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In the second of our series on the power of local perspective, we illustrate how deep industry research in the European equity market can help to uncover hidden value through active long/short investing — an approach we think investors may find increasingly compelling as we steer through ongoing volatility and structural change.
Driven by deglobalisation, a higher-rates environment and diverging fiscal policy, the European equity market is in the midst of a regime change that is having a fundamental impact on most European companies. Here, Equity Portfolio Manager Dirk Enderlein and Investment Director Boris Kergall share their insights on why they believe this environment offers opportunities for research-led long/short investors.
We think the European equity market of the next decade will look very different to the one many overlooked in the last, as a result of three structural changes underway:
In this environment, we expect new equity market leaders to emerge and the potential for significantly higher levels of return dispersion versus the directional markets we’ve experienced since 2008.
Historically, long/short investors have outperformed in periods of above-average stock dispersion (Figure 1) and because many structural changes in the market point to increased stock dispersion again, we think long/short investors have the potential to outperform versus long-only approaches over the medium term.
Figure 1
Focusing solely on European equities, rather than taking a broader global approach, means that we can really get to understand local markets and companies through strong engagement on the ground. Typically, we hold more than 500 meetings a year with company management teams, which allows us to gather a significant amount of information for our bottom-up stock selection process.
On the long side, we look for companies with a compelling long-term structural growth path through cycles and a strong competitive position, but where valuations are pricing in neither of these things over the next two to five years — and we are finding a wealth of opportunities in the current investment landscape.
Equally, over the next 12 – 18 months, we anticipate many companies across Europe facing structural issues, where below-average growth and a worsening competitive environment result in valuations that leave room for the downside — hence the high number of attractive short opportunities we’re uncovering.
Heightened market volatility and growing performance dispersion makes for a fertile ground for long/short investors with the scale and research capability to cover a diverse mix of European stocks across sectors and countries.
As well as the many idiosyncratic long/short opportunities — notably in industrials, health care and consumer stocks — we see some compelling long and short potential opportunities for select companies in the energy-transition theme. Europe has significant exposure to the energy transition, not only through government fiscal spending but also as the home to many companies helping to enable the transition.
Within this theme, we think a number of European cement companies stand to benefit from the structural drive across Europe, and globally, to lower carbon emissions in the construction process. We also expect upcoming carbon-credit regulatory changes, which are being driven by decarbonisation efforts, to create bifurcation in the industry in favour of larger players and to drive industry consolidation — the larger players are likely to decarbonise at a faster rate as they take the lead on a number of initiatives like the use of alternative fuels and carbon capture. These dynamics should lead to an improvement in market structure and pricing power.
One likely beneficiary — a European materials firm — has one of the world’s broadest low-carbon-cement and low-carbon-concrete product ranges and was the first company in its sector to have 2030 and 2050 net-zero targets validated by the Science Based Targets initiative. This company has a solid structural growth driver, with demand for its building decarbonisation solutions set to continue rising as the energy transition gathers pace, as well as a strong competitive position and an attractive valuation.
On the short side, we have identified companies in the same sector that we think have been built on unsustainable business models, may struggle to finance themselves in a higher-rates world or have perhaps had their business become overvalued given the volume of capital flowing into the space. A European supplier of speciality chemicals to the building industry may be a prime example of the latter. Although the company has strengths in product innovation and distribution, its high valuation is, in our view, unjustified, particularly given the intensifying competition in the construction chemicals space.
Large regime changes of the type we’re witnessing today typically happen only once every 10 to 15 years — the last was the global financial crisis in 2008 and before that, the dotcom bubble of 2000 — and completely transform the investment opportunity set. In our view, the significant dispersion today’s new environment is creating between winners and losers in the European equity market presents experienced, research-led long/short investors with compelling opportunities for return potential and portfolio diversification in the years ahead.
Please refer to the investment risks page for information about each of the following risks:
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