European equities: Insights into 2025 – A conversation with John Surplice

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(upbeat music)

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- Joining us today, my name is Georgina Millar.

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I'm one of the two Product Directors

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on the Invesco European Equities Team,

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and I'm joined today by John Surplice,

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Head of Fundamental Equities for EMEA at Invesco,

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as well as one of our most experienced fund managers

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on the European Equities Team.

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And John and I are here today

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to talk about our thoughts on the outlook

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for European equities as we go into 2025.

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We want to discuss the opportunities

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for active equity investors like us

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and why we think our funds are well positioned

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as we go into the new year.

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But John, hello.

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Can we first touch on the performance in 2024?

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- Hi, Georgina, and welcome, everyone.

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So yeah, 2024 has been a year of US domination.

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US has dominated the investment narrative,

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and Europe has felt a bit like a backwater.

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So not only has Europe struggled,

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but we as investors have struggled within that context.

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We felt that 2024 was gonna be a year of recovery

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and expectations in Europe

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as we came to the end of a destock cycle

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and we came towards the end of a high inflation period

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and we could get to a period of more normalizing inflation,

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which could give the opportunity for rate cuts.

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And we felt that that was gonna change the narrative

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for investment in Europe

 

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to be one of optimism and one of recovery.

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But unfortunately, 2024 has not played out that way.

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- No, it's been a challenging year

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for some of our portfolios for sure.

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Have you seen market conditions like this before?

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Is there anything that you can dig from your experience

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that might give you confidence going forward?

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- Well, I think when you get your timings wrong in a market,

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you need to question yourself

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and you need to question, were you wrong?

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Or was it just timings?

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And I think you sort of go back to first principles

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and you look at,

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if we look at this situation now,

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the demand weakness that we're seeing in Europe is partly

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because we have high savings ratios,

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we've had those through Covid,

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and they just simply haven't come down.

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And even though rates have started to come down,

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that hasn't encouraged people as yet to spend.

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We've also had a very weak investment cycle

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or investment spending in Europe.

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And we think that that is going to recover,

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but it just hasn't yet.

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And there are a number of reasons why it has to recover,

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the investments required for digitalization,

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for decarbonization, et cetera,

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but still investments being at being at a very low level.

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So we think that growth will improve.

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And as I said, we have come to the end

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of that destock cycle, but we just haven't seen it yet.

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And in terms of other previous periods,

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I've been investing in Europe for a long time,

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since the mid '90s.

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And Europe does go out of favour for periods.

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And as a consequence, it can get very cheap,

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and some of the companies within Europe can get very cheap.

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And I think that's where we are now.

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And when you get market out of favour, not just Europe,

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but any market out of favour,

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that does create opportunities.

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And as an active investor, you've gotta be prepared

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to take advantage of those opportunities

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and be positioned for those opportunities.

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- Okay, so what you are describing

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to me sounds like Europe perhaps is on the cusp

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of a sort of positive change

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like of an incremental improvement.

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So how is that reflected, I suppose,

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in the positioning of the funds?

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And are there any indicators really that give you confidence

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that we're going to see a recovery

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that could be reflected in the portfolios

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in the sort of medium term?

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- So what you're describing is what is the narrative?

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And I might say to you as a product director,

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the narrative is your job.

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But no, that is where Europe is definitely struggling.

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The US has a strong investment narrative,

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which is why it's re-rated

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and why it sucked money globally towards the US

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and investing in the US because as a strong narrative,

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and that's been exacerbated by the election of Trump

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and people's memories of what happened in Trump 1.0.

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Europe doesn't have that strong narrative

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right at this moment

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because we've had declining growth expectations

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and we think growth expectations are bottomed,

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but they haven't turned.

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So if you're looking for the PMIs,

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Purchasing Manager Indices,

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they just haven't turned yet.

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But we think they will, and when they turn,

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that will improve the investment narrative for Europe.

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- Yes, because sentiment is certainly very low in the region

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at the moment, but amongst the equity investors at least,

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and that's reflected I think in quite a lot

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of very cheap valuations.

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But for us, as for bottom up stock pickers,

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obviously as you've said,

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that opens up lots of opportunities.

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And when I think about our investment style on the team,

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our approach,

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it's all around this idea of quality transition.

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So about companies getting better basically,

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about positive change ahead.

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And I don't know if it's a bit of a stretch,

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but it feels like Europe as a region

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is also its own quality transition opportunity in a way.

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Would you agree with that? Is that fair?

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- Yeah, obviously we don't invest

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in a continent as such as you say,

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we're investing in individual companies.

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And so you're looking for that investment narrative

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around those individual companies.

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But for sure, Europe, like a lot of regions,

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has to go through a period of change.

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We've gotta meet these challenges,

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whether it's more defense spending,

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whether it's the electrification that's required

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of our economies, whether it's investment in energy supply

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or digitalization and automation and decarbonization.

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There are a lot of themes

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that we've been talking about for a long time.

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But post-Covid, the recovery from Covid,

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and this period of week for economic growth,

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I think that the market's lost sight

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of these longer term narratives

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that are gonna be very important.

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And going back to one of my earlier points,

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you don't really see it in the numbers.

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Our fixed capital formation

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and our private investment in Europe

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is at really low levels.

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And if these themes are gonna come to pass,

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that there has to be a pickup in investment in these areas.

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- Yes, okay, so if we think about some of our stock picking,

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because as you've rightly said, we are stock pickers,

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perhaps now is an opportunity

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to talk about one of our holdings

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across most of our portfolios.

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Perhaps let's start with one of our trickier ones in 2024.

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What is the quality transition pieces as such

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behind whichever example you choose,

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and what gives the team the conviction

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to hang on in there if it's been a tricky 2024?

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- So yeah, there's nothing like airing your dirty linen,

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is there?

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I guess a good example would would be Neste,

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which was a company we first invested in in 2022

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in the period close to the invasion of Ukraine.

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Neste is all about renewable diesel

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and sustainable aviation fuel or SAF.

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It's a market leader in this area

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and has invested a lot in growing capacity

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to make sure that it's gonna be a dominant player

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in this area.

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But it's a young industry,

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and the challenges it's faced this year have been

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typical growing pains for a young company,

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or it's not a young company,

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but certainly for a young industry investing

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in a new industry.

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And to take one example,

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the blending requirements in Sweden got cut this year

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as Sweden faced up to the high cost of energy.

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And that led up to a big shortfall

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in demand versus supply

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and really hurt pricing, that's a growing pain.

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That's not going to affect

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the long term demand for Neste products.

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There've been other issues within Neste,

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there's been management issues,

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and it's all come together into

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a really disappointment investment this year.

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But it as we look at it

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and we've looked at this company a lot,

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we've searched the company a lot,

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the opportunity going forward looks to be really strong.

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So SAF that I mentioned, sustainable aviation fuel,

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it only gets a blending requirement in Europe

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starting next year.

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And then that blending requirement is gonna ratchet up

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as we go through the years,

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and Neste there should be at the forefront

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of benefiting from that.

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And sustainable aviation fuel is the only way

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we're gonna decarbonize the aviation industry,

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which is clearly one of the big carbon outputters around.

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- But when I think of a lot

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of our holdings in our portfolio,

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they obviously all require a lot

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of rigorous investment analysis, a lot of discipline,

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close communication with management teams,

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et cetera, but also patience.

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Is that a fair assessment that

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the typical characteristics of a quality transition stock

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or a quality transition story in our portfolios?

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- I think you didn't mention debate there and challenge,

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I think when we have a an idea that that is struggling,

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you don't necessarily always keep digging.

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You actually have to challenge that idea

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and challenge your colleagues' opinions

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and do that in a forthright way totally lead to

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better decision making.

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So where we have a stock that goes wrong, like Neste,

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it does lead to a period

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of self-reflection within the team to examine

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what went wrong

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and whether that undermines the investment case

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on a going forward basis.

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- Yes, and also though, there's that collaboration

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or there's that debate I suppose about when they do go well

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because you've got to work out

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how long you hold onto these names for.

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So perhaps we could touch on a couple

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of quality transition names from 2024,

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which have performed well where you might be having

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that kind of conversation in the team right now.

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- Yeah, so I mean that point's really good point

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that when something is going well,

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it's very easy to get euphoric.

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It's a natural tendency

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and you need to stay grounded in this business.

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We do that with the discipline of using our IRR spreadsheet.

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We target double digit returns on all our companies

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on a three year view, on a three to five year view.

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And if a company perform well

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and the IRR looks to be going to single digit,

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then we will reevaluate the investment case

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of that company.

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One of the areas that's done well for us this year,

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banks have done pretty well, and within that,

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UniCredit I would say has probably been a standout.

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That's a company we've invested in for a number of years.

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When we initially made that investment,

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there was no prospect of the company,

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the bank making double digit return on equity.

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Whereas now we believe that

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mid-teens return on tangible is

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what the company can make and the stock has re-rated

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from being significantly below book value

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to around book value.

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So it's been a very successful investment

 

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as we've moved from the negative rate period pre-Covid

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to having positive rates,

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and it's been a big beneficiary

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of that change in expectations.

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- And then there are other,

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when I think about all the portfolios

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and the different themes within quality transition

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and change, sometimes M&A plays a role for example,

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so Smurfit Kappa comes to mind,

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it's another very interesting idea

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I think across most of our portfolios right now.

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Would you like to elaborate on that one?

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- Yeah, well one of my colleagues introduced

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that idea as a potential investment

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and I was a little bit skeptical at the time

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because it looked to be that Smurfit Kappa

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was a Covid beneficiary, you know?

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They make cardboard boxes,

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so when you're ordering at home online delivery,

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that that was a real,

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and the growth of that during that Covid period,

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they were a big beneficiary

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because there was a big increase in demand for that product.

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They have pricing power,

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and it takes a while for capacity to adjust.

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So they had a revenue uplift

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and they had a margin uplift.

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And as I say, I was a little bit skeptical

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because I felt that we had to have the other side of that

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and the correction back to

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what is actually the underlying level of demand,

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and would pricing change

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if the demand outlook changed.

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And sure enough, that's what happened,

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and it was then a poor investment

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or would've been a poor investment for a period of time.

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But we got to the autumn of '23

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when it had derated quite significantly

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and was suffering negative organic growth

00:15:09:10 - 00:15:13:05

from a volume perspective and negative pricing.

00:15:14:02 - 00:15:16:07

And then they announced the acquisition,

00:15:16:07 - 00:15:18:27

or the intended acquisition of WestRock,

00:15:18:27 - 00:15:21:19

which has only been executed on mid this year.

00:15:23:08 - 00:15:26:18

And I guess the history that I've had is if you put

00:15:26:18 - 00:15:30:08

six companies together at the bottom of the cycle,

00:15:32:07 - 00:15:34:13

that's probably quite a good starting point

00:15:34:13 - 00:15:38:02

for making money out of M&A,

00:15:38:02 - 00:15:42:01

and that's been the case so far that

00:15:43:00 - 00:15:46:07

the integration seems to be going reasonably well.

00:15:46:07 - 00:15:49:28

Volumes seem to be picking up, stemming from the US,

00:15:49:28 - 00:15:51:26

which is their biggest market,

00:15:52:26 - 00:15:54:12

and the dollar's gone up as well a bit.

00:15:54:12 - 00:15:56:09

So it's proved to be,

00:15:57:16 - 00:15:59:14

after I would say a slow, tricky start from when we make

00:15:59:14 - 00:16:03:13

that investment in Q3 last year.

00:16:03:13 - 00:16:06:18

It's been a good investment this year.

00:16:06:18 - 00:16:08:28

- Yes, a good example I think

00:16:08:28 - 00:16:10:19

of a different kind of goods transition

00:16:10:19 - 00:16:13:14

to what you described earlier with UniCredit.

00:16:13:14 - 00:16:17:06

- But also going back to your point on patience,

00:16:17:06 - 00:16:19:21

it was one where the idea was presented to me

00:16:19:21 - 00:16:23:29

and I felt our ducks didn't look

00:16:23:29 - 00:16:25:28

to be completely in a row on that idea.

00:16:25:28 - 00:16:28:18

I liked it conceptually

00:16:28:18 - 00:16:30:05

because I could see this company

00:16:31:08 - 00:16:34:02

could make decent returns on capital,

00:16:34:02 - 00:16:35:20

but the timing just didn't look right.

00:16:35:20 - 00:16:37:27

So we sort of parked it for a while.

00:16:37:27 - 00:16:40:15

We carried on assessing the idea,

00:16:41:19 - 00:16:44:10

and delayed making that initial investment

00:16:44:10 - 00:16:47:17

until the risk opportunity,

00:16:47:17 - 00:16:51:13

the risk reward opportunity looked a lot more favourable.

00:16:51:13 - 00:16:52:23

- Yeah, yes.

00:16:52:23 - 00:16:55:28

Great, and just quickly touching before we conclude,

00:16:55:28 - 00:16:58:01

can we come back to the banks very briefly

00:16:58:01 - 00:17:01:23

because something that clients have been asking me about

00:17:01:23 - 00:17:05:02

is the performance of value as a factor this year

00:17:05:02 - 00:17:07:14

because the output across most

00:17:07:14 - 00:17:11:02

of our large cap equity portfolios is value,

00:17:11:02 - 00:17:13:18

and value has performed very strongly this year

00:17:13:18 - 00:17:16:06

because banks have been such a large component

00:17:16:06 - 00:17:17:26

of that index.

00:17:18:27 - 00:17:22:11

Now we overweight banks in some of our funds

00:17:22:11 - 00:17:24:00

or have been through the course of this year,

00:17:24:00 - 00:17:27:04

but not to the extent that the value index has,

00:17:27:04 - 00:17:29:29

and that has impacted our returns relative

00:17:29:29 - 00:17:31:15

to value this year.

00:17:32:14 - 00:17:33:25

What are your thoughts on that

00:17:33:25 - 00:17:35:22

and about balance across the portfolios

00:17:35:22 - 00:17:37:23

going forward, et cetera?

00:17:37:23 - 00:17:39:20

- Yeah, Georgina, it's a really good point

00:17:39:20 - 00:17:42:18

and it's one that, I mean,

00:17:42:18 - 00:17:45:23

our colleague Joel wrote a really good blog on

00:17:45:23 - 00:17:49:08

a few months ago, and it's the difference between

00:17:49:08 - 00:17:52:10

market neutral value and sector neutral value.

00:17:53:15 - 00:17:56:09

So if you take market neutral value,

00:17:56:09 - 00:18:01:09

50% or almost half that value benchmark is financials.

00:18:03:04 - 00:18:06:10

Now there's no way I'm gonna have half my portfolio

00:18:06:10 - 00:18:08:03

in financials.

00:18:08:03 - 00:18:12:01

So we tend to have a more balanced approach

00:18:12:01 - 00:18:13:24

to our portfolios,

00:18:13:24 - 00:18:17:05

so I'm overweight banks for example

00:18:19:29 - 00:18:22:01

versus the market versus the benchmark,

00:18:23:19 - 00:18:27:25

but I'm not overweight banks versus a value benchmark,

00:18:27:25 - 00:18:30:24

which is quite a narrow, quite a distorted benchmark.

00:18:32:19 - 00:18:35:27

So that's been one of our challenges.

00:18:35:27 - 00:18:37:12

And probably the other one is,

00:18:40:22 - 00:18:43:06

if you were looking at factor characterization,

00:18:44:18 - 00:18:48:15

we have a lot of cyclical value within our portfolios,

00:18:48:15 - 00:18:50:19

and this goes back to the Neste

00:18:50:19 - 00:18:52:17

discussion we were having earlier.

00:18:52:17 - 00:18:56:26

This has been a really problematic part of the portfolios

00:18:56:26 - 00:18:59:11

in an area of weakening PMIs

00:18:59:11 - 00:19:02:19

and weakening growth outlook in Europe.

00:19:02:19 - 00:19:06:25

- Yes, so I think today we've sort of touched on obviously

00:19:06:25 - 00:19:08:23

the sort of outlook for Europe,

00:19:08:23 - 00:19:12:25

which perhaps in our minds  isn't quite as negative as it is

00:19:12:25 - 00:19:15:18

for other investors across the market.

00:19:15:18 - 00:19:17:23

We've talked about quality transition

00:19:17:23 - 00:19:20:10

and some of the individual holdings in our portfolios

00:19:20:10 - 00:19:23:05

that sort of illustrate our approach.

00:19:23:05 - 00:19:25:08

And obviously also then talk about balance

00:19:25:08 - 00:19:27:07

across the portfolios and how important that is

00:19:27:07 - 00:19:29:03

to us in terms

00:19:29:03 - 00:19:32:26

of thinking about long-term risk-adjusted returns.

00:19:32:26 - 00:19:35:03

John, are there any sort of concluding comments

00:19:35:03 - 00:19:38:12

that you want to add at this moment before we sign off?

00:19:40:00 - 00:19:41:16

- Well I'll just say,

00:19:43:13 - 00:19:47:12

when the outlook often looks bleak,

00:19:47:12 - 00:19:51:00

that can often be the contrarian,

00:19:51:00 - 00:19:52:24

that's often a good time to invest,

00:19:52:24 - 00:19:54:24

and when you take a step back

00:19:54:24 - 00:19:56:28

and you look at the investor narrative globally

00:19:56:28 - 00:20:01:28

at the moment, it's very pro-North America

00:20:05:08 - 00:20:06:13

in terms of narrative.

00:20:06:13 - 00:20:10:27

And the US has had a 15 year,

00:20:10:27 - 00:20:15:17

over 15 year now outperformance of the rest of the world.

00:20:15:17 - 00:20:18:08

And that has sucked money into North America.

00:20:18:08 - 00:20:22:19

And it has led to you US companies

00:20:22:19 - 00:20:24:25

of earnings have outperformed the rest of the world

00:20:24:25 - 00:20:28:06

for reasons that we can all talk about and understand.

00:20:28:06 - 00:20:30:10

But there's also been a significant re-rating

00:20:30:10 - 00:20:34:00

of US assets versus non-US assets.

00:20:34:00 - 00:20:36:15

And that's why we think there's an opportunity

00:20:36:15 - 00:20:37:29

in Europe right now because

00:20:39:02 - 00:20:40:17

there are whole swaths of companies

00:20:40:17 - 00:20:44:06

that you can buy that are intrinsically very undervalued,

00:20:44:06 - 00:20:46:22

and that's a good environment

00:20:48:09 - 00:20:49:27

when an asset class is out of favour

00:20:49:27 - 00:20:51:23

and valuations are cheap.

00:20:51:23 - 00:20:54:20

- Yeah, well, agreed.

00:20:54:20 - 00:20:57:00

Well thank you very much for today.

00:20:57:00 - 00:21:00:02

On that note, I think it's time to wrap this up,

00:21:00:02 - 00:21:03:00

but thank you very much again for joining us today.

00:21:03:00 - 00:21:04:06

If you have any questions,

00:21:04:06 - 00:21:05:08

please don't hesitate

00:21:05:08 - 00:21:08:06

to contact your sales contact at Invesco

00:21:08:06 - 00:21:11:15

or come directly to us on the European Equity Desk.

00:21:11:15 - 00:21:13:17

Thank you very much.

- Thank you.

00:21:13:17 - 00:21:16:04

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