This article is part of Morningstar's special report on What the Experts Say
Over the years, there have been plenty of reasons for global investors to not invest in Europe. In this current environment, that is still very much the case.
There’s political unrest across the Continent. Italy is in recession, with Germany teetering on the brink, too. The automobile sector, one of Europe’s most important, is weakening. And that’s without even mentioning Brexit.
So, there are a plethora of top-down reasons why it would be easy for many to let Europe pass them by. So, what are the positives? “The only thing you can really hang your hat on in terms of Europe is that valuations are not expensive,” David Dudding, manager of the Bronze-rated Threadneedle European Select fund told delegates at the Morningstar Investment Conference 2019.
That’s not it, though. Europe tends to respond well when economies across the world are growing, particularly those in the emerging world and China more specifically. That’s because, as we’ve explored recently, many European companies have big presences in emerging countries.
And if you look hard enough, Dudding explains, you can find plenty of world-class businesses that are global leaders in their field. Alcoholic drinks maker Pernod Ricard (RI), for instance, derives more revenues from the US, India and China than it does its home market of France.
“European companies have benefited a lot from globalisation and there are certain areas, drinks being one of them, where European companies really lead the world,” says Dudding.
Dudding looks for companies with higher returns on capital than the average, with strong growth that can be sustainably funded by the company itself. Many of these have a competitive advantage, making it difficult for new entrants to disrupt their market position.
He ranks companies using the five attributes Morningstar has identified that can give companies an economic moat. “It’s the best definition [of competitive advantage] that we’ve come across,” he says.
At MICUK, Dudding took each five attribute in turn and gave an example of a portfolio company that meets the requirement.
Intangible Assets: Pernod Ricard
Pernod’s competitive advantage, explains Dudding, is its brands. Jameson makes it the leader in the Irish whiskey thanks to its huge success in the States, while Absolut vodka, Beefeater gin and its eponymous Pernod and Ricard aperitifs are hugely popular, too.
The main threat to the business at the moment is the spawning of lots of craft distillers, particularly in the Irish whiskey industry. “But the rest of the industry looks pretty good,” says Dudding.
“Spirits is an industry that in the US is still growing at about 4% a year and much faster than that in emerging markets. Pernod has a stable of great brands and traditionally has managed them very well for long periods of time.”
Cost Advantage: Ryanair (RYA)
Ryanair is not a typical company with a cost advantage, in the sense that it does not have pricing power. Low-cost airlines are currently in a race to the bottom on flights, meaning margins are continually being squeezed.
Its cost base is the main attraction here, which Dudding says is by far the lowest in the European aviation industry. “That means they more than cover their cost of capital each and every year through the cycle. That is virtually unparalleled in the world of aviation.”
That said, its cost base is now rising. A recent dispute with trade unions has seen the salaries of its pilots and cabin crews increase. Elsewhere, now its planes are starting to fly to larger airports, the deals they get are less good than those they received from the smaller airports that are dependent on Ryanair as a source of traffic.
But Dudding is confident its cost advantage will continue for the foreseeable future.
Efficient Scale: Fresenius Medical (FME)
German firm Fresenius develops and manufactures kidney dialysis machines, systems and disposable products. Despite operating in what is a highly regulated industry, it and US-based rival DaVita have a duopoly.
It’s a growing area due to ageing and increasingly unhealthy populations, says Dudding, with the US a large market. The pair has “basically divided up the market of clinics between them”, so it’s very hard for new entrants to break into the sector.
Switching Costs: Relx (REL)
UK conglomerate Relx is the poster child for quality growth companies with strong balance sheets, says Dudding. It grows the top-line at around 3-4% every single year, with margins improving year on year and lots of cash being generated. That allows it to buy back stock and pay a decent dividend on top.
It is a prime beneficiary of the switching cost attribute because businesses become so reliant on its products, it becomes hard to change supplier. That’s particularly true with regards to its LexisNexis legal business, where there are only a couple of competitors and once people have been trained to use Relx’s systems, it’s very difficult to switch.
Network Effect: Dassault Systemes (DSY)
Dudding thinks the network effect is the best attribute any company can have when it comes to a competitive advantage. It’s most prevalent in technology platform businesses like the social media and e-commerce giants, which tend to be based in the US or China.
It’s hard to find in Europe, therefore. However, there are some and French 3D designer Dassault is “a rare European technology winner”.
Its product lifecycle management software is used in a wide range of industries including finance and aerospace and defence as well as transport, energy and construction.
It’s now increasingly moving into more exciting areas, adds Dudding, like simulation. “That really does benefit from the network effect through enabling product engineers, for example, to work together across many different geographies.”
