amLeague Portfolio Managers ViewPoint - Euro Equities Mandate - January 2014

amLeague is pleased to present you the new edition of its monthly amLeague Portfolio Managers Viewpoint.

This month, 3 Portfolio managers on amLeague Euro Equities Mandate were chosen to give their thoughts and comments on their portfolio choices and results.

Value is back. After several years of macro-driven, risk-on, risk-off trading patterns, with investors generally preferring stocks seen as safe, 2013 saw investors return to fundamentals. Many under-valued stocks with strong underlying business trends, but often somewhat elevated idiosyncratic or cyclical risk, came back into favour, with strong earnings driving strong investor returns.

Take Valeo for example. Investors had been concerned about its exposure to the European auto sector. But strong earnings momentum, driven by its success in increasing share and content per vehicle, as our research had predicted, ensured excellent stock price performance through the year. Or Société Générale, where reduced concerns about the future of the euro freed investors to reward good performance across the range of its businesses.

How does our research establish conviction in such names? We use a broad range of quantitative metrics, for example capturing aspects of management behaviour and earnings quality as well as valuation, to identify potential opportunities. Our company analysts then investigate potential candidate companies in detail, making sure that they have fully understood the controversies around the stock and applying their knowledge of dynamics in the industry and analysis of company dynamics to build detailed long-term earnings forecasts. We buy only those names where we have high conviction in the return potential that comes from buying those earnings at attractive valuations in the market today, adjusting position sizes according to the degree of risk we see to those earnings. We are happy to have very large deviations from the benchmark, for example very limited exposure to Spain today, where that is where our fundamental company research takes us, but keeping an eye on potentially dangerous industry or country concentrations.

We continue to find a rich seam of under-valued opportunities within the eurozone. The risk aversion of recent years has produced unusually wide stock price disparities in Europe, for example between more stable, lower beta, and more cyclically exposed, higher beta stocks. Our research has identified two big groups of stocks with the attractive valuations and high return potential to take advantage of these conditions:

• High quality names with relatively little exposure to the eurozone, but whose share prices have been driven down by generalised concerns about the region. This group includes many manufacturing companies with strong franchises and good long-term growth. Airbus, Volkswagen and Michelin are all good examples.
• Stocks with more domestic exposure that will do well as the eurozone finally emerges from recession. This group includes banking holdings such as KBC and Unicredit, as well as companies positively exposed to a recovery in business spending, such as Cap Gemini and Arkema.

With valuation spreads still unusually wide, and the portfolio trading at a deep discount to the broader market, we expect our approach to continue to generate excellent returns for a prolonged period.

Being pioneers in dividend investing, ING Investment Management has been managing dividend based products since April 1999. With more than EUR 8bn under management as at 31/12/2013, the Equity Value Boutique’s approach is typified by selecting undervalued stocks with sustainable dividends, below-market volatility in a disciplined and systematic way.

Investment approach
Our investment philosophy is based on the importance of dividends in the total equity return; dividend yield and dividend growth represent the majority of total equity return over the long-run. Moreover, dividend yield is always a positive source of returns, dividends are less volatile than earnings and dividends are a good signal for a company’s future. We designed our investment process to exploit these characteristics of dividends in a systematic and contrarian way.

Risk management
We strive for a portfolio with a high active share, but with a relatively low volatility. The high active share target - at least above 60% - means the share of portfolio holdings that differ from the benchmark weightings is relatively large. At the same time, by focusing on dividend paying stocks, we can lower the overall volatility of the portfolio and offer an attractive risk-return profile to our clients.

Current portfolio positioning
We expect the rotation from quality growth towards value to continue in Europe as bond yields rise while good quality growth companies still trade at a valuation premium relative to value stocks following five years of significant rerating.

Cheap valuations in Europe combined with a mild recovery next year support our pro-value, pro-financials and pro-cyclical positioning in European equities for 2014.

The portfolio investment process is built on two pillars:

1. Stock selection based on fundamental and momentum criteria
2. Portfolio construction based on risk control with both Risk parity methodology focused on sector allocation and risk controlling within those sectors.

As portfolio management is driven by risk management techniques such as Risk Parity on sectors, we should expect a portfolio behaviour showing a better resistance than the underlying equity index Eurostoxx in case of drawdowns or volatility increase.

Since inception 31.03.2011, we get the following numbers:

These spreadsheets clearly show that our portfolio construction methodology based on risk management techniques and our systematic exposure to well-identified risk premia are delivering according to expectations: less drawdowns, less realized volatility, a lower beta without compromising with performance than the index.

In 2013, our sector rotation process has been intensive especially after the drawdowns the equity markets experienced in May and June. Consumer Discretionary sector (automobiles, durable goods, client services, media, distribution) weight was increased substantially similar to industrials (equipment, business services, transports) whereas weights on consumer staples, energy and health care have been largely reduced compared to benchmark.

Sector weights as of 31.12.2013: