Long/short investing in a changing Europe

Thomas Mucha, Geopolitical Strategist

Dirk Enderlein, CFA, Equity Portfolio Manager

2024-07-25T12:00:00-04:00 | S3:E7 | 24:43

The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.

Episode notes

Portfolio manager Dirk Enderlein joins host Thomas Mucha to discuss how European markets are evolving and how long/short investors can potentially make the most of the changes.

2:15 – Long/short investing amid Europe’s structural shifts
5:00 – Bubble or durable regime change?
7:30 – Energy transition
10:00 – Defense sector deep dive
15:45 – Bottom-up stock picking
18:30 – Evaluating emerging technologies
20:30 – Investing with an engineering mindset

Transcript

DIRK ENDERLEIN: We think there will be quite a few valuations that have to come down. And in some cases, you will have companies that will outgrow the market slightly, but will still underperform, because valuations have just reached levels that were so high. Now, one thing that will drive that, we think, is basically other areas that weren’t really let’s say, part of the cool kid crowd until recently have started to grow earnings substantially. Defense is there at the forefront, where you see double-digit earnings growth, and this will clearly drive a revaluation.

THOMAS MUCHA: The expression “seeing the forest through the trees” refers to the ability to appreciate the big picture, as well as the smaller details that make it up. Now, for investors, this is a critical skill, because every company, and every asset, for that matter, operates as part of our broader macro and, of course, geopolitical systems. My guest today is a veteran portfolio manager at Wellington, Dirk Enderlein, one of the most skilled investors I’ve ever met, and who personifies this forest for the trees approach. He’s a long/short equity investor, focused on Europe. Dirk’s experience and curiosity help him understand company management minutia, market trends that are now taking shape, and overarching shifts in the monetary, fiscal, and geopolitical backdrops. Today we’re talking about the changes Dirk is seeing in European markets, and how investors can potentially make the most of them. He joins us from our London office. Dirk, it’s great to have you here, and welcome to WellSaid.

DIRK ENDERLEIN: Thank you.

THOMAS MUCHA: So let’s start with the big picture. Several structural shifts are now underway, from deglobalization and rising protectionism, particularly in the form of onshoring and national security; we’ve got the energy transition; big shifts in demographics and labor markets; accelerating change in technology; and on and on. So, Dirk, at a high level, what do these structural shifts mean for European equity markets?

DIRK ENDERLEIN: So, first of all, as Europe is probably the most globalized region globally in the world, any kind of bigger shift that happen as regards to the globalization trend reversing, or bigger shifts that happen on other continents, will have an impact on Europe, in terms of supply/demand of products, in terms of trade flows, et cetera. I would, however, especially point out a few developments which will have a very big impact, specifically on the European equity markets. So one is the new trend to more investments into national security, which will clearly impact Europe a lot, because Ukraine is just around the corner, and Gaza is not far away, either. Secondly, the energy transition. This trend, which has, to a large extent, started in Europe, but is now gathering pace globally, has a very big impact on many companies in Europe, because of investments, because of capex that is being spent, and a lot of companies in Europe, being at the technological forefront of this trend. And lastly, I’d say the changes in labor market, demographics, so, a reduced labor force going forward in many Western countries, which will mean either immigration or more automization, or both of it. Here, as well, Europe is, I would say, at the core, and this will also have an impact on the markets and a lot of companies.

THOMAS MUCHA: So, Dirk, you’ve touched on maybe my favorite topics of all, given my geopolitical focus, but, as a long/short investor, focused on Europe in particular, why do you find these conditions so interesting?

DIRK ENDERLEIN: So for a long period, far more than a decade, we had a very clear trend in markets globally, but also in Europe. One was tech was outperforming almost nonstop, for a long time. And then, also, a lot of what was rightly seen as quality growth stocks -- so certain stable companies had seemed to be delivering regular earnings growth for a prolonged time. They also outperformed quite strongly, and expanded the valuation multiple quite substantially. We do think there is a highly likelihood of a regime change, so the leaders in the market will actually change, so thinking next five, six, seven years, we’ll be less driven by tech, by quality growth, but by other sectors. This means you’re basically revaluating a lot of equities, a lot of single securities. So some that did really well over more than a decade, there is a chance of a devaluation, so multiples coming down. Other areas that weren’t of any interest for a prolonged time period, such as defense, might actually be reevaluated, and might actually get to different multiples. And whenever you have such a regime change in the market, where basically two parts of the market are being completely newly assessed, that means there are a lot of opportunities on both sides, for longs and for shorts.

THOMAS MUCHA: So, from a market sentiment perspective, do you think we’re on the cusp of another bubble in certain areas, or is this more of a slow-moving, durable regime change?

DIRK ENDERLEIN: So the one thing that has puzzled us a little bit, it is a mixture of the two, I would say. So in some areas we have already seen almost bubble-like setups. One example, we’re thinking about energy transition, some of the renewable energy areas, where there were a lot of companies loss making, negative free cashflow, no clear path to any free cashflow being earned in the next five, six years, and on really almost crazy price-to-sales multiples. This was a few years ago, and we’ve seen a big deflation of that, I would say, bubble. In other areas in tech, we’ve seen exaggerations especially in some parts of the market in tech where you had loss-making companies, such as consumer-oriented tech or in some fintech areas. And here evaluations have come down, but we didn’t see necessarily the same exuberance we’ve seen in late ’99, early 2000. And then you have companies that produce earnings, have certain growth path, are quite stable, and they did revalue quite substantially from the early 2010s until 2022, 2023. Here, we’ve seen quite a few wobbles. The extremes are not as extreme as we’ve seen, for example, in 2000, or during the Nifty Fifty, mostly, but in some cases they are almost there. And here, the big question mark is: is it a bubble or not? Is it just an exaggeration? But we think there will be quite a few valuations that have to come down. And in some cases, you will have companies that will outgrow the market slightly, but will still underperform, because valuations have just reached levels that were so high. Now, one thing that will drive that, we think, is basically other areas that weren’t really let’s say, part of the cool kid crowd until recently have started to grow earnings substantially. Defense is there at the forefront, where you see double-digit earnings growth, and this will clearly drive a revaluation.

THOMAS MUCHA: Yeah, sounds like a good setup to be a long/short investor.

DIRK ENDERLEIN: We do think so, yeah. I mean, it’s a setup that usually you only get every 10 to 15 years, or even 20 years. Last time, we had a similar setup in the early 2000s, and before that was probably in the early ’80s, so you don’t get that very often, and I think we are very lucky that we are in this situation right now.

THOMAS MUCHA: I wanna dig into defense in a minute but before I do that, Dirk, what are some of the other sectors you think are likely winners and losers as we move into this new regime?

DIRK ENDERLEIN: So one area, or one broader subject that then touches quite a few areas is clearly the energy transition and here it’s, one, companies that basically deliver the means to do the energy transition. This can be EPC, which means engineering, procurement, and construction companies that basically help to reengineer a refinery to, for example, a refinery then being able to work with natural resources, like corn, et cetera, as an input factor, as opposed to crude oil. But then there are also companies in sectors like cement. So Europe is there at the forefront, in terms of carbon trading schemes, in terms of the way to net zero for cement. This will lead to, we think, quite a few smaller and mid-sized competitors dropping out or selling out, and you can already see that. So the downside we saw in volumes in cement in Europe over the last two years has been the biggest downdraft since, basically, the Global Financial Crisis in 2008 and ’09. Now, at the same time, cement prices are up, which is unheard of, and the reason is exactly this situation: the move to a net-zero, zero-carbon economy, which has led to certain restrictions in terms of what can be imported that will be getting even tougher from 2026 onwards, and then the pricing discipline of the main players, and lots of small players not being able to put out the capex that is needed to go through this transition. And so there will be a number of sectors that benefit exactly from this transition, and subsectors, and that’s what we are very, very interested in ’cause these companies will likely grow at double-digit rates going forward, even if we see a recession.

THOMAS MUCHA: Yeah, I think we’re just at the beginning of more paradoxes and market surprises, given the scope and scale of such a large transition. So, Dirk, I wanna dig a bit more into the defense sector here, given today’s deeply challenging geopolitical context, and, selfishly, my own research interest in these topics. Of course, we’ve got the ongoing Russia/Ukraine conflict, the biggest war in the Middle East in decades, potential significant conflicts across the Indo-Pacific right now, the structural challenges, of course, of great power competition, and, you know, from a national security perspective, as we’ve been discussing, climate change further stressing this already difficult backdrop. So as an investor at Wellington who thinks deeply about these aspects of the global environment, how are you assessing both the opportunities and risks here? And, you know, what I want to get from you is a sense of both the traditional legacy defense perspective, as well as defense innovation, these emerging dual-use civilian/military applications, that are now playing such a larger role on battlefields today, as well as on defense budgets globally. How are you separating all this?

DIRK ENDERLEIN: So I think first you think about supply/demand. And Europe basically started really moving backwards in terms of investments into defense in the early ’90s, after the wall had come down, and everyone was thinking about a peaceful transition to a bigger Europe. At one point this clearly meant including not just Eastern Europe but even Russia as a large trade zone, et cetera. This led to, if we take Germany as the largest economy, the defense spending as a percentage of GDP being around three percent in the ’80s, moving first below two, then far below two, and moving to levels which were basically at a point where the Army couldn’t actually be kept up and running anymore. and that’s not only true for Germany; it’s true for a number of other European countries, as well. So now with the outbreak of war in Ukraine, this has reversed decisionmaking substantially. So, first, the ammunition stock in Western Europe had been drawn down already, and now Ukraine then kicked in, and the deliveries led to a further drawdown, that basically there was almost nothing left. and basically the lightbulb went on that investments are needed to keep actually the defense infrastructure, you can call it, up and running. And now we see more and more special budget, extra budget, et cetera. We don’t think it’s inconceivable that we will actually see the three percent number again in the next five to seven years. because just to get to a level that these countries are, again, able to defend themselves needs billions and billions and billions to be invested in the coming years. Now, at the same time, building a lot of these factories is not something you just do, So it will take time to rebuild all this, which is a great starting point in terms of supply/demand for the companies and the industry. Second thing is in some areas, such as ammunition, if you are actually a leader, and you can actually ramp up, it’s very tricky for a number two or three to bid at the same price as you are bidding because of these economies of scale. And then, thirdly, as you pointed out, there are lots of new technologies. Here, it’s important to monitor which technologies I would say are more clearly military, because that’s where, then, some of the companies can really distinguish themselves. As soon as there is a mixture between military and civil it gets a bit trickier, because you really need to analyze how is the competitive landscape in two or three years if some of the civil companies actually move in, ’cause this is a big change. If you think about it, five years ago most companies were purely active in some civil applications. It wouldn’t even have dawned on them to move into defense, because it would have been a negative seen by the public. This has completely changed now. We’ve talked to one very big European defense contractor based in Germany. Last year, they got more than 100,000 CVs. This is something five years ago they couldn’t have dreamt of. Lastly, especially for Europe, there will be some consolidation. We’ve already seen some in the overall sector, but as we’ve seen recently with some of the actions between the French and the German government, it is not that easy, because immediately political interests play an important role, jobs play an important role, so while consolidation will be great for a lot of companies, and probably also for the countries in the end because you get more R&D power in one hand, it will probably take longer than we all think.

THOMAS MUCHA: Dirk, as you know, I’ve been in agreement with your views here for a long time. I do think that war is clarifying to the policy backdrop. I think it’s creating long-term structural shifts in the defense backdrop. And I’m curious do you think these trends, this movement towards national security, this need to build up defense capabilities, is larger than the domestic political shifts that may be occurring in countries across Europe, or do you think there is a chance here of domestic politics slowing this trend?

DIRK ENDERLEIN: So in some countries clearly, it’s a bit on the edge here and there, ’cause some more extreme parties that have become closer to become actually a meaningful size in parliaments have voiced concerns on it, and obviously some of these parties have very strong views on spending in other areas. But then, at the same time, you’ve also seen already shifts from, first, like, oh no, we don’t want to spend more, to, okay, we do understand we have to spend more. So I would say looking three to five years out, I would be more in the camp that if most of these parties will actually get their head around this, as well, because, one, the closer these conflicts become, and the bigger they become, and the more kind of shocking some of the pictures are that come out of it, will actually probably convince parts of the population; and secondly, it also creates jobs. We shouldn’t forget that. I don’t think there are any parties that will say no to more jobs.

THOMAS MUCHA: Yeah, that’s my view, as well. I think national security is larger than any one person, any one party, any one system. It’s fundamental to how a country exists in the world, and clearly the geopolitical environment is going to be challenging for countries all over the world for a long time to come. Now, let’s shift and, and talk a bit about the trees in the forest. Now, Dirk, you’re a bottom-up stock picker at heart. So what characteristics do you look for in a company?

DIRK ENDERLEIN: So whenever we look at a company, there are basically three things we try to understand, and the first thing is the longer-term structural growth path on which the company is on, particularly for earnings and free cashflow. This is something where, of course, you always listen to a company, what they think their growth path is, but then you always need to do double checks, because, fortunately, most human beings tend to be optimistic, and so the likelihood that many CEOs will overestimate their long-term growth is quite high, But really getting an understanding, cross-checking this growth path with competitors, with similar companies in the similar industry, but maybe on other continents, and making sense of that. Why do we look for growth? Because compounding is so important in investing. It’s one of the most powerful forces. And so, ideally, you want to invest it in an asset that grows, and ideally the driver is structural, so not just cyclical but through the cycle there should be growth. That’s the first step. Now, the second step, if you think about growth and compounding is great, but how can actually growth that is there for a company be really translated into the earnings growth and the free cashflow growth? And therefore the second point is competitive landscape, because only if your competitive landscape works out okay for you, you will be able to put through pricing, you will be able to have a certain margin and return profile that is then, in the end, helping shareholders to actually get their return. So structural growth profile, and then the competitive landscape, which is very, very important for margin trajectory and returns trajectory. And then, lastly, putting these two things into context was a third point, and that’s valuation, because ideally you want a compounding asset that is well-positioned from a competitive landscape, at a price where there is upside, as well, how the market is valuing that asset. Now, assets that grow, and especially if they can show then earnings growth over a prolonged time period, tend to show one particular characteristic that comes up again and again, and has been coming up for more than a hundred years. If, originally, the market doesn’t fully believe in that growth, and then it slowly comes through, one, you get actually a return as a shareholder from that growth; but two, you usually tend to get a revaluation of that company as the market is reevaluating the prospects of the company, which is then, bluntly said, a multiple expansion.

THOMAS MUCHA: Does this change when you’re looking at companies that are in relatively new areas of the market? Here I mean, like, energy transition. So how do you assess whether a company has what it takes to succeed in something that’s so new to the world, whether that’s censors or batteries or next-gen solar cells and all of these emerging technologies?

DIRK ENDERLEIN: So when something is new, then the question is always is it new-new or is it new-old? Now, the good news in the broader renewable energy, or more, in terms of energy supply chain changes, you can find companies that have been around for a long time, have a lot of old technologies that they have basically remodeled, and that they can use, and where they have proven with this is new, new usage -- they can actually make money off it, and that’s a very good thing. So it’s basically a proven technology, but then, further researched, further advanced, further developed, with new applications, and then making money. With something completely new, where there are no profits, either, that is often very difficult. Now, we’ve seen, in 2020, 2021, lots of these stocks went almost ballistic, in quite a few sectors, because there was something like a castle in the air, hanging out there five years out, in 2022, when a lot of these dreams basically hit reality, and then these stocks corrected. So with new-new, from our perspective, a path to profitability, and where we can get to some assessment of the competitive landscape. Now, unfortunately, the bad news is that in a lot of new, new, new technologies, especially when you have times when there is a lot of money that is coming into the market, very often you have a very, very fierce competitive landscape. The good news to this is, though, that if this happens, you can sometimes find too many competitors, and then a clear out of the market, and then five years down the road there might be actually some really interesting opportunities, because still there are certain barriers to enter. But that’s how we look at it, ’cause the competitive landscape is, in the end, key. .

THOMAS MUCHA: Yeah, I think all the aspects that we’re talking about today, Dirk, here are well set up for long/short strategies, right? We’re talking about a lot of disruption across a lot of areas. Disruption means differentiation, which means you have the ability to find winners and losers across the board. So I’d like to end on a more personal note, Dirk. So you grew up in Germany. I believe you studied mechanical engineering at university, yes?

DIRK ENDERLEIN: Yes, yeah.

THOMAS MUCHA: So how does that engineering mind make you a better fundamental investor? I mean, what are the crossovers in these two worlds?

DIRK ENDERLEIN: So that’s actually a question I thought quite a lot about also when someone else asked me that a few years ago, and I think one of the key things that we use, as well, in our team is this question around numbers versus narrative. Narratives are a nice thing, but there have to be numbers. And in investing, I think one of the big pitfalls is always that you fall for a narrative which sounds really great, as I said earlier, where there is a castle in the air. And if the numbers don’t come through, the stock will not react accordingly, or they will actually react accordingly, i.e. it will go down. And so this is, I think, one of the things that I think I have preserved, and which we’ve now really put into the team, as well, as a big cultural piece. The narrative is a nice thing, and you need to be able to have a narrative why a stock is a buy or a sell, and you need to be able to explain it, I always say, to your grandmother in three minutes. If you can’t, you probably don’t fully buy into the thesis, either. But then the next question is: are the numbers actually there to basically underpin this? And this is so, so, so important. Now, we’re not talking about an exact earnings per share estimate five years out, because you know that estimate will be wrong. No one knows exactly how the world looks like in five years, but the direction of these numbers has to be right. And that is what I think is very, very important for the team, and for me personally, ’cause I’ve always been a numbers guy. That’s probably that educational background. I like numbers, and I wanna see the numbers.

THOMAS MUCHA: Yeah, I think there are a lot of grandmothers who are long on defense right now out there.

DIRK ENDERLEIN: ’Cause they know the history, right?

THOMAS MUCHA: They know the history. They’ve been here before. Once again, Dirk Enderlein, portfolio manager based in our London office. Thanks so much for being with us on WellSaid. It’s been a great chat.

DIRK ENDERLEIN: Thank you so much, Thomas. Have a great day.

Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced July 2024.

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