For European equity fund managers, the UK has been the worst performing country year to date, though that has largely been driven by currency translation. The pound has tumbled against the euro by more than 15% in 2016. But in pound terms, the Morningstar UK Index has returned a hefty 13.5% in 2016.
Most top-rated funds in the Europe large-cap equity categories were somewhat underweight the UK. The average exposure to UK stocks was 25% compared with 27% in the Morningstar Europe Index. Therefore, the allocation effect was muted for many funds. That said, most managers were caught off guard by Britain’s vote to leave the European Union, and stock selection had a more pronounced impact, especially for those funds that were short commodity-driven names and favoured domestic-oriented UK stocks.
Bronze-rated T. Rowe Price European Equity was negatively affected by poor performance among holdings such as Capita, Howdens Joinery, and William Hill, while Berkeley, Great Portland Estates, and Lloyds Banking Group were among the largest negative detractors from performance for Silver-rated BGF European Special Situations.
Although they have a relatively small weighting in the Morningstar Europe Index, less than 5%, Italian stocks made their presence felt in an unfortunate way, losing around 20% year to date. This made them the third-biggest detractor from the index's returns, behind the UK and Switzerland. Above-average allocations to Italian stocks weighed on the performance of Silver-rated Allianz Euroland Equity Growth and Metropole Selection as well as Bronze-rated funds Argo Pan European Alpha.
The Power of the Economic Moat
The concept of the economic moat is one of the cornerstones of Morningstar’s equity research methodology. It is defined as a structural feature that allows a firm to sustain excess profits over a long period of time, that is, earn returns on invested capital over and above the analysts’ estimate of a firm’s cost of capital, and it plays a crucial role in the qualitative assessment of a firm’s long-term investment potential and fair value estimates.
Morningstar analysts assign economic moat ratings of either wide, narrow, or none, where companies with wide economic moats possess the strongest possible competitive advantages. When looking at performance across moat buckets within the Morningstar Europe NR EUR Index, narrow-moat stocks held up better than wide-moat stocks in 2016 so far, but no-moat stocks performed best. If we take into account the quantitative moat, which is assigned to a larger universe using a statistical model derived from the Morningstar Economic Moat Ratings that our equity analysts assign to companies, we can reach a similar conclusion.
An above-average share of wide- and narrow-moat companies has been a hallmark of funds with a strong quality bent, such as Bronze-rated Threadneedle European Select, and Bronze-rated Allianz Europe Equity Growth Select, all of which have generated excellent risk-adjusted results over the long-term. In view of the rotation toward cyclical sectors, exposure to moaty stocks has provided less of a tailwind in 2016, but it's worth noting that wide-moat stocks have generally held up much better in the first half of the year when market volatility spiked.
