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Fidelity European benefits from continued rebound in 2021

Fidelity European (FEV) has announced its annual results for the year ended 31 December 2021. During the period, FEV’s NAV increased by 23.5%, which it says outperformed its World Europe (ex UK) benchmark index, which returned 17.4%. The discount widened over the course of the year but has narrowed in recent months. Reflecting this, FEV provided a share price total return of 21.7%, for the year, which was comfortably ahead of its benchmark Index. FEV’s board is recommending a final dividend of 4.18 pence per share which, when together with the interim dividend payment of 2.65 pence per share, provides a total of 6.83 pence per share for the year. This represents an increase of 5.1% over the total dividend of 6.50 pence paid in the prior year.

FEV’s chairman, Vivian Bazalgette, says that Continental European equity markets built on the rebound of the second half of 2020 to stage a strong 2021, helped by higher vaccination rates, earnings upgrades and improving investor sentiment. Most sectors ended the year in positive territory, with IT, Energy and Financials leading the way. From a style perspective, growth stocks outperformed value and large capitalisation stocks marginally outperformed smaller companies. A key influence was that the European Central Bank took a more cautious approach to reducing asset purchases, indicating that it also expects rates to rise more gradually than in the US and UK.

Portfolio Manager Q&A – with lead manager Sam Morse and co-manager marcel Marcel Stotzel

Interestingly, the portfolio manager’s review is provided as a Q&A in the interim report. Rather than try and paraphrase from this, we have provided a copy of the Q&A below.

Question: 2021 marked a significant milestone for the Company as it celebrated its 30-year anniversary. Sam, you have been at the helm for more than 10 of those years. What stands out to you as you reflect on this period?

Answer: Sam: There is much to celebrate. Continental Europe is sometimes seen as a poor prospect when it comes to investing and this is understandable given newspapers filled with headlines about political upheavals and sclerotic economies. The companies of Europe have, however, done much better than many might have expected over those decades. An investment of ten thousand pounds in the Company at launch on Guy Fawkes day in 1991, would now be worth as much as half a million pounds assuming all dividends received have been reinvested – an annualised total return of almost 14% per annum in sterling terms. That is a testament to the power of compounding, the benefits of gearing (one of the great advantages of an investment trust as a vehicle) and the merits of stock-picking. The Company has had four different portfolio managers, each with their own approach to stock-picking, but the secret sauce has been Fidelity’s in-house research effort. Almost three hundred different analysts have supported the Company over that time with fantastic investment ideas. They are really the unsung heroes of this celebration.

Question: As we head into yet another year under the veil of a global pandemic, what lessons have you learnt both personally and professionally?

Answer: Sam: We are learning as we go, probably like everyone else. We are learning that like many things in life, it is often two steps forward and one step back. We must avoid being too gung-ho when optimism is ascendant and we must avoid being too despondent when bad news surfaces. Those waves in sentiment can offer good opportunities to add value through trading existing positions. Despite the pandemic, companies’ earnings and dividends are still growing and stock prices are still rising. It pays to stay invested whatever the headlines. That is because even if the pandemic dampens short term activity, the stock market rewards long term earnings and dividend potential. The pandemic’s impact has encouraged companies to pursue greater innovation and efficiency which will result in growing dividends for investors on a multi-year view. The benefits of stock-picking remain undiminished.

Marcel: Amazingly, despite having over 10 years of investment experience, this has been my first experience of a real stock market downturn given how strong markets have been since 2007. In many ways this downturn has been unique in its severity and speed, however, in other ways it has shown the same textbook opportunities and threats that we usually see when market fear is very high.

Question: How has this translated into performance over the previous twelve months?

Answer: Sam: Markets entered the year still riding a wave of exuberance which followed the news regarding the high effectiveness of anti-COVID vaccines. However, it soon became clear that despite having a growing arsenal of vaccines and drugs to protect us, new variants would still require restrictions impacting mobility and economic activity. As the year progressed, there was increasing recognition that the pandemic was reducing supply due to labour shortages, etc. and investors grew concerned that we might have to endure a period of “stagflation” (low growth and high inflation). The year ended with a curious cocktail of worries due to the emergence of a new more contagious, but perhaps less harmful variant (Omicron), and a more hawkish-sounding Federal Reserve following the reappointment of Jay Powell. This all contributed to a much more variable year in terms of stock market leadership with periods where cyclicals and value stocks did well and other periods where defensives and growth stocks shone. Overall, however, the rising tide of earnings and dividends coupled with tremendous liquidity, thanks to supportive monetary policy, propelled equity markets to new highs. Over the twelve months, the Company’s NAV rose by 23.5% outperforming the Benchmark Index which rose by 17.4%. The Company’s share price lagged the rise in the NAV due to a widening of the discount but still returned a very healthy 21.7%, also outperforming the Benchmark. All performance data is in sterling and on a total return basis.

Question: What stock picks have done well, which ones not so well, and why?

Answer: Sam: It was quite a varied list of outperformers this year with representatives from many different sectors. In technology, ASML was a standout performer as a result of the announcement of big increases in capital expenditure by semiconductor customers in the wake of on-going shortages. Hermes International and LVMH Moët Hennessy both rose strongly in 2021 with high-end consumers redirecting their spend from experiences and holidays, due to restrictions, to luxury goods. Private equity names, EQT and Partners Group, enjoyed an exceptional year of rising values and accretive transactions. By contrast, in healthcare, Grifols and Fresenius Medical Care struggled due to on-going headwinds resulting from the pandemic. The industrials sector was also an area of relative weakness for the Company’s portfolio, especially elevator companies Kone and Schindler Holding, due to a deteriorating outlook for the Chinese new installation market given the balance sheet problems faced by Evergrande and other Chinese property developers. Enel performed poorly during the year too as investors grew increasingly concerned that returns from renewable energy projects would suffer from growing competition and that governments, particularly in Spain, would seek to mitigate high electricity prices by requiring utility companies to shoulder some of the burden.

Marcel: A stock that performed well and one that is interesting is Novo Nordisk. While Novo Nordisk’s core insulin drugs continued to perform strongly during the year, we also saw very encouraging numbers from their obesity products; an area we continue to be very positive about with regard to its long term potential. MTU Aero Engines performed poorly, as did most of the aerospace sector, from the view that Omicron could cause the COVID pandemic to be longer and more severe (interestingly, this view has changed entirely in 2022, with the view now being that Omicron could result in COVID becoming endemic much more quickly than the Delta variant would have).

Top 5 Stock Contributors (on a relative basis) %
ASML +1.2
EQT +0.8
Novo Nordisk +0.8
Linde +0.8
Hermes International +0.7
Top 5 Stock Detractors (on a relative basis)
Grifols -0.7
MTU Aero Engines -0.5
Deutsche Börse Group -0.5
Telenor -0.5

Question: Many macro uncertainties remain as we head into 2022. What does this mean for the companies in the portfolio?

Answer: Sam: We do not try to predict which uncertainties will become realities. We do, however, try to build a balanced portfolio using the sector groupings as our guide, such that it is the stock-picking, with our particular focus on attractively-valued dividend growers that will drive the performance of the Company over time rather than macroeconomic or other factors. Each individual stock position is, of course, subject to macroeconomic factors but the beauty of diversification is that exposure can be dampened through portfolio construction, allowing idiosyncratic elements to determine performance. Clearly, sometimes we face stylistic headwinds in the short term. Our focus on steady growers, sometimes tagged as bond proxies, can mean we face a headwind to performance when inflation expectations or bond yields rise. Over the long term, however, these factors even out and relative performance, good or bad, is primarily a function of stock-picking.

Question: Marcel, you recently wrote about Europe driving the next decade of innovation. Which sectors are you looking at most closely in 2022 to position the Company to take advantage of this?

Answer: Marcel: The most obvious example comes from the European tech sector where we see companies such as Dassault Systèmes and ASML continuing to be amongst the most innovative companies globally. However, another recent example is European consumer goods companies which are at the leading edge when it comes to the latest tech buzzword – the “metaverse”. Put simply, the metaverse is a network of 3D virtual worlds that is facilitated by the use of virtual and augmented reality. Examples of European innovations include: EssilorLuxottica partnering with Meta (formerly Facebook) on augmented reality Ray-Ban sunglasses, Gucci (part of Kering) and Roblox partnering to offer digital outfits, Louis Vuitton selling Non Fungible Tokens (NFTs) and Adidas announcing a partnership with leading crypto exchange Coinbase and purchasing virtual real estate in The Sandbox. While these initiatives are currently small, some experts are forecasting that over the coming decade digital purchases could account for 25% of luxury goods sales, which given the high margins these products have would be very meaningful for share prices. Although clearly given the long term nature of these trends, we also should not lose sight of the short term drivers such as inflation potentially hurting luxury good spending.

Question: How are you thinking about positioning the Company’s gearing into the next year?

Answer: Sam: As mentioned in last year’s Annual Report, the Board has endorsed a new approach to the Company’s gearing. In keeping with Fidelity’s long-held conviction that it is a “mug’s game” to try to time markets, going forward, the intention is to maintain a relatively fixed level of gearing within a range that is approximately double the 6% average during my tenure as the Company’s Portfolio Manager. Gearing is, of course, one of the great advantages of an investment trust, and although it may amplify volatility in the short term, we expect it to enhance long term returns. The agreed level of gearing takes into account our cautious investment approach and allows considerable headroom in the event of a sharp sell-off in the market.

Question: Fidelity continues to evolve its approach to Environmental, Social and Governance (“ESG”), with a new Climate Investing Policy, sustainable investing voting principles and guidelines, and improvements to its proprietary forward-looking ESG and climate ratings. Has your investment approach adapted as a result?

Answer: Sam: ESG is becoming ever more integrated into our investment approach as our resources in this area grow. Environmental, social and governance risks have, of course, always been monitored in the quest for companies that can sustain consistent dividend growth; even well before they were tidied up into a handy acronym. Activity on this front is on-going from meetings with Nestlé regarding the use of plastic to conversations with board members of many holdings regarding the appropriateness of management incentives. At Fidelity, we strongly believe that integration and engagement will yield the best results in terms of both ESG outcomes and investment performance. Exclusion is reserved, very much as a last resort, for persistent offenders that express no intention to change.

Below we share an example of our thematic engagement in the consumer staples and plastic packaging sector and a case study on Nestlé.

Question: One of the macro uncertainties is the conflict in Ukraine. What implications does this have for the Company?

Answer: Marcel: First and foremost clearly our thoughts go out to the people suffering as a result of the war in Ukraine. We all hope that this conflict will end peacefully soon.

With regards to the Company, we have no direct investments in the Ukraine and Russia. Having said that, the Company is clearly exposed to the wider impacts of the conflict, most obviously stock market indices declining, energy prices soaring and defence spending materially increasing among a number of EU countries (most notable Germany). While we factor all of these into our analysis, predicting how the situation plays out from here is very difficult however, and we are not positioning the Company to profit from any particular outcome. This is a good example of why we stick to bottom up stock picking – not only are macro uncertainties hard to call but even if one does call them then correctly predicting their impact is another challenging task. A small proportion of people who predicted COVID correctly in the early days would have called the resultant bull market that was soon to follow.

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