also disappointments in terms of stock picking. The most notable of these was Iliad Group, the French telecoms company, which suffered from poor execution in an increasingly competitive market and Atlantia, the Italian motorways operator, which had a major setback when the Morandi bridge collapsed with tragic consequences.


There have been a number of challenges for European equity managers this year, not least the high sales exposure to emerging markets of many European companies, rising input prices and political uncertainty. How have you navigated these?


More than a quarter of sales by European companies are now made in emerging markets which demonstrates their considerable success in expanding outside their domestic markets. Emerging markets may be unfashionable today, having had a difficult 2018, but the longer term growth prospects remain good. My investment approach is to try to make sure that we own the best balance of companies with respect to consistent dividend growth and what is discounted in the share’s valuation. I tend not to react to events or changes in stock market fashions but try to make sure that there is a balance in the portfolio across sectors and regions, including emerging markets, which will make sure that the Company can perform consistently in different environments. Rising input prices are a function of where we are in the economic cycle. If a company has pricing power, it is often able to pass these rising input prices on to customers and mitigate any hit to margins. Weaker businesses will struggle to do so. I have always favoured companies with strong pricing power which are often strong business franchises that are capable of growing their dividends consistently. Political uncertainty is, I’m afraid, here to stay. Ultimately, strong businesses which can deliver consistent dividend growth will continue to thrive in difficult times even though political uncertainty may cause the markets to be volatile on a shorter term view.


What have been the major changes to the portfolio over the period?


I seldom make ‘major’ changes to the portfolio because my investment horizon is quite long term. I am focused on attractively-valued companies, which I think can grow their dividends consistently on a three to five year view. Indeed, many of the Company’s investments have been held throughout my tenure as this Company’s Portfolio Manager, which is now more than eight years. As a result, the turnover in the portfolio tends to be quite low and 2018 was no exception to this. Holdings in BIC Group, the lighters to pens company, Elior, the contract caterer, Anheuser-Busch InBev, the beer company, and Aena, the Spanish airports owner and operator, were all sold during the year. The first three were sold on concerns regarding their dividend outlook given deteriorating fundamentals while Aena, which has been a very rewarding investment since purchase around three years ago, was sold because the valuation was no longer as attractive. I was concerned that the strategy of the company might change for the worse following the election of a new government in Spain. One new holding was added during the year: Grifols, which is one of the global leaders in plasma-derived treatments, where we expect to see earnings growth accelerate beyond expectations as the number of suitable indications grow and as newly-opened collection centres mature.


How has your derivative strategy performed in the year under review?


Gearing did not help given falling markets and unfortunately, the short portfolio did not really add much value either. Having said that, there have been some soft benefits in terms of meeting companies and analysts with whom I might not formerly have engaged. Assessing performance over one year is also, probably, too short a period to draw a conclusion as to the merits of this shorting strategy. However, I am mindful that time focused on the derivatives strategy may distract from or dilute the main objectives of the Company. I have committed to the Board that, until there is evidence that this strategy works, I will not make it a larger proportion of the Company. Time will tell.


The market seems to be assuming that there will, ultimately, be an agreed withdrawal deal between the UK and the EU. What if there isn’t? How would that impact the Trust?


The UK represents a small proportion of continental European companies’ sales and profits: less than 5%. So the direct consequences of a ‘no deal’ Brexit, and a subsequent devaluation of UK sterling, would be minimal for most companies. Those more affected would be companies with larger businesses in the UK such as the Spanish banks Santander and Sabadell. A number of companies, such as those in the auto sector, might also suffer from short term disruption due to supply chain issues if there is a ‘no deal’ Brexit. A devaluation of UK sterling in the event of a ‘no deal’ Brexit would, however, result in exchange rate gains for UK sterling investors in the Company. An appreciation of UK sterling would have an opposite effect. Note 17 in the Financial Statements below provides foreign currency risk sensitivity analysis. There may, of course, also be some indirect consequences, or second order effects, such as a general drop in business confidence which may affect equities negatively.


What should investors remain focused on in the months ahead?


Focus on the long term. The Russians, I am told, have a proverb that says: ‘if your shoes are dirty, point to the horizon’. Well the shoes may be a little dirty as we enter 2019 which could be a tricky year for European stock markets given on-going earnings downgrades, Brexit machinations, continued uncertainty about the impact of US Federal Reserve tightening and the end of quantitative easing in Europe. In the long term it pays to stay invested in equities and, in particular, in those companies that are able to grow their dividends consistently. Valuation is improving but we are far from trough levels. The current dividend yield of the European markets is only about 70% of the highest level seen during my tenure as Portfolio Manager of the Company. Often, in a fundamental downturn, valuations become very cheap in historical terms. Fidelity has pointed out many times, however, that it is extremely difficult to try and time markets, so my policy is to stay fully invested and ride through the cyclical ups and downs of the market. In the long term, investors are rewarded for taking that risk. For my part, I will continue to focus on attractively valued cash-generative companies, with strong balance sheets, which have the potential to grow their dividends consistently over the next three to five years.

Sam Morse
Fidelity European Values PLC Portfolio Manager
14 March 2019

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