Macro backdrop

August was once again a month where value-style stocks strongly outperformed the growth style. This was due to both rising bond yields – with the US 10-year government bond yield climbing from 2.65% to 3.20% – and a hawkish US Federal Reserve (Fed).¹ The market was generally weak with cyclical stocks underperforming once again after their partial recovery in July. It seems that July was a month in which the more cyclical companies in the market rallied due to no worse-than-expected second quarter numbers, while August was a month where investors focused more on the likely earnings downgrades to come in the final two quarters of 2022. From speaking to a wide range of companies, it is pretty clear that trading conditions are worsening, or are at best not improving from already supressed levels; this seems to be true across most sectors.

Trust performance and activity

EuroTrust returned -2.6% and underperformed its benchmark slightly in August after two strong months. The FTSE World Europe ex UK Index re turned -2.2%.¹

Within the best contributors to fund performance in August, there was a clear pattern of financials (Munich Re, Bawag, UniCredit, Deutsch Boerse), energy companies (Total) and perceived defensive stocks (KPN) producing strong performance. This pattern is linked to rising bond yields, the outperformance of value stocks and the underperformance of cyclicality during the month.

With our biggest detractors from performance, there was certainly a pattern of the more growth-orientated companies underperforming (such as DSM, Cellnex). Sanofi (the fund’s second worst performing position over the month) also underperformed and deserves some explanation. We bought Sanofi last year and it has generally performed very well for us since. This year, even with the August issues, it remains a top 10 contributor. In August, however, the shares fell around 13% following the widespread news coverage of potential litigation against a product called Zantac. To give a brief history, Zantac, in both prescription and other-the-counter (OTC) form, has been owned by numerous different pharmaceutical companies since it came to marke t in the late 1980s. Sanofi owned the rights to the OTC product for three years between 2017 and 2019 be fore the company voluntarily withdrew the product from the market following concerns from the US Food and Drug Agency (FDA) that the product might contain higher-than-allowed levels of a potential carcinogen called NDMA. It is a complex situation but at a very high level we are about to see a number of US court cases with claimants looking for damages, even though there is no clear-cut scientific evidence that the product even causes cancer. Most legal experts would agree that the range of potential pay-outs from the involved industry parties could range from $10-30 billion (or maybe up to $50 billion in a stretched worst-case scenario). Sanofi has seen a $20 billion loss of market cap this month, which we think seems to be pricing in a worst-case outcome as well as Sanofi being liable for a much higher proportion of damages than their period of ownership would suggest. We have maintained our full position but have so far held off from the temptation to buy more, however.

As with June and July, August was another uneventful period for trading activity. We added no new positions and sold no existing holdings. However, we generally continued to reduce the fund’s exposure to some of the strong-performing, higher valuation, high-quality defensive growth companies (KPN, Novo Nordisk, Sartorius) while adding to slightly less defensive but also lower valuation holdings (Kion, CNHI, Airbus, Metso). Leverage currently sits at 3-4%.

Outlook/strategy

We will continue to retain balance in our exposures by considering two types of business for investment; those where we see the potential for high and sustainable returns that we think are undervalued by the market and those companies where we can see a material improvement in medium-term business prospects.

¹Source: Bloomberg as at 31 August 2022

Glossary Expand

Bond yield – The level of income on a security, typically expressed as a percentage rate. For a bond, this is calculated as the coupon payment divided by the current bond price. Lower bond yields means higher bond prices.

Cyclical – Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.

Earnings before interest and taxes (EBIT) – Earnings before interest and taxes (EBIT) is an indicator of a company’s profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.

Growth investing – Growth investors search for companies they believe have strong growth potential. Their earnings a re expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.

Gross profit margin – Gross profit margin is a metric analysts use to assess a company’s financial health by calculating the amount of money left over from product sales after subtracting the cost of goods sold (COGS).

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.

Return on invested capital (ROIC) – Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments.

Quality investing – Quality investing is an investment strategy based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet stability).

Value investing – Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favoured techniques is to buy companies with low price to earnings (P/E) ratios.

Valuation metrics – Metrics used to gauge a company’s performance, financial health and expectations for future earnings e.g. price to earnings (P/E) ratio and re turn on equity (ROE).