287. The ‘Cashflow Champions’ of Europe

2 November 2023 (pre-recorded 18 October 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.

[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast, brought to you by FundCalibre. This week our interview focuses on European equities, the importance of ‘cashflow champions’ and concerns about energy prices on the continent.

James Yardley (JY): I am James Yardley, and today I’m joined by Samantha Gleave, the Elite Rated manager of the Liontrust European Dynamic fund. Samantha, thank you very much for joining us today.

Samantha Gleave (SG): Hello, James.

[INTERVIEW]

JY: Now Samantha, your fund invests in European equities. Can you tell us a little bit more about your Cashflow Solutions process and how that works in the portfolio?

SG: Yes, of course. So, as the name suggests, we focus on corporate cash flows. We think cash flow is the most important driver of good share price returns. That simply means we’re looking to buy companies or a fund that are generating strong and sustainable cash flows and/or are attractively valued on those cash flows, and where the management team have a really strong focus on cash generation in their businesses, and also quite a prudent approach to how they then go on to spend that cash.

We screen stocks in the investment universe on the basis of initially, two simple cash flow ratios; the first one’s a quality ratio, so it’s free cash flow over assets, it’s like cash return on capital. And the second ratio is a value ratio, so it’s free cash flow yield. And we simply add together those two ratios for each stock in the investment universe and then rank stocks on that aggregated score. And we have a simple rule at that point. We’re only going to look at the top 20%, so the best cash flow stocks, for further investment analysis. And that top 20% is what we call our ‘Cashflow Champions’ watch list.

In the next stage of the investment process, we bring in what we call our secondary scores. And this is just simply where each stock on that ‘Cashflow Champions’ watch list will get a score across four different criteria: momentum characteristics, cash return characteristics, recovering value, and contrarian value.

And finally, importantly, running in the background are what we call our market regime indicators. And they’re very helpful in two ways because they guide us on the outlook for markets, but also on the style tilt that we want to have in the fund for the prevailing market conditions. So, it is a flexible investment process, [and] it has been tried and tested for many years now in different market conditions.

JY: And is the fund style agnostic then? I mean, I think you’ve had a little bit more of a value bias recently, which I think has worked very well. But we have seen a big de-rating in a lot of these growth names. So, is the fund now tilting back the other way towards growth? How does that work?

SG: I think it’s fair to say that today, in this year, we have had more balance in the portfolio in terms of style positioning. So, if we were to go back to the years prior to Covid, this fund had really quite a significant growth tilt and that worked well. Our market regime indicators took us to growth. Whereas in the last few years, the fund has had much more of a positive tilt to value. Now, importantly, high forecast growth stocks have been derated significantly in the last 12 months. I mean, at the end of 2021, on our calculations, they were sitting at four standard deviations above the long term average. Today they’re still a little bit on the expensive side, but not nearly as expensive as they were 18 months ago. So, we have reduced the negative tilt that we had away from growth this year, and we’ve brought it back up to a more neutral, modestly positive position.

I think it’s worth noting overall, we are still positive on value. Value has rerated in the last 18 months or so, but it’s still sitting at at quite an attractive discount to its longer term average valuation. So, we still have this positive tilt to value, but yes, we’ve reduced that negative tilt that we had away from growth. And we’ve added a couple of stocks into the fund that have more growth characteristics, but it is important to find growth at attractive value at this point.

JY: And how important is the macroeconomic environment to your process, or do you generally just focus on the bottom up? So, in terms of choosing that style tilt, I mean, are you of the belief now – as some are – that we are in a higher interest rate regime for longer and therefore that favours value investing again vs growth, or do you just focus more at the stock specific level?

SG: We do a lot of bottom-up analysis on stocks when we’re selecting stocks, but our market regime indicators are sort of guiding us on the macro backdrop, and our market regime indicators pick up lots of data in markets. So, they’re picking up data in terms of how investors are responding to economic data; they’re picking up data on how corporates are responding to the macro backdrop; and they’re picking up data on valuation in markets. And so we use all of that information to guide us on the style tilt that the fund should have at a particular point in time. And today, our indicators are guiding us still a bit more towards value.

JY: Right, very interesting. And in terms of thinking about the macro environment today, I mean last year there were a lot of concerns around Europe in regards to whether Europe would run out of gas. Now we’ve seen this flare up in the Middle East again, are are there any concerns this year in terms of the gas price or is that all okay now?

SG: I think at the moment there certainly is an increase in uncertainty in terms of the outlook for energy prices and that’s a headwind for growth in Europe. So, we’ll be watching those indicators quite closely. I think in the short term, we probably should expect the base case is, higher volatility and gas and oil prices, and I’m sure corporates will be watching that very closely in Europe. So, it could be a challenge to growth. And of course higher oil prices, higher gas prices, that’s an inflationary effect, which will also challenge growth.

JY: And Germany seems to be having quite a difficult time at the moment. I believe it’s in recession. Do you expect that Germany can bounce back quickly now? And what implications does this have for the stock market?

SG: Our country exposure that we have in our fund is a reflection of the investment process and we don’t have individual macroeconomic views on countries across Europe. Having said that, of course, we do see all the economic news flow and we do watch the key indicators and yes, Germany does look as if it’s slipped into recession at the moment. We don’t expect that really to turn around anytime soon. I think the difficult trading backdrop in Germany for manufacturing companies, for industrial companies, does come through in our investment process. Overall today, the fund has quite a significant underweight position versus the benchmark to Germany, and I don’t anticipate that to change in the short term. We’ll see if some German companies become more attractively valued from our investment process point of view, then, of course, we’ll look to increase that exposure. We’re just not quite there yet, we feel on Germany.

JY: And what countries are you naturally investing more in Europe at the moment? Do you prefer the southern countries or the Nordics? Do you have any particular biases?

SG: It is relatively widespread. I would say that one of the biggest country exposures we have actually is in France at the moment, but that’s not because we’ve got a particularly really positive view on France; it reflects stock selection and indeed the exposure that we have in France covers quite a wide variety of different sectors, from industrials to consumer discretionary stocks to financials. So, the sector exposure is quite broad in France.

JY: Can you give us a couple of examples of your favourite stocks at the moment?

SG: So, well, a couple of names that we’ve added just recently, have perhaps been on the growth side, so attractively valued growth stocks. So, a name that we added a little while ago was Inditex [Industria de Diseño Textil, S.A] the retail company, the owner of the Zara clothing chain. And that’s a company that’s enjoying very strong business momentum at the moment. It’s enjoying positive revenue growth that’s translating through into strong growth in cash earnings, helped by an improvement in their profit margins. The company has a very strong balance sheet and we expect good cash returns to shareholders. The stock is trading on a dividend yield of close to 5%. That’s the purchase that we made earlier on in the year to reduce that negative growth tilt that we had in the fund.

More recently, we’ve added a position in Partners Group [Holding AG], the Swiss-headquartered, private equity business. This is a business that generates a very high cash return on capital score, from an investment process point of view. It’s had quite a challenging backdrop in recent months in terms of exit opportunities for some of its portfolio companies. And also it’s been a bit more challenging on the fundraising side. We think we’re past the worst on that. And you know, this is a business that is exceptionally well run. The senior management team have a lot of skin in the game and we think the backdrop for fundraising and for exits is set to improve over the next 12 months. There’s also, longer term, huge opportunity for this business from private wealth clients across Europe that want to increase their allocations to private markets. So, I think that’s a sort of positive longer term theme that we hope will come through.

JY: And what is your outlook for European equities going forward into 2024? Where are we in terms of valuations and growth expectations?

SG: Well, I think I’d answer this question in two parts, if I may. First of all, just starting off with our top down market views and then perhaps just highlighting that at the stock level, there are lots of attractive opportunities there.

So, first of all, at the top down level, our market regime indicators, as I said, are a bit more balanced at this point in time, our overall valuation indicator for Europe is at fair value. So, that’s more constructive than it was 12 months ago where our valuation indicator were telling us that markets were expensive. Today, they’re at fair value. When we then combine that with an indicator that we’ve got that looks at corporate behaviour, which is not a worrying point, we think that’s quite a positive combination; we’re not seeing aggressive corporate behaviour, and that typically is quite constructive for the outlook for markets.

From a style perspective, we look closely at what we call our investor anxiety index, and our investor anxiety index is not yet at a low level. So, that’s still supportive of having more value exposure in the portfolio.

At the stock level, we see plenty of opportunities to purchase attractive stocks in Europe. There’s lots of companies that are enjoying strong, secular growth. There’s lots of companies that have very positive stock specific news flow. A holding in the fund is Novo Nordisk [Limited]. That’s a company in the healthcare sector. It has a very large market share in the treatment of diabetes. Recently they’ve developed a weight loss drug where growth prospects for that drug are very high, not just in Europe but also in other markets such as the US. And they have treatments for helping heart disease and kidney disease. So, that’s a company that is enjoying very strong growth at the moment and in fact very recently just upgraded expectations for forecast over the next 12 months.

JY: Brilliant. Well, thank you very much for sharing your thoughts Samantha, and congratulations on the excellent performance over the last few years.

SG: Thank you.

SW: Liontrust European Dynamic is a concentrated fund of around 30-40 holdings. As discussed in this interview, the team believes cash flow is the single most important determinant of shareholder return. To learn more about the Liontrust European Dynamic fund please visit fundcalibre.com and don’t forget to subscribe to the Investing on to go podcast, available wherever you get your podcasts.