Fidelity fund manager Sam Morse has said he thinks his portfolios could hold up better than people expect if inflation takes hold across western economies, a spectre that has increasingly exercised markets so far this year.
His £2.9bn Fidelity European fund and £1.1bn Fidelity European (FEV) investment trust focus on ‘steady Eddie’ companies that he believes can grow their dividends each year, as a route to constructing a portfolio which will outperform the wider market over time.
Investing in those kind of predictable businesses means the Citywire A-rated manager’s funds were relatively resilient as the coronavirus pandemic took hold last year, but conversely have caught less of the updraft in the wider rally after November’s string of vaccine breakthroughs.
The open-ended fund delivered a 9.1% return during 2020, ahead of 7.5% for the MSCI Europe ex UK index, according to the latest factsheet. That masks a more sluggish final quarter as the index rallied 9% from the beginning of October, while the fund eked out 4.9%.
The portfolios are heavy on consumer staple companies, such as Nestlé, a 6.8% position in the fund and top holding at the end of January, which operate somewhat outside the bust and boom of the economy.
Some also worry that such ‘bond proxies’ – companies that generate fairly predictable and growing returns over time – will be hit in a climate of rising prices. The holding was one of the biggest detractors from performance in the latter half of last year.
Yields in the bond market, which move inversely to prices, have moved markedly higher on the same concern this year, with the 10-year Treasury yield breaking through 1.4% this week for the first time since last February.
Nestlé was the top holding in Morse’s European fund at the end of January
‘I fancy my chances’
Morse downplayed the idea we were about to see a return to rampant and sustained inflation.
‘I’m sceptical, I have to say. Fundamentally, I think some of the big causes of disinflation over the last few years are still with us,’ he said. He pointed to factors like technological innovation and globalisation, whose reversal has probably been halted with Joe Biden in the White House.
A short-term bout of rising prices looks likely, however, as oil and other commodities strengthen and pent-up demand is unleashed.
Morse, at the helm of the open-ended fund since 2009 and celebrating a decade on FEV, also emphasised the distinction between inflation expectations and inflation itself. He acknowledged the former would certainly hit the portfolio, as the market discounts the value of projected future cash flows.
However, if prices really do start to rise for real, the manager argued the outcome would be benign for the likes of Nestlé. The Swiss company’s suite of strong brands means it can raise prices if its own costs start to rise.
‘When we actually get into the stage of inflation, those sorts of companies actually do quite well, because they have pricing power. And it’s the companies that don’t have pricing power that start to suffer, because their margins get squeezed,’ he said.
‘You get that knee-jerk valuation impact which is certainly going to hurt my portfolio in the short term. But when that second stage starts to come through, I slightly fancy my chances to be frank,’ he added.
Pragmatic on dividends
While not an income fund, Morse said dividend growth was his ‘guiding light’ when running the fund. However, conditions last year meant he had to take a more ‘pragmatic’ stance about companies which cut or suspended payouts.
Fielmann, which accounts for about half of the spectacles market in Germany, and French hospitality company Sodexo both suspended dividends but maintained their places in the fund.
Companies in France, accounting for more than a quarter of the portfolio, came under particular political pressure on dividends. LVMH, a 4.7% position, was a notable holding to cut. The managers reduced the position last year amid strong share price performance.
Morse explained that, unusually, the yield on the underlying portfolio at the end of 2020 had risen to 2.4%, just below the wider market. Underlying dividend growth would now likely lag in the short term as the types of recovery plays they largely eschew aggressively bring back payouts. That could be a short-term headwind for the manager.
Not all about growth
However, Morse added that there were also plenty of higher-yielding ‘value’ names in both the fund and trust, with his relatively ‘benchmark-aware’ strategy always maintaining some exposure to those kinds of sectors.
French oil company Total is a top-10 holding, as is Italian utility Enel. Spain’s Red Electrica is a very high-yielder in the same sector while they also own Telenor, the Norwegian telecoms company.
More than the growth tilt, the holding in SAP was the biggest detractor in the last year’s final quarter. The German software company, a 3.6% position at the end of last month, issued a profit warning in October which sent its shares spiralling.
Prosus, which holds Nasper’s international internet assets, was a new buy in 2020’s second half. Positions he topped up included French industrial group Legrand and Swiss insurer Zurich. Austrian engineer Andritz was sold while the holding in 3i (III), the UK private equity firm which owns Dutch discount retailer Action, was trimmed after strong performance.
New co-manager, higher gearing
Marcel Stötzel formally joined the team as co-portfolio manager of the trust and fund from September. However, 58-year-old Morse said he plans to work until he is at least 65.
The trust also dropped ‘Values’ from its name last year, with Morse joking that they did not want people to think it would outperform in a rally for the style.
In the five years to the end of January, the fund delivered an 82% return versus a 63% in the index.
In the five years to 24 February, the trust’s shareholders enjoyed a 95% total return, while its index notched up 67% over that time.
The trust’s net gearing was also raised to 10% at the end of January. Such borrowing amplifies returns when markets rise as well as losses in falling markets. Morse said the move was not about market timing, but a change of policy, moving to structurally higher gearing between 10% and 15% to accentuate long-term gains.
‘We’re slightly throwing away the steering wheel and saying this is the level that we’ll be at come hell or high water and we’re going to stick to it,’ he said. ‘I always regret that we stuck at 6% in the last cycle, with the benefit of hindsight.’