‘Reminiscences on a decade as a Euro Stock Operator’

Exactly a decade ago, I began managing a European equity fund. My core belief has always been to look for stocks with superior earnings momentum: that is to identify and invest in stocks that I thought could earn higher profits than the market was anticipating and at the same time avoid those that would be unable to deliver their forecast profitability. Although over the last ten years I made numerous mistakes, learnt lessons and refined my process, sticking to this simple strategy has allowed me to outperform in eight calendar years, delivering a compound return of 228% vs. the (Europe ex UK) sector average of 111%¹. It now seems appropriate to share some thoughts on the past decade as a European “stock operator”.

Although core beliefs should not change, good investment processes evolve. As I became more experienced it became clear that a purely “bottom up” earnings momentum strategy worked so long as the future was similar to the recent past. The strategy would struggle at macro-economic inflection points when corporate profits could either collapse or conversely rebound at a rapid rate. I resolved that in order to identify stocks with superior earnings momentum to the market from the “bottom up” it is also necessary to have a “top down” view as to what earnings momentum for the overall market might look like. This is why I believe it is necessary to always combine “stock-picking” with a “macro” view of the world. In order to beat the market, some idea of what the market might deliver is fundamental.

Europe has not been a particularly glamorous market in which to operate over the past decade; being considered a “low growth” economy rather than the home of some of the world’s best companies often trading at discount valuations as a result of their European domicile. This is not to say that economic growth rates have been unimportant: the most important input into any “macro” view has been the likely change in – rather than the overall level of – economic growth. When in 2008, profits collapsed as European GDP growth fell from +3% to -5%², dull stocks that could still hit predicted earnings were from a relative perspective as valuable as gold dust. Conversely, in 2009, as our “macro” analysis suggested a “V-shaped”³ economic recovery (subsequently confirmed as -5% to +2% GDP growth)² we were positioned in cyclical businesses most likely to reap the benefits of the rebound in economic growth. This was a “once in a decade”⁴ opportunity to buy stocks and probably the most fun I ever had (to date) investing.

But more recently it has been easy to mistake economic cyclicality with the new “mid-cycle” whereby economic growth in Europe oscillates between -0.5% and 1.5%⁵ and global growth is structurally lower than in the last economic cycle. In such an environment it will be difficult for corporate profits to see meaningful progress on an aggregate basis. Contrast this with the massive bull market in corporate profits seen 2003-2007. But those were the days of an abundance of global economic growth and cheap and widely available debt which not only lubricated economic growth but could be used to artificially boost returns on equity. Today those companies able to deliver meaningful profit growth are superior companies with better products, lower costs, superior scale, and preferential access to capital⁶. Their management will leverage these competitive advantages to increase market share and eat their competitor’s lunch. In any stock-market market cycle where competitive advantage is the defining theme, it is axiomatic that market leadership can only be limited to a narrow universe of stocks.

I have recently been asked for my best and worst investments over the decade. It is always much easier to remember successful investments: steel-tube company Vallourec (2005-2006), German TV station Prosieben (2009-2011), Irish cardboard box outfit Smurfit Kappa (2009-2010) and German chip maker Infineon (2009-2011) were all spectacularly successful investments. But my most memorable investment was made at the end of 2003 in Frontline, which owned a fleet of large oil tankers, run by Norwegian entrepreneur John Fredriksen. For many years ownership of an oil tanker had been more of a liability than an asset. Orders for new-builds were negligible. At the same time single-hull vessels – around one third of the global fleet - were being phased out on environmental grounds. Suddenly, Chinese demand for crude oil rapidly accelerated and with it demand for tankers to carry oil from the Middle East to Asia. Ship-owners like Frontline suddenly had significant pricing power and went from making no money to indecently high profitability. We made three times our original stake back in dividends alone in addition to two and a half times our stake in capital appreciation in just a couple of years before selling the shares.  Since then I have always followed Mr Fredriksen’s companies very closely.

My worst investment is still painful to recollect. In 2010 we invested in a Scandinavian gold producer, Nordic Mines. For over a year the stock performed well on the back of a buoyant gold price and increasing estimates of reserves. It all started to go wrong at the beginning of 2012 when the gold actually had to be taken out of the ground. It slowly dawned on us that the company seemed lacking in mining expertise. It was then revealed that the company had promised to pay back all of the debt used to finance the project in an impossibly tight timeframe. Every time the company raised additional equity to more securely finance the mine expansion, the cash subsequently disappeared from the balance sheet at an alarming rate.  By the time we sold our last share we had lost 75% of our initial investment. We learnt a number of lessons: never assume that management has expertise in their chosen industry; never assume that management insider buying of their own shares is a fool-proof signal of confidence; never assume that visiting a mine (twice) serves any useful purpose, and finally never invest in gold stocks. The stock has subsequently gone down another 80% since we sold. I have since been reminded me of Mark Twain’s quote that “A gold mine is a hole in the ground with a liar on top”. 

Any student of stock market history should be acutely aware that bull markets rarely repeat: every new market cycle has a different seductive narrative. When I began my career in the late 1990s it was the Technology boom. When the NASDAQ peaked in 2000 capital fled from US dollar assets into Emerging Markets funding China’s rapid industrialisation. This in turn accelerated demand for commodities and resulted in supernormal profits for commodity producers. We have long been sceptical that the new global economic cycle which began in 2009 would be a re-run of the previous Chinese Industrialisation cycle narrative⁷. It now seems likely that economic leadership for this cycle has moved away from EM with the US reasserting global economic hegemony through a renaissance in particular in its housing and energy sectors. This is likely to mean a structurally stronger US dollar, particularly when the main alternative, the Euro, has further work to do to convince markets of its durability. Figure 1 below shows our view of how this stock-market cycle likely compares to the previous cycle.

Figure 1.  Two very different stock-market cycles (2000-2008 and 2009-2017?)

But the leitmotif of this new market cycle is likely to be “nifty fifty”⁸. The best argument for equities is the absence of value in any other asset class whilst interest rates remain close to zero. The best argument for European equities is world-class companies at knock-down European valuations. The best argument within European equities is for companies that can still grow profits when there is little aggregate profit growth. I fully expect better companies to not only deliver superior profit growth but to also re-rate as investors recognise that in this cycle it is low-risk companies that have the best growth opportunities. Investors will come to recognise that it is abnormal that all stocks should trade on the same P/E ratio regardless of the quality of their business model or strength of their balance sheet, particularly in a low growth environment in which capital remains difficult to access. Higher P/E’s for lower risk and higher growth equities can be justified as long as there is no risk free return available in other asset classes⁹. This narrative is today too easily dismissed as too boring and consensual without any suggestion at a credible alternative.

A word on risk: the risk of underperforming a benchmark and of the risk of losing money. My returns have tended to be accompanied by above average tracking error but below average standard deviation¹⁰: in other words high relative risk but relatively low absolute risk. This is in part a reflection of a stubborn refusal to invest in significant areas of the market in which I have no belief (such as Banks and Southern Europe today) just to bring down benchmark risk. I also view the worst sin of all in running a fund is underperforming a falling market given the faith individual investors have placed in me to look after their hard earned savings. Nevertheless, inevitable inconsistency of performance of any fund which is meaningfully different to the benchmark means that successful investment is as much a test of character as a test of intellect.  Finally, I have only ever run funds which I have personally launched: in my ten years of running money I have been thankful for the support I have received from my investors despite the unpopularity of my asset class and the lumpiness of my returns. Here’s to the next decade and the new opportunities it will bring….

Barry Norris
Founding Partner & Fund Manager
4th December 2012