More Brexit-style referendums loom in Europe, RBC manager says

Amid volatility, Dominic Wallington is focusing on companies with low valuation or high dividends.

Michael Ryval 14 July, 2016 | 5:00PM
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The political fallout from the United Kingdom's decision to leave the European Union as a result of the so-called "Brexit" referendum is casting a pall primarily on continental members of the EU, as the potential for another member country holding a referendum hangs in the air, says Dominic Wallington, manager of the $5.7-billion RBC European Equity and chief investment officer of London-based RBC Global Asset Management (UK) Ltd.

Nevertheless, even as continuing uncertainty means that markets promise to be volatile, Wallington is staying the course and focusing on companies that either are cheap on a valuation basis or pay high dividends.

Curiously, while the FTSE 100 Index -- the benchmark for UK stocks -- is up about 4% year-to-date, the Frankfurt DAX Index is down almost 10%. And much of that is due to the fall of the pound sterling against a basket of currencies, which has improved the competitiveness of international firms based in the UK, says Wallington. "The reason why the FTSE 100 has performed as it has is because of the predominance of international companies."

More importantly, investors are expressing concerns about weakness in continental economies and anticipating higher levels of political risk. "One of the major partners in the single market is leaving. Investors are raising questions about the possibility of this sort of event occurring again," says Wallington, a 25-year industry veteran who joined RBCGAM in 2007. "That's something investors need to factor in."

Wallington argues that the European Commission is now under greater pressure to reform than ever before. "If it did so that would obviously be a good thing."

One positive aspect to the referendum is that it has pushed valuations down considerably. Looking at the long-term trend for price-to-earnings ratios, Wallington says: "Europe has never been so cheap relative to the U.S. It's trading at a 36% discount against a long-term average of 10%."

Wallington attributes part of the widening discount to companies deferring expansion plans. "It may be due to less development from a European perspective. Or it could be a generalized concern that another country in a similar situation to the UK may call a referendum. It's a longer-term theme. For the first time, there is a consideration that there are risks to certain aspects of the Eurozone," says Wallington. "It's plausible that Europe should have a higher risk premium. But that's being delivered in the valuation metrics we described."

Uncertainty is at a high level since it may not be until the spring or summer of 2017 that Britain will start the process of exiting the EU. Meanwhile, the UK has a new Prime Minister who will likely call an election in the fall, which adds to the uncertainty. "But the market is not interested in the political intrigue. It's showing quite clearly that international companies will do well as a consequence of the weakness of [the pound] sterling. I'm broadly in agreement with that," says Wallington, adding that he had concerns about the merits of calling a referendum. "When I look at the big international companies that we have exposure to in the UK, I'm still pretty relaxed."

A bottom-up investor, Wallington owns about 50 companies, which tend to fit within two broad themes. First, Wallington argues that the best quality European companies are cheaper than comparable ones in the United States and tend to have higher returns on invested capital. Second, European firms with low so-called "capital intensity" have better free cash flow generation. "In a region that has a dividend culture this means they can grow their dividends more quickly than firms that require a lot of capital to operate and grow."

In the first category, Wallington cites  Unilever NV (UN), a global leader in food and personal care products that has high market shares in countries with large populations such as India. "They make everything from ice cream to Dove soap to Knorr soup," says Wallington. "There is some European exposure, but the bulk of their revenue comes from outside Europe. And based on their cash flow return on assets, it's a 20% return business."

While some market pundits have said that Unilever is a boring company and categorized it as a bond proxy, Wallington disagrees. "That's a category error. On a five-year basis, the average annual increase in dividends has been about 8%. Bonds cannot increase their income streams," says Wallington, adding that the stock currently pays a 3% dividend. Unilever is trading at about 24 times trailing earnings, versus 27 times for  Procter & Gamble Co. (PG).

In the second category, Wallington likes Swedbank AB (SWDBY), a dominant Swedish savings bank that has a significant mortgage business. "It's essentially a utility and has a very high Tier One ratio, over 16%. It generates returns in the mid-teens and it pays a 6.5% dividend yield," says Wallington. "Management is not interested in high levels of growth. It's much more interested in making good underwriting decisions."

The 5-star-rated Series D version of the fund returned -3.1% for the 12 months ended June 30, versus -8.3% for the benchmark MSCI Europe (C$). Over the trailing three and five years, it returned an annualized 11.3% and 10.2%, respectively, compared to 9.6% and 7.8% for the benchmark.

Wallington admits that it's been a challenging period and will likely continue to be so. "I can't say what will happen. The only thing I can say is that a lot of our companies have been around for many years. We like firms such as  Novo Nordisk A/S (NVO), which was established in 1923," says Wallington, noting that the Danish pharmaceutical firm has emerged as a leading provider of diabetes medications. "Even though I'm not able to gauge what the future holds, our investments are in the best hands."

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Michael Ryval

Michael Ryval  Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

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