McCarron's cautious optimism bears fruit

Fidelity's approach to succession management has been well documented in recent months, given its announcement about the Fidelity Special Situations fund. However, just over three and a half years ago, advisers faced a similar situation when Tim McCarron assumed management of the flagship Fidelity European fund from Anthony Bolton. Advisers and investors trust in Fidelity and McCarron has been well rewarded as the fund has remained a top performer under the new manager's tenure.

The £4.2bn fund is ranked seventh out of 85 funds in the Europe ex-UK sector since McCarron took over with the fund, returning 122.04% compared to the sector average of just 92.48%*. The fund is rated AA by Standard & Poor's and AAA by Forsyth OBSR. McCarron has also delivered equally impressive performance on the Fidelity European Values investment trust, which he took over from Anthony Bolton in 2001.

While McCarron's performance over the past three years has been strong, the fund underperformed its peer group in the final quarter of 2005 and into the first quarter of 2006.

McCarron says the underperformance can be partially attributed to an overweight position in the oil sector. Despite the high oil price, oil stocks have not fared particularly well and the sector has underperformed.

Going forward, McCarron expects that some segments of the oil sector should come good given the dynamic of strong demand and short supply remain. As a result, his positive view on certain areas of the energy market is being maintained.

"I doubt the major oil stocks will be the top performers. However, there is a lot of work in the oil services sector, for example, that will come through to earnings and subsequently share prices," he says.

Furthermore, the recent market turmoil has not rewarded undervalued stocks, as more defensive companies have come to the fore, although it has offered an opportunity for McCarron to revisit certain areas of the market that had become expensive. McCarron is confident in the shape of the portfolio over the longer term and expects the underlying stocks will ultimately deliver good returns to his investors. In fact, his thinking is already bearing fruit as the second quarter of 2006 saw the fund return to the first quartile of the Europe ex-UK sector.

Cautious optimism

Although the European stock market has not escaped the correction in global equities, McCarron remains optimistic about stocks on the continent.

But he warns there are some drawbacks. "The corporate earnings cycle is well advanced," he says. "Over the past three years, earnings have been well above trend. The long-term annual earnings growth trend is 5-6%, however currently companies are growing their earnings at 15% per year."

"This is a negative as the fact that earnings are above trend means that it will eventually revert toward the mean. That means earnings growth in the next three years will not be anything like the past three years. Things could go flat for a while," he says.

Another factor to consider is that corporate profit share as a percentage of GDP is also at a historic high, meaning this cannot be sustained for ever.

Europe was in a similar position back in 1999 and early 2000.

McCarron argues however that there is a big difference between the scenario back then and now. Primarily, that is because the valuations of European companies are far more attractive now than back in 1999 and early 2000.

Between 1988 and 2006, the Price to Earnings (PE) ratio in Europe, on forward consensus earnings, ranged from 10-11 times in 1988 to a high of about 22 times in 2000. McCarron says the current PE ratio across the market stands at around 12-13 times, so is low compared to historic levels.

"This demonstrates that we are not in the same market environment as that experienced back in 2000, when, not only were earnings above trend, but valuations of companies were also quite high", states McCarron.

He feels Europe offers far more attractive prospects than other stock markets such as the United States. "In addition," adds McCarron, "I believe valuations in Europe are far cheaper than that of the US, yet the economy of the former is in far better shape. There are a number of strong signs that the US economy is slowing down. In particular, the consumer is showing signs of slowing down and there are strong concerns over house prices".

"By contrast, Europe is in a much earlier phase of the recovery cycle. To date, the recovery cycle has been driven by export growth and industrial production growth," McCarron says. "Some European countries have particularly strong export performance, notably Germany, which is now the biggest exporter in the world, as well as Sweden and Switzerland."

Interestingly, however, McCarron says these countries, particularly Germany and Switzerland, currently have weak consumer trends. This raises the prospect that it could be quite early in the cycle in terms of the consumer and a strengthening consumer would be good for the domestic economy.

Already there have been some improvements in the data relating to the German domestic economy and the consumer. "Even though the World Cup would have created some distortions in the data, there is strong evidence of a recovery nonetheless," states McCarron.

"If the consumer in Europe continues to improve through to the end of the year, then we really could get quite a good picture in Europe, even in the face of a US GDP picture that looks a lot weaker."

Furthermore, unlike the US, Europe does not have a current account deficit but is in the enviable position of having small current account and trade surpluses. Although this is the net result of a few specific countries being in a strong position, McCarron says it is definitely the case that economic imbalances are not something to put on the "worry list" for Europe.

And although interest rates are rising in Europe, McCarron says this is little cause for concern. "People get very negative about interest rates. Sometimes there is the assumption that if interest rates are rising, that is the death knell for markets. But actually, that's not how it works. Generally, interest rates rise if economic growth is improving. The central bank is trying either to normalise that or is being vigilant against inflation," McCarron explains.

Overall, the factors that lead to rising interest rates are generally very good for markets. Take for example the years 2004-2005, which were very strong for US equities in absolute terms. Although in relative terms the US lagged Europe, the US stock market still managed to perform well in absolute terms in a period when interest rates were rising.

He believes the European Central Bank will continue to act in the interest of Europe, saying it is very clearly on the guard against inflation but is not having to have rapid rises.

So what are the concerns facing Europe? The major risk, McCarron says, is if the US does not have a soft landing. That said, he does not consider this to be highly likely.

"From a company point of view," he says "there have been very few major disappointments on earnings in Europe. Provided there is not a severe slowdown, Europe should remain in good shape."

Changing corporate landscape

European companies went through a big step change in quality in the late 1990s. That is because in the 1980s and early 1990s, many European companies were not run on behalf of their shareholders.

However McCarron says this has very much changed in the past seven or eight years. "Nowadays there is generally a much more disciplined application of financial criteria and the recognition of shareholder interests. With the help of improved corporate governance, the quality of European companies has improved substantially," he explains.

"The breaking up of cross shareholdings has also resulted in better companies with a stronger focus on shareholders. Government influences have also had a significant impact in driving this trend. For instance in Germany, the government has eliminated capital gains tax on corporate disposals."

One interesting factor, McCarron says, is that the Government tax on European companies is falling considerably. "Although Europe has typically had high tax and high Government intervention, the burden on corporates has been falling quite steadily in percentage terms in recent years."

McCarron attributes much of this trend to some of the lower tax countries such as Ireland and the eastern European countries entry to the European Union. The entry of eastern European countries (which have corporate tax rates of less than 20%) has prompted governments in nearby countries to reduce their corporate tax.

He points to Austria being one of the best performing of the European markets in 2004 and adds that it is worth noting that in the same year the Austrian government cut its corporate tax rate from 35% to 25%. Austria is bordered by several of the lower tax eastern European countries, and it is inevitable this geographic trend forced the change in Austria.

"This downward pressure on tax is even more wide reaching," explains McCarron. "Nowadays there are few European corporates paying a tax rate of more than 30%, while most are paying closer to 25% tax. And the trend continues to move downward. In Germany, for example, there is a proposal on the table to cut the corporate tax rate to strongly improve the overall competitiveness of Germany as a location."

"Within the US and Japan there is typically a much higher tax take out than in Europe. That is very much a positive for European company earnings, company return on equity, and overall returns to shareholders," McCarron says.

Positive impact from eastern Europe

"Not only is the lower taxation from eastern European countries having an impact on the more established markets in Europe, the positive impact on the labour market also cannot be ignored," McCarron states. "Indeed, the possibility of immigration and cross-border workflows means that there is downward pressure on labour costs, and hence the inflation picture is less of a risk than it might otherwise be."

Another important effect, McCarron says, is that eastern Europe is not only a producing area, but also potentially an area of strong consumption growth. "Many of these countries, such as Romania and Bulgaria are very poor and are typically very far down the consumption curve. This provides potential for consumer goods penetration. Although small at the moment, this represents an interesting and important market," he says.

The Fidelity European fund has held eastern European companies in the past. In fact, back in 2004, these represented as much as 9% of the portfolio. However, exposure to these has been reduced after the market peaked and in 2005 McCarron held virtually no eastern European stocks, based on valuations no longer being attractive in his view.

However, McCarron says he is once again looking to this market with interest. Share prices have declined recently amid the global stock market correction and he expects that there could be some good value opportunities within eastern Europe to be found.

Stock selection key to returns

With such a wide area in which to invest, how does McCarron go about finding opportunities? As ever, McCarron points to the significant resources Fidelity has in place. McCarron is supported by 72 pan-European equity research professionals.

McCarron is not restricted in the choice of company either by size or industry, or in terms of the geographical split of the portfolio, which is largely determined by the availability of attractive investment opportunities, rather than taking a top-down view of each market.

Similarly, the size of each holding will reflect McCarron's conviction in the company, meaning the portfolio can therefore vary significantly from that of the index. The fund will typically hold between 120 to 140 stocks so is well diversified.

In the mould of his predecessor, McCarron tends to have a value bias and looks for companies which display one of three characteristics.

The first category include undervalued stocks which he describes as out-of-favour and unfashionable companies trading at below their intrinsic value, based on earnings potential or discount to asset value.

Companies displaying growth at a reasonable price (GARP) represent the second type of stocks that appeal to McCarron. These are the companies that have strong growth prospects which are not necessarily recognised by the market.

The third type of company is the turnaround situations relating to those companies McCarron considers to be underperforming their potential, yet where there is a clear catalyst for change. This may be either internal (management change, asset divestment) or external (cyclical) factors.

McCarron explains that each of these three categories of stock are designed to work in different markets and each will display opportunities at different phases of the cycle.

"There tends to be, for example, more turnaround stocks when the economy and stock market are ailing and corporate profits are depressed. As a result, in 2003 there were a lot of turnaround examples within the portfolio. I held about 35-37% of the portfolio in these types of stocks back in 2003, but there's about a third of that now given there has since been a sharp recovery. This reflects the fact many companies have enjoyed a significant recovery in profitability and that has been discounted in the share price," he says.

Currently, McCarron says the portfolio has shifted to have a bias toward stocks that fit within the GARP category, and to a lesser extent by those that fall into the undervalued realm. "There are typically more GARP type stocks to be found when there is a more stable and defensive stock market environment such as that being experience in recent years," he states.

In particular, he is finding good GARP opportunities within the pharmaceutical sector. "Within this sector", he says, "there are companies growing their earnings by 10-12%, yet are on a price earnings ratio (PE) equivalent to that of the broader market of 12-13 times."

"A stock with such financial characteristics definitely represents a good investment on a three-year view. In 2003 I held very few pharmaceutical stocks but now the portfolio is quite overweight in this sector," McCarron says. Both Novartis and Roche Holdings are among the Fidelity European fund's top 10 holdings, for instance.

McCarron says GARP stocks have been able to weather the recent stock market volatility well because of their dependable earnings, however they should also perform well in a steadily upward rising market.

"There are also good opportunities within the undervalued category," McCarron says. "This relates to companies where there is some sort of hidden value which is not being appreciated by the stock market. Consequently, stocks that are subject to corporate activity form a key area within the undervalued category."

In the past year there has been a sharp spate of corporate activity and McCarron expects this to continue. "The market is not yet anywhere near the highs of early 2000. Furthermore, positive feedback from investment bankers indicates further strong corporate activity is likely both among large and small companies," he says.

Looking ahead, McCarron remains optimistic on the prospects for European equities. "I am confident of finding strong stockpicking opportunities in the area. For investors, Europe remains a sound investment opportunity and one which should warrant a position within a well-diversified equity portfolio," he concludes.

* Source: Standard & Poor's as at 30 June 2006.