Hermes’ Crockford: Why we’re cautious on Europe’s bond proxies


These are challenging times for investors and asset allocators. Developed market equities continue to rise, but the ground is becoming increasingly shaky across a number of sectors. Rather than being driven by earnings, equity valuations in all regions continue to be dragged up by a relentless tide of quantitative easing.

While we see Europe as offering the best relative value in developed markets, we have become more cautious on “bond proxy” names in the region, where high multiples are paid for companies that offer low organic growth and reasonable dividend yields relative to fixed income.

Further contractions in bond yields will continue to drive short-term performance amongst these names, as income-starved investors add fuel to soaring valuations. However, we see greater long-term opportunities elsewhere, where structural changes are exposing compelling opportunities and themes across a number of sectors.

Leaner and meaner

Despite considerable headwinds to macroeconomic sentiment, it has been a decent earnings season so far, particularly if you strip out oil and gas and financials. Overall, we have seen more positive than negative earnings surprises, compared to revenue, where there were roughly as many beats as there were misses, for the second calendar quarter. This suggests to us that cost cutting remains the main driver of the average European corporate’s bottom line. Growth sectors such as tech and healthcare have been the stand-out performers, in terms of sales and earnings year-on-year growth, with recently acquired ARM Holdings generating the largest revenue beat in the technology sector, while another Hermes’ holding, Merck KGaA had one of the higher sales growth performances in the healthcare sector.

M&A activity ramping up

M&A has been to a large extent focussed in areas where companies are generating relatively high organic growth, with sectors such as tech and healthcare proving to be a fertile hunting ground. Companies are more willing and able to acquire growth as the cost of debt gets cheaper and cheaper, particularly when excess capacity in the acquiring companies’ existing markets often makes fixed asset investment even less attractive, relative to these acquisitions.

While we do not explicitly play M&A as an investment theme, we are not surprised that it is those companies that can generate substantial organic growth that are increasingly making their way onto other companies’ shopping lists.

Mid-caps offer diverse themes

We are currently hunting for mid-cap names that have exposure to structurally persistent growth themes that will drive revenue and earnings growth for many years to come. This includes companies such as German forklift-maker KION Group, whose warehouse automation systems for distribution giants such as IKEA and Amazon will fuel earnings; and Sartorius AG – one of four major suppliers of biopharma manufacturing equipment into a market that is expanding rapidly.

We are also playing emerging market demand for wind turbines through Spanish-listed Gamesa, while French video game maker Ubisoft gives us exposure to a market transitioning from physical, in-store sales to more stable, higher-margin digital game distribution.

Innovation Europe

While Europe has yet to fully challenge the tech aristocrats of Silicon Valley, it is currently home to 47 billion-dollar tech companies and a growing array of opportunities in areas such as semi-conductors, software design and online payment processing. We seek to exploit long-term industry disruption and innovation, and thus tech has been a long-standing overweight for our long-term investment style and is our largest sector overweight. We maintain holdings in ASML, Amadeus, Wirecard, as well as Ubisoft.

In a market where central bank policy is increasingly distorting equity valuations, structural change continues to unearth new opportunities that are being overlooked by a market that is more focussed on next week’s rate move, rather than next generation technology. We would encourage investors to take a break from analysing the parlance of central bankers, and dig down into the sectors and companies where change is rife, rather than buying or selling the market.

Tim Crockford is portfolio manager for the Hermes Europe ex-UK Equity fund.