Fund positioned for long-term recovery in European banks, home builders and energy stocks.
PM Capital’s investment style is to buy companies at bottom-quartile valuations and sell at top-quartile valuations. Our high-conviction, patient approach seeks stocks that offer deep value.
No market during COVID-19 better suited our style than Europe. As the Eurozone suffered recession, and European stockmarkets underperformed those in the United States, outstanding value emerged. We saw a once-in-a-decade opportunity in some European stocks.
To be clear, PM Capital focuses on company valuations in a long-term context. We do not invest based on geographic markets, trends or themes. But as we looked worldwide for deep-value opportunities before and during COVID-19, European stocks appealed.
That was no surprise. Unlike US sharemarkets, European markets are more of a value than growth play. European indices tend to have higher weighting in banks and energy – sectors that currently appeal to value investors – and relatively less exposure to tech and other growth sectors.
PM Capital expected a multi-decade rotation from growth to value stocks to start in FY2021. The rotation quickened when Pfizer announced its successful vaccine trial in November 2020. Although growth stocks will periodically be back in favour during FY22, we believe a long-term rotation from growth to value stocks has just begun and will take years to play out.
This rotation strengthened the case to invest in deep-value plays in Europe. It also reinforced why investors should be wary of overvalued US technology stocks.
At end-June 2021, 37% of the PM Capital Global Companies Fund was invested in companies listed on European exchanges, just behind our North American listings at 40.2%.1 A year earlier, 29.2% of the Fund was invested in European stocks, with 54% in North American stocks.2
Europe-focused banks are now one of the Fund’s largest positions. Key holdings include Lloyds Banking Group Plc, Bank of Ireland and ING Groep NV.
In FY2021, European banks appealed on two fronts. First, we believed the European banking sector was at least 12 months behind the recovery in US bank stocks.
Tighter regulation was a key difference between those markets. In December 2020, the European Central Bank (ECB) called on banks to refrain from, or limit, dividends until September 2021.3 The ECB also called on European banks not to conduct, or to limit, share buybacks. The ECB recommendation aimed to safeguard the banks’ capacity to absorb losses and support the Eurozone economy during COVID-19.
This regulation added to the second reason we favoured European banks: valuation. The market was paying much higher valuations for US and Australian banks that were less hamstrung by regulation. European banks had become badly oversold.
In early 2021, European banks sold at 0.5x their book value, on average. By contrast, United States banks sold at 1x book value. In Australia, the Commonwealth Bank sold at 2x book value. We saw that as an opportunity to arbitrage value between global banks.
PM Capital expected European banks to recover to at least 1x book value and for a substantial dividend recovery to begin this year as ECB restrictions were lifted. In early 2021, we outlined our expectation for high single-digit yields from European banks in FY22.4
In July 2021, the ECB said its dividend recommendation would expire on September 30, 2021.5 That has paved the way for European banks to declare dividends in the fourth quarter of 2021 and for prudent share buybacks in the sector to resume.
ING’s latest quarterly profit result6 reaffirmed PM Capital’s expectation on European bank dividends. In August, ING reported a better-than-expected quarterly profit of €2.07 billion and reversed some provisions for bad loans it expected during the pandemic.
ING said it intends to distribute a dividend-per-share of €0.48 in October that will cover both the 2020 and 2021 interim dividends. In addition, it will distribute €1.74 billion that was reserved over 2019, either through dividends or share buybacks.
At its current price, ING is trading on a double-digit forward dividend yield.
PM Capital expects the removal of COVID-19 restrictions on dividends and buybacks to start a process of re-rating in European banks that could take years to play out.
As European bank yields rise over the next few years - and look even more attractive compared to a near-zero or negative rates in Europe - more investors will likely buy bank stocks, driving valuations higher. As we wait for this recovery, attractive yields from European banks stocks will support the total return.
European home builders
PM Capital increased its position in Irish and Spanish home-building companies in FY21. Like the banks, European home builders will benefit from economic recovery in the region in FY22.
Also like the banks, European home builders have lagged US home builders. Record-low interest rates in the US have driven home prices well beyond peak level before the 2008-09 GFC and encouraged a recovery in home-building activity in that market.
By contrast, housing construction in Europe is at historically low levels. In Ireland and Spain, new home sales remain around 70% below peak 2007 level. New housing in Europe is in chronic undersupply, but that will change as European economic growth recovers.
PM Capital believes select European home-building stocks could have a long runway of growth as the region plays catch-up on years of underinvestment in home building. Like the banks, European home builders are well positioned to pay higher dividends as their earnings rise.
European energy stocks
Royal Dutch Shell is a key European energy holding in the PM Capital Global Companies Fund. Although oil is a commodity in structural oversupply, we believe the global oil industry is spending well below what is required to expand oil production. That could lead to a squeeze in the oil price in coming years, and control of oil markets returning to OPEC.
On valuations, Royal Dutch Shell has similarities with European banks and home builders. It, too, badly lags valuations in comparable US oil producers. In July 2021, Royal Dutch Shell sold at 8x current forward oil prices – or half what its peers in the US sell for.
Like other European stocks in the Fund, we expect Royal Dutch Shell to re-rate closer to its US peers as its dividends increase and buybacks return its strong cashflow to shareholders.
Furthermore in July, Royal Dutch Shell increased its second-quarter 2021 interim dividend by 38% to US24 cents and launched a US$2 billion share buyback program that it expects to complete by year’s end. The size of the dividend increase surpassed market expectation.7
Valuations for select European banks, home builders and energy stocks were unusually depressed when PM Capital added to its position in them in FY21.
We believed the recovery in these sectors was at least a year behind that in the United States. As European economies strengthened, earnings and dividends from the Fund’s key European stock holdings would increase and, in time, lead to a re-rating in valuations.
However, no recovery occurs in a straight line. European banking regulation remains a significant risk, as does COVID-19 and its effect of delaying a home-building recovery in the region. Oil-price uncertainty as the world focuses on lowering carbon emissions is another challenge.
Patience is key. PM Capital believes investment cycles can take 7-10 years to play out. Having invested through several market crises over the past three decades, we understand the value of genuine long-term investing. And the power of receiving attractive, rising dividends from undervalued companies, as a re-rating in their valuation slowly unfolds.
1 PM Capital Global Companies Fund. ‘Monthly Update’, 30 June 2021.
2 PM Capital Global Companies Fund. ‘Monthly Update’, 30 June 2020.
3 European Central Bank, December 2020. ‘ECB asks banks to refrain from or limit dividends until September 2021,’ Press Release.
4 PM Capital Insights. ‘Global Investment Themes – Domestic Banks,’ 15 February 2021.
5 European Central Bank, July 2021. ‘ECB decides not to extend dividend recommendation beyond September 2021.’
6 ING. Aug 2021. ‘ING posts 2Q2021 net result of €1.459 billion.’ Press Release.
7 Reuters, “Shell boosts dividend and launches buyback as profit soars,’ July 30, 2021.