the manager of european growth believes opportunities are round the corner but growth in 2005 will be lacklustre
William Davies, head of European equities at Threadneedle, is pessimistic about earnings growth on the Continent for 2005, but believes the market is cheap and there will be some superior stock opportunities in the year ahead.
Davies manages the £533m Threadneedle European Growth fund, working with Darrell O'Dea, who runs the £924m European Select Growth offering.
Over three years to 6 December 2004, these funds are ranked 32 and 34 respectively of the 87 funds in the Europe ex UK sector, offer to bid.
Why do you believe there are issues with growth in the year ahead?
Consensus expects economic growth next year will be about 2%, but we believe it will be nearer 1.5% or lower. Estimates are therefore too high.
Consensus has been forecasting 2% growth for 2005 since the middle of the year. But despite the stronger euro and higher oil price, which have evolved since and are detrimental for markets, forecasts have not changed.
It seems the market has underestimated the impact of the strong oil price, which has risen from E25 before summer to around E40 at its peak. Although it has since come back to around E30, it is still stronger than last year's average.
How do you expect earnings growth to fare?
We agree with consensus estimates that earnings growth for the market during 2004 will be around 20%. Next year, however, consensus is forecasting around 13%. We expect that is too high and is probably going to be nearer 5%.
Meanwhile, we have not found anyone else suggesting earnings growth would be this lacklustre or slow. Therefore, over the next six months or so, there will be a number of earnings disappointments. As a result, there will be a distinct amount of choppiness or volatility in the market as earnings disappoint.
How are you hoping to gain the best investment opportunities given this scenario?
Despite increased volatility due to earnings disappointments over the next six to nine months, the market as a whole is not expensive from a valuation point of view. When factoring in our lower growth estimates of 5%, the P/E is lower than it has been for most of the 1990s, which means European equities are looking quite cheap.
Therefore, looking ahead 12-18 months, we are positive about European equities as a whole. However, it is important to avoid companies that will have earnings disappointments – and there are going to be lot of them.
These are most likely to be in the areas that are more, rather than less, dependent on economic activity or economic growth.
Meanwhile, we expect there will be a lot of companies that still deliver or exceed expected earnings growth, and these will attract a premium rating. They are the sort that will start to outperform and looking out we expect there will be greater appreciation that certain companies should trade at premiums to others.
Will those companies that go to a premium be found in any particular area?
A growth area is healthcare, excluding drugs. A holding in the portfolio is French company Essilor, which makes spectacles. This is growing faster than the market, generates cash, and reinvests in its own business. It is attractive, yet is not trading at a ridiculous premium to the market.
What is the difference between the Growth and Select Growth funds?
The main difference is that Select Growth is a more concentrated portfolio, with 60-70 stocks compared with more than 80 for Growth. The stocks within both are similar. Select Growth has more flexibility than Growth fund in terms of stock and sector risk controls. In European Growth, we would not hold a sector position of more 10% away from the index. In Select Growth, there is no such limit.
Similarly, at a stock level, European Growth would not have an active stock bet of more than 3%, while in Select Growth the limit is 5%. European Growth has a tracking error of 3%-6%, while Select Growth will have a tracking error of 3%-8%.
Do you hold smaller firms?
Yes we do. If defining small companies as those with a market cap of less than £2bn, around 15% of the European Growth and 10% of Select Growth would be invested in this part of the market. By contrast, the FTSE Europe ex UK index has only 3%-4% of companies with a market cap of the same. We also run a dedicated smaller companies fund.
How does your research team work?
Threadneedle has a pan-European team of about 30 people. Within this team, around 20 have sector research as well as fund management responsibilities. Their roles are to help identify ideas and rate companies within their sector. Companies are given a ranking of 'A' to 'E'. 'A' is a company we believe will outperform the sector by more than 15% over the next 12 months, 'B' is 5-15%, 'C' is -5 to +5 and so on.
Do you have to follow these lists?
We have a core stock list that comprises the 20 largest stocks in the index. We will always have a view of underweight, overweight or neutral. We do not have to hold them but we do have to have a view. Then we will have our favourite 30 stocks outside the top 20, the preferred list, in which the European Growth fund has to be overweight. Select Growth does not have to be overweight.
European Growth will have at least 60% of its portfolio coming from the top 20 and preferred lists. Select Growth will have least 50%. Realistically, both funds have around 70% based on these lists. We cannot hold 'E'-rated companies.