Global Perspectives: European equities tapping into global tech themes

Matthew Bullock (MB)

Hello and welcome to the latest recording in the Global Perspectives podcast series. My name is Matthew Bullock. I’m the EMEA Head of Portfolio Construction and Strategy here at Janus Henderson Investors. And today I’m joined by Tom O’Hara, Portfolio Manager on our European Equities team. Good to have you here.

Tom O’Hara (TOH)

Likewise.

MB

Tom, to set the scene, I was doing a bit of research in advance of doing this podcast. I’ve read a few comments that you made in recent articles, and so I’m just going to throw a few quotes back at you, to get you to explain.

On the market sell-off that we saw in recent times, you said that financial media articles are not likely to gain much traction if the main thrust is “something went up, something went down – but for no apparent reason”.

The second quote I’m going to throw at you is that you are on the fence regarding whether European markets will continue to seek refuge in large macro-resilient companies or broaden the horizons into smaller and midcap companies.

And then finally – I think this is probably the most important one, is that you discussed how the reduced impact of easy money in the venture capital space has resulted in, again, quoting here: “small craft brewers going bankrupt left, right and centre, so now is the time to be a big brewer.”

So there are some quotes. A few things just to unpack, but I’m going to start at the beginning with the sell off of more recent times and start big picture. So I want to pick up on that comment. One of the things was that we saw plenty of articles around that time talking about the cause of the sell off being AI and essentially disappointment.

So going into your words: was this a case of something went up and down a lot for no reason? Or is AI actually one of the key drivers of disappointment that led to that sell off?

TOH

I think positioning around AI was the driver of that sell off. And when I was being a bit chippy in the article from which you kindly quoted, I was referencing the absence from a lot of these articles of something that’s very fundamental to the job we do, which is the market structure.

It is a fact that we as active investors, as ‘long-only’ active investors, are very much minority participants in the market now. You know when you look at the daily volumes traded, and I got this from our head trader, so I’m quoting him (Glenn) now. But it is, roughly speaking 30% hedge funds, 30% CTA ‘quant style’ strategies, 20% passive and then 20% active investors.

So, we are the 20% of the market and the only participants in the market that actually have a time horizon beyond the next month. A lot of the hedge fund money and the CTA quant style stuff is very short term, and the passive stuff is passive.

It is a combination that the market on a volume basis, in terms of daily trading activities, is 80% short term (and/or dumb money). When I say dumb, it means that it just doesn’t have a view. It just tracks the market. And that is what drove it.

It wasn’t people in our seat saying we are getting scared about AI now. It was a lot of hedge funds and quant strategies loaded up in AI and, for whatever reason, you know, the yen carry trade or just heading into the pre summer close out of trading positions, it led to profit taking in AI.

But the media at the same time then tries to sort of pin a tangible narrative onto these moves. And in this case, it was AI and concerns around return on investment in AI.

MB

Is that the ‘80/20’ (I won’t say rule)? Has that sort of break up been a more recent phenomenon?

TOH

It has been a creep over a number of years. I think it has become more extreme even over recent years. But on a longer-term basis, you know, we are talking 10-15 years that that shift to passive, the growth in, in the sort of highly leveraged hedge fund business models, it has just been this ongoing creep.

And I think I can see it in a more pronounced way now than certainly a couple of years ago. Just during results season – the outsized reaction to a company’s results. Often it is nothing to do with the fundamentals or any change in the outlook for that business. It is a 2% miss versus expectations – the share price gets hammered or it is a beat, okay but not enough. And then you get all these mad terms communicated from the sell side about ‘buy side ask’ – ie. Buy-side expectations were above sell-side consensus expectations. ‘Whisper numbers’, ‘smart consensus’, which is quite interesting. I presume we’re not in the smart consensus.

MB

What is ‘smart consensus’?

TOH

That is the cleverest subset of consensus that had a more finely tuned expectation for what this company might deliver. You get this whole narrative, this whole ecosystem around what is very much a short-term focused business.

MB

So does that mean then that if you have seen that potential now for more short-term volatility when there’s a miss, does that mean that first the investors should expect the recent sell off that we saw to happen more often? And then the second part of that question then is, well, how do you manage around that, if you can manage around that at all?

TOH

So the first answer is yes, this, this will keep happening, just by the nature of the market structure. We will see short, sharp gyrations in the market and it is something that we as active investors will have to live with.

But what it also means is we really have to focus on what our competitive advantage is, given that market structure. And we are in the minority of those people who can take the other side of the trade during those irrational outsized moves in response to results and so on.

For example, [the recent] tech sell off, what were we able to do? Well… buy some more.

MB

So you focus on European markets and so I just want to zero in on Europe specifically. And if we look at Europe right now, it faces a number of different challenges, whether it is political instability, broader geopolitics, the ongoing war in Ukraine.

How do you think about positioning for events that are largely unpredictable and way beyond the control of a of a portfolio manager?

TOH

Well, one of the benefits of being a large cap-focused European fund manager is it is very global. So really, I am a global investor, but through a subset of European-listed companies. And that gives us the ability to mitigate or have actually quite small exposure to the various sort of social, political, economic flare ups that you might get from time to time across different parts of Europe. We are a much more globally exposed strategy, in terms of revenue exposure, geographical revenue exposure.

MB

Is that something that you are specifically doing? Or is that more of a market structural feature?

TOH

A bit of both. Actually, one thing you have seen over the last 10 to 15 years is, you’re always shown this chart of Europe’s perennial underperformance versus the US, and it is two lines on a chart and the US always going always above the European line.

What that doesn’t fully explain is Europe has kind of gone through a process of renewal. It has gone through a bit of a purge. So you used to have a less concentrated European market. You used to have about 11 names making up the top 20% and today it is 7. But even those names within that, that top end part of the market cap spectrum – they have churned as well.

So you have lost names in telcos, in banks, a more kind of European-focused businesses, often lower growth, often a bit cheaper. They have been replaced by much more global winners I suppose you could say. Whether it is Nova Nordisk in obesity and diabetes treatment, LVMH in luxury, SAP in enterprise software. It is the likes of ASML, which is a basically a global monopoly on a particular part of the semiconductor equipment supply chain.

Europe has shifted and I think that’s still quite underappreciated. So that is one aspect, you know, my opportunity set is just more global now within Europe than it was 10 to 15 years ago. But it is also fair to say that is how we have preferred to position ourselves, at least in recent years. And it relates to the beer quote that you provided there. I absolutely love talking about beer.

One of the reasons for that is actually simply to do the change in the price of money and how that changes business models and the funding of those businesses. Over the last couple of years, while interest rates have been higher, we felt that actually being bigger, having scale, having the resources to invest in digitalisation, diversification of supply chains; being able to manage inflation better because you’ve got a bigger procurement function that can use it scale to achieve discounts on cost of goods. That has been a good place to be and those businesses, what we call ‘big is beautiful’. Again, they tend to be global.

MB

So in one of the other quotes I mentioned before, we left you sitting on a fence. This is where you were saying you didn’t have a strong view on whether markets will favour the larger resilient companies or start leaning more towards more growth-oriented small- or mid-cap stocks. So did the sell off push you off the fence one way or the other?

TOH

Not really. I still have no strong view as to whether it is ‘rates down and a soft landing’, or ‘rates down and a hard landing’. They would be different scenarios or they would, typically if you look at the historic playbook to how you might be positioned for either of those scenarios. It can be a bit different.

What I can see so far is we have had a rotation more into small- and mid-caps as a function of rate expectations. Which again is a kind of knee jerk ‘true to the playbook’ type activity. What we haven’t yet seen is any appetite for cyclicals. And I guess that is because the market is struggling to get comfortable on the trajectory from here in terms of real economic activity.

We can’t really see much good news in terms of the cyclical parts of the market yet. When you get these rotations, again, it’s one of those kind of media-heavy environments and it changes day-to-day and then the next macro data point changes the game again. We just try and speak to the companies. Even just over the last couple of weeks we have been in touch with some of those earlier-cycle companies that might give us a read on where the economy goes next to, to put it basically.

So temporary staffing agencies, some of the shorter cycle industrial names. We have spoken to these companies and actually the conversations have been quite gloomy. So when I bring that back to my large cap strategy, I think well, if this rotation, this broadening out that we have seen so far is to be sustained, at some point, it probably should broaden out.

And by cyclicals, which we are absolutely not seeing right now in Europe (defensives are quite extreme levels versus cyclicals), based on some of the indications we get from some of the banks. We are not seeing any appetite for cyclicals yet. And I kind of think a sustained broadening of the market requires those cyclicals to be brought into that rotation at some point, or it maybe just peters out.

And the other interesting aspect of the rotation so far is – traditionally rates down should benefit some of your long duration names, you know some of your higher multiple names. Tech sold off, but that was a function of the positioning probably. So far, we have seen the market buy mid caps and buy small caps. But we have not seen anything in terms of buying those areas of the market that require a more positive sentiment towards GDP.

MB

So if you did lean into the small/mid-cap space, are you able to do that with the same global mentality that you just mentioned before?

TOH

A bit less so. A lot of your smaller midcap constituents in the market will tend to have a more concentrated geographical exposure. Not always the case, but generally. And the other challenge for us with our strategy is liquidity, in that part of the market makes it harder to access.

So, the way for us to play a sustained broadening, broadening out of the market, a sustained rotation, is some of those cyclicals. We’ve already got them in the form of chemicals, pulp and paper, analogue semiconductor names. They are not the guys making the machinery like ASML, they are the guys selling the chips to the automakers, the smartphone makers and by virtue of their customers, they are cyclical.

Those are the parts of the market that we currently own. We could, if we see signs, we get signs that actually the direction of travel from here in the real economy is positive. When we speak to the temp staffing agencies, when we speak to the short-cycle industrial players, then that is the part of the book that you would look to nudge up to make sure that you get the full benefit of a sustained rotation.

MB

So I have heard you and I have read a number of articles that you have written about AI in European markets. And I must admit it is not something I have ever really associated too much of the European market (technology or AI). So how, how does the European market compare to the US and what type of opportunities do you see here in Europe?

TOH

It is another really interesting structural shift in Europe that perhaps is still not fully appreciated. I mentioned that sort of 15-year view of how the composition of the European equity market has quite fundamentally shifted, more global, higher quality, more concentrated at the top end, although thankfully not as concentrated as the S&P500.

Semiconductors and semiconductor capital equipment have gone from basically nowhere in the index 15 years ago to now being a good 5% plus. And just for you know, by way of comparison, 15 years ago banks used to be 15% of the index, and now having done quite well over the last year, they are back at about 8.5-9%.

So semis have become a meaningful part of the European equity market and those makers of the equipment. It is quite an interesting, predominantly Dutch ecosystem of companies – ASML, ASM International, BE Semiconductor,

They are fundamental enablers of this AI ‘revolution’ – if we want to use that term. But it isn’t just confined to those names. You can access this huge amount of money being spent on data centres and infrastructure through actually quite a diverse set of names, across sectors, diverse by their valuation attributes.

We are not talking all expensive growth stocks here, we are talking about building materials as well, companies like a CRH, like a Holcim – big American businesses, big western European businesses. And they do a lot of the subsurface infrastructure for the data centres. So, it is kind of the boring picks and shovels that you can access to take advantage of this amount of money being spent.

And one of the articles that I wrote recently that that you referenced is really about this AI-ROI (return on investment) debate and how personally I think that ROI narrative that attached itself to this recent tech sell off under appreciates just how committed these hyperscalers are to this capex wave.

We are talking hundreds of billions of dollars and they are still free cash flow positive while they are doing it. In fact, collectively they are building their net cash positions over the coming years by doing this. They are likely to keep on spending and obviously it is huge sums of money.

And when I put that in the context again of US versus Europe, and how you access technology, one of the things that we mentioned in this article is the quite dramatic change we have seen in the financial profile of a company like Microsoft. So, 10 years ago, Microsoft used to spend about 6% capex to sales and now it is spending about 18%. So that is three times more money coming down the supply chain to the suppliers that we can access through Europe.

And again, you have seen the value of its property, plant and equipment increased tenfold over the last 10 years. So it is now $135 billion, but it is growing. And we said, well, you know, if you want to actually construct a worst-case scenario for these hyperscalers, it is that maybe they are on a long-term journey towards becoming more like telco companies. Really capital intensive, really asset intensive for not great returns if they can’t generate those incremental revenues on AI.

But that is a worst case. And even in that worst-case scenario, there is still a load of money coming down the supply chain, because they’re not just going to stop overnight. As much as you know the commentary, the narrative around this recent sell off would like you to think that.

So, we are talking huge amounts of money. And again, the ‘big picture’ sort of way I think about that as a European investor is – big tech/Mag 7. All of those sort of illustrious names in the US were a bit of a challenge to a European investor over the last 10 to 15 years, because we couldn’t invest in them. And they were kind of the only game in town if you wanted to own technology.

Now, because of their capital intensity, because they are spending so much money with other companies in order to build these data centers, fill them with chips, all to be ready for, for AI, we can actually benefit from them in a way that we couldn’t in the past. And that is how we sort of put it into the context of what we are owning here in Europe and how big Tech/Mag 7 used to be a bit of an enemy of the fund manager. And now it is a friend because at least we are finally benefiting from their vast profitability via their capital expenditure.

MB

So we are almost out of time, but there’s one quote that I haven’t come back to yet. And I did say I would, which is about brewers. Because you did say that small craft breweries are failing and the big brewers are succeeding.

TOH

Smaller brewers don’t have anywhere close to the profit margins of the big brewers, because brewing beer is all about industrial scale. The bigger you are, the more hectolitres of liquid you produce, the bigger your gross margin.

So when inflation came along in agricultural commodities, in glass, aluminium, it absolutely destroyed the gross margins of the small brewers. That is great for the big brewers who actually spent 10 years sort of selectively chasing and acquiring these craft breweries to keep themselves relevant.

It slightly served them right because they clearly didn’t give the consumer everything they wanted and so they had to catch up by buying these smaller breweries. But the other thing that has happened alongside, which is a bit harder to put into tangible terms or demonstrate through numbers, is we have sort of passed ‘peak’ craft.

So again, stronger beers, people maybe not liking the taste of various beers, a lot of quality issues with all of these various small breweries throwing out these really interesting craft ales. There seems to be a trend back towards trusted brands, good quality lagers and so on.

The benefit to the big brewers there is they can be, they can be more efficient with their sales and marketing spend again, rather than investing behind this much broader portfolio of the core brands, but then a long tail of craft beers. It is now back to… if you look at an AB InBev, the world’s biggest brewer – its focus is on a maximum of five ‘mega brands’ per market, and that is where they can generate the most efficient growth.

So tying all of that back to this ‘big is beautiful’ theme, the small breweries have suffered through lower margins, higher cost inflation and venture cap private equity funding drying up. And again, that does relate to the change in the price of money. So higher interest rates are more normalised interest rates, and that has led to more rational dynamics across a number of sectors and beer is one of those. And it’s also probably the most fun to talk about.

MB

I think we’re out of time, but I think we should probably do another podcast just on brewers. I think we can probably spend a good at least half an hour and a bit of sampling at the end. But unfortunately, we are definitely out of time in this podcast.

But thank you, Tom for all your time. It has been fascinating. And thank you to our audience as well for listening.

So, if you wish to learn more about any of Janus Henderson’s investment views, or if you have any other questions, then please don’t hesitate to contact your client relationship manager or visit our website.

So with that, thank you very much for listening and I wish you all a very pleasant rest of the day.

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[jh_accordion title="Definitions" icon_position="right"]

Active investing: An investment management approach where a fund manager actively aims to outperform or beat a specific index or benchmark through research, analysis and the investment choices they make.

Capex: Short for capital expenditure, ie. money invested to acquire or upgrade fixed assets such as buildings, machinery, equipment or vehicles in order to maintain or improve operations and foster future growth

Cash flow: The net amount of cash and cash equivalents transferred in and out of a company.

CTA: Commodity Trading Advisors are a form of hedge fund.

Cyclicals: Companies that sell discretionary consumer items (such as cars), or industries highly sensitive to changes in the economy (eg. mining)

Defensives: Companies where revenues are more stable and less tied to changes in the economy, for example utilities and food retailers

GDP: Gross domestic product, a measure of economic growth. The value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). A measure of the size of the economy.

Hedge fund: An investment portfolio generally accessed by private investors that utilises a wide range of strategies, including alternative investments, to generate performance. These can often be higher-risk investments, or investments that are tied up for a particular time period.

Hyperscalers: Large cloud service providers, which provide computing and storage at enterprise scale.

Inflation: The rate at which the prices of goods and services are rising in an economy. The Consumer Price Index (CPI) and Retail Price Index (RPI) are two common measures.

Leverage: The use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets. Leverage is also an interchangeable term for gearing: the ratio of a company’s loan capital (debt) to the value of its ordinary shares (equity); it can also be expressed in other ways such as net debt as a multiple of earnings, typically net debt/EBITDA (earnings before interest, tax, depreciation and amortisation). Higher leverage equates to higher debt levels.

Liquidity: A measure of how easily an asset can be bought or sold in the market. Assets that can be easily traded in the market in high volumes (without causing a major price move) are referred to as ‘liquid’.

Long duration: Duration is the measure of sensitivity of an asset’s price to changes in interest rates. Long duration assets typically rise in value when rates fall.

Macro resilient: Macroeconomics is the branch of economics that considers large-scale factors related to the economy, such as inflation, unemployment or productivity. Macro resilience would indicate an ability to survive the impact of large-scale economic or market factors.

Mag7: Magnificent 7 is a catch-all term for the large, high-performing tech companies on the US stock market: Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla.

Market rotation: A shift of money from investors that moves from one industry to another, to reflect different stages of the economic cycle, or to indicate a market change or event that leads to more significant investment flows.

Mid-caps: Companies with a valuation (market capitalisation) within a certain scale, eg. $2-10 billion in the US, although these measures are generally an estimate. Mid-cap indices, such as the S&P MidCap 400 in the US, track the performance of these mid-sized publicly traded companies. Mid-cap stocks are generally perceived to offer better growth potential than their larger peers, but with some additional risk.

Passive investing: An investment approach that involves tracking a particular market or index. It is called passive because it seeks to mirror an index, either fully or partially replicating it, rather than actively picking or choosing stocks to hold. The primary benefit of passive investing is exposure to a particular market with generally lower fees than you might find on an actively managed fund.

Quant (quantitative) investing: Investment strategies that identify investment opportunities through the use of mathematical models, computer systems or data analysis to guide investment decisions.

Return on Investment (ROI): A profitability ratio that measures a company’s return on its investments. It is used as an indicator of the return on particular investment by a company, relative to the cost of the investment.

Rotation: Investors moving money out of one sector and into another.

Small caps: Companies with a valuation (market capitalisation) within a certain scale, eg. $300 million to $2 billion in the US, although these measures are generally an estimate. Small cap stocks tend to offer the potential for faster growth than their larger peers, but with greater volatility.

S&P500®: Standard and Poor’s 500 is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the US.

Smart consensus: In this instance, a subset of consensus views that have, or believe they have, a more finely tuned expectation for what a company might deliver.

Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.

Whisper numbers: An unofficial earnings forecast.

Yen carry trade: A strategy in which investors borrow funds in Japanese yen, historically known for its low interest rates and invest in higher yielding assets elsewhere.