242. Wherever risk is mischaracterised, may well lead to an opportunity

TRANSCRIPT: EPISODE 242
28 February 2023 (pre-recorded 9 February 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTROUDCTION]
Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. This week we’re focusing our attention on the Continent as we look at inflation and energy risk in Europe — and what buying opportunities could be available for investors in European equities.

Chris Salih (CS): I am Chris Salih, and today we’re joined by Will Cuss, one of the co-managers of the Elite Rated Barings Europe Select Trust. Will, thank you for joining us today and talking about all things Europe.

Will Cuss (WC): Hi Chris. It’s a pleasure to speak with you.

[INTERVIEW]

CS: Let’s start with a lovely macro-economic view of the environment in Europe at the moment. We always hear things about there’s a new disaster around the corner, but you know, how are companies generally faring with higher interest rates, inflation and slowing economies?

WC: Yeah, so inflation and its path from here is probably still the dominant debate in Europe. And I think it’s been an interesting few months because we’ve seen headline inflation data that would suggest the worst is over for Europe. So, we’ve seen a drop from 10.6% in November to 9.2 [per cent] in December. And inflation for the Eurozone is expected to hit about 8.5% in January. And I suppose what’s interesting is, underlying that headline number, there’ve been some big moves in commodity prices. So, that includes things like industrial metals that are back to pre-war levels. It includes things like plastics and resins, and things like freight prices, which are down some 80% since peak. So, some really, really material moves and even includes some of the softer commodities like wheat and corn. Now the number one constituent in the inflation debate has probably been energy and that’s been the biggest driver of inflation for 2022. And the gas forward market has also come back significantly, back to pre-war levels.

So, we’re at an interesting point at the start of 2023. And specifically with energy, it’s interesting because the availability of gas is now better than we’d feared a few months back. So, storage levels for the Continent are at the top end of the historic range for this point of the season, thanks to some stockpiling efforts, it’s thanks to some benign weather and a few proactive measures too. And when we really start to look ahead for the prospects of the European corporate and for the European household, things look incrementally better now than they did back in the autumn.

So, you know, the energy availability risk has abated a little bit for the winter of ’23 – ‘24. And when we think about inflation and what that means, we’ll, we’re going to start to see the base effects from March ‘23 kick in, start to annualise some of those big increases in things like energy, but also food.

And then I guess longer term for the Continent – it’s probably also worth just reminding that, you know, we should start to see some new gas supply, really Middle Eastern supply, come on stream around the middle of the decade – that, coupled with growing investment in renewables, does offer a glimmer of hope for the Continent, and perhaps a path away from Russian energy dependence now. But ultimately, our goal as a reminder is to be focused on the cost structures of the corporates we’re looking at and understanding where the pressures may be growing or easing. But that’s really kind of snapshot of the backdrop.

CS: And you kind of started answering the next question I had, which was, while obviously your mind is focused on the backdrop, I mean, to an extent how much does that, I mean, how much do you care basically because, you know, your focus is on about identifying companies that can do well in any sort of economic backdrop. So, do they tend to have the similar characteristics that almost mean the backdrop doesn’t matter so much [for] things like, for example, pricing power in an inflationary world?

WC: Yeah, it’s a great point you make and ultimately, you are right to say we are after companies with idiosyncratic growth leaders, those where the growth is not just tied to a top-down commodity price move or tied to a GDP number. So, we are looking for companies that can drive growth through a new product, through entering a new market, perhaps even a transformational strategy.

But we do need to think about how the corporates operate in the wider economy and what’s happening to their cost structures and their end markets. So often we use what we’re seeing in commodity prices to inform the conversations we’re having with the corporates. Now, you know, when we think about any stock and identifying opportunities, we put equal importance on growth, so those idiosyncratic growth levers as well as quality and valuation.

And I think the quality point is a really important one, and we spent a lot of time thinking about it and it’s really mattered this year, because for us it’s both qualitative and quantitative. So, you know, we’re looking for the competitive advantages the most, you know, you typically think about when you think about a quality company, but also quantitatively – how that manifests in things like returns, things like cash flow, etc.

So, it matters where the company is today, but also the journey it’s on. So, we’re looking to reward companies that are improving. In terms of the how, you know, you kind of alluded to how do we get there? Well, it’s largely through the interactions we have with the company. So, we have conversations much like you and I are having now. We do something like 250 of these conversations a year. And that’s one of the great things about the smaller company asset class – we’re fortunate we get access to the decision makers in the companies. So, you know, we speak to the CEOs, the CFOs, the COOs, that’s something that’s less frequently afforded to colleagues in the larger cap asset classes. So, what we’re looking to glean from those interactions is firstly, what is the strategy the management team are implementing? And secondly, how are they dealing with a lot of the challenges, which at the moment have been largely exogenous factors – could be the freight prices, the metal prices etc, the wage inflation for instance that they’re dealing with. How they’re going to mitigate it? How they’re going to price for it? And trying to evaluate those two things together. So, hopefully it gives you a feel.

CS: Is that easy to do over the long term when you’ve got things like war and the pressures around, you know, we talked about some of the energy crisis and things like that. Is it easy to take a long term view when things like that are happening?

WC: Well, the volatility’s been really tough and testing this year and we’ve seen some big, correlated moves in sectors. And ultimately, what we’re trying to do is delineate where a big top-down change has broken a thesis from where, actually, it’s creating an opportunity.

So, when you think about the first, really the first three quarters of last year, it was kind of a ‘risk-off’ sentiment. It was really kicked off post the invasion, and the big inflationary forces that were accelerated. And we saw expensive sectors sell off the most. We saw discretionary names being sold off aggressively.

And it was interesting because, you know, to your point, you had some sectors – I mean the worst sector it was probably the e-commerce sector, to kind of classify as a Covid winner. Within that space, to give you two extreme examples, you had stocks where they were cash burning, you know, they needed to tap equity markets to grow; they were loss making and you could see, well actually there could be companies in this sector that might not survive this down cycle, but you also had companies that were sold off some 80% plus, where actually, they were profitable, where actually they had big net cash on balance sheet. They wouldn’t need to tap equity markets. And in fact, they’d probably hoover up share from their weaker competitors. Those two correlated sell offs – you know, when you sit there with your fundamental investment hat on – could well lead to an opportunity. So, that’s the kind of thing we’ve been thinking about: where is the risk mischaracterized? And really that should be borne out over the longer term in good share price performance.

CS: We have to talk about some of the specific opportunities when you talk about small caps, obviously [an] under researched area of the market versus some of their larger peers. And I think we caught up with Rosemary about a year ago and we took, we discussed Thule [Group AB] which is known for its roof racks, but also expanding into the baby stroller market. And she was very positive on the market and talking of more product lines coming on. Maybe could you give us a bit more of an update on the company and whether you’re still invested and if so, why?

WC: Yeah, so Thule or as the Swedish say Thu-ler, it is a company we know well over many years – it’s been a successful holding for us. And basically, as a reminder, they are leaders in a couple of small niches, so, roof racks for vehicles and bike-related accessories, and they’ve got a successful track record of building brands, but also of innovating products. So, they’re kind of at the premium end and they’ve been doing a great job there.

Now with that said, we actually exited that stock in the year, and we did so because we saw headwinds building after a period of very strong growth, very strong execution through the lockdowns we saw in Europe. And I guess those headwinds revolved around both the demand side but also the supply side. So, we were seeing evidence on the demand side of inventory building up with the likes of distributors in the UK and Europe, so people like Halfords talking about bike inventory building, but also coupled with some of those commodity prices we talked about a second ago, and what that might mean for margins.

So, we were at a juncture where we could see margin pressure hitting the company for the next 12, 18, 24 months. That wasn’t reflected in consensus or indeed the valuation – the stock had been a very good long- term performer, trading on a big premium to the sector and the market. And whilst there was this exciting and still is this exciting baby stroller opportunity – a new addressable market – we thought the likelihood was it would be overshadowed at least in the coming year or two. So, subsequently we made the decision to take profit in the name, so we exited back in the summer. Now, subsequently the company did profit warn – we saw some of those risks materialise and we did see a period of underperformance. So, that’s where we are now. Do we still interact with the company? Could it feature again in the portfolio in the future? Quite possibly yes, to both. So, you know, we are engaging with them. We will absolutely continue to stay in contact and we’re starting to see those risks be reflected in the consensus expectations and in the valuation. So, watch this space, but it’s been a good exit so far.

CS: We also talked about a year or so ago about another company called Elis [Elis SA]. Could you maybe just remind us about what the company does and did the sort of reopening boost business as much as was hoped?

WC: Sure. So, Elis is another leader in a niche. They lead the niche of textile rentals. So, essentially they will do hotel linen and work wear and they will provide clean linen to hotel groups and they’ll pick it up, wash it, and deliver it back. So, they’re leaders in Europe and they’ve also got a good Latin American presence. So, the way to think about this business is really, it’s a network density business model. So, economies of scale are what really matter; if you want to get good throughput on your plant network and your logistics, so, basically your fleet of trucks, you need that scale. And fortunately, Elis have that, they’re very efficient the way they run their network and their fleet, and that’s led to some really sticky client relationships and also translating some good margins and very attractive returns.

Now, in direct answer to your question, it has been a good performer, seen very strong price performance come through as the numbers have exceeded expectation. And there are a couple of things to highlight there. One, they have navigated the cost challenges far better than many feared. So, that’s thanks largely to very tight contracting. It’s enabled fast pass through on things like energy inflation and wage inflation.

And, more recently, you know, you mentioned specifically the reopening; yes, they have been a beneficiary of that – more business and leisure travel have supported the end markets, be it restaurants, be it hotels – and they actually posted mid-teen organic growth in their most recent quarter of Q4. So, which was, you know, ahead of expectations and is leading to upside risk to consensus. And that’s for a stock which is on a discount to sector and benchmark. So, we’ve seen good share price performance there.

CS: We’ve been doing a lot of discussions with some of your peers in the US smaller companies space, and in particular this theme of on shoring and near-shoring of production lines and suppliers being a boost basically to small caps in particular. Is that something you are seeing in Europe and if so, is that a long- term trend?

WC: I mean, what we are seeing with corporates and actively discussing is how supply chains on the Continent are being reworked. And specifically to the question of near-shoring is some of that will result in near-shoring or kind of fringe-shoring?

I suppose the backdrop is – you know, we need no reminder, it’s been a period of prolonged disruption for European corporates. You know, we’ve seen logistical bottlenecks with ports and shipping in 2020. We saw semiconductor shortages arise after that. And then the kind of issue of tariffs arising subsequently. And, you know, we are hearing from some of the corporates that they’re looking to secure supply chains closer to home. So, it does have a potential to be of benefit to some of our European corporates that are either well located or can help reduce some of the friction of moving or reworking those supply chains.

So, you know, I think about the portfolio at the moment, you know, we have a position in a company called GTT [Gaztransport & Technigaz] for instance, that’s an energy tech business. And they’ve got a dominant position – really a monopoly, globally – in this very interesting niche of cryogenic membranes for LNG [Liquefied Natural Gas] transportation. And what we have seen there is very strong order growth in part due to exactly that. It’s the reworking of energy supply chain away from Eastern Europe. And I think you’re right, I mean near-shoring or kind of more generally, proactive supply chain management, you know, will continue to be an active area of questioning in our company meetings and hopefully will materialise in some interesting opportunities and investment ideas too.

CS: And just lastly, obviously, you know, in for most fund managers they sort of live and die by their stock selection, but particularly, you know, in the small cap space, I think it’s extremely important. Could you maybe just highlight a couple of other opportunities you’ve found lately and why you’re sort of bullish on them?

WC: Sure, sure. So, you’re right, I mean, as ever we kind of cast our net wide. We’re open to a whole host of investment opportunities across our geographies and across our sectors. And there have been a number of investments in recent months. Some of the names have been stocks we’ve owned in the past and subsequent to exiting them, they have sold off really quite dramatically, maybe entered the investible universe after graduating from it. And, you know, one example of one of those names that we’ve revisited is a company called Gerresheimer [AG]. And Gerresheimer is a pharma packaging manufacturer, and then they do other sectors as well, but they make glass vials for medication for instance. And I guess really I’d characterise this one as being an exciting product mix story. So, they’re moving to sell much higher value, much higher margin products which are more complex, into the pharma sector. And they’ve got a particularly interesting niche in that they’re a global lead supplier for the obesity drug market, which is really taking the US market particularly by storm. It’s this exciting new molecule and their footprint is leading to them being very well-positioned.

So, we’re at a point where they have a multi-year demand assurance from their big customers – far more demand than they can actually meet – that’s underwriting the investments they’re making. Meanwhile, they actually, either through luck or by judgement, took out a long duration, five-year hedge on energy prices at the end of 2019. So, they’ve got this really good demand visibility with actually excellent cost visibility. And we think that can de-risk the earnings over the next few years for a stock which is on a really undemanding valuation. It’s on a low double-digit earnings multiple. And we think there’s scope to meet and surpass expectations. And that’s one.

I mean, you know, we’ve also been doing work on new names. One of those that’s enteed the portfolio is a Swiss industrial called Accelleron [Industries AG]. And they’re a leading company in the servicing of turbochargers – these are things that go into the marine industry or energy generation, and it was spun out of a much larger conglomerate, ABB, last year.

And, you know, post the spin out, we’ve met with them a number of times and evaluating the strategy and appraise its execution. And I guess really what we liked and saw here was a very attractive aftermarket opportunity and it’s really, that’s the majority. It’s three quarters aftermarket, this business, you’ve got very long duration, very sticky contracts with very good pricing and margin. And they’re on a journey to expand the suite of services, thereby growing their market and differentiating more versus peers. And it’s quite an interesting angle they’ve got to help increase efficiency for their customers, which is both great for their carbon footprints, but also has a nice ROI [return on investment] with their input costs. So, we think that was underappreciated. Yeah, it came to market on an undemanding 14 times earnings for what is [an] offensive earning stream and scope for surplus capital returns, because the balance sheet’s very strong there too. So, that would be another one I’d just highlight to you Chris.

CS: And do you specifically, with companies like that, want them to go global or are you happy if they’re sort of Eurocentric?

Well, Accelleron is a global company. I mean the marine market, by its  nature, I mean these are big, big tankers that will move, you know, across oceans. They have a global footprint in their ability to service. And that’s not uncommon I suppose for companies in our portfolio. We have a collection of both local champions that can dominate their local geography and have good moats there. But also companies that do have a global footprint or are embarking on a strategy to globalise. And then this one would fall very much in the camp of the latter.

CS: That’s great, Will, thank you again for talking to us about all things Europe.

WC: Pleasure. Thank you, Chris. Enjoyed it.

[CLOSING]
SW: The Barings Europe Select Trust invests in small and medium-sized companies, an area which is under-researched and ripe for good stock pickers. The strategy itself is tilted towards growth companies, but the managers won!t overpay for them. The final portfolio will typically hold between 80-100 companies.

To learn more about the Barings Europe Select Trust visit fundcalibre.com – and don’t forget to subscribe to the “Investing on the go’ podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening, Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.