Annual Report and Financial Statements 31 August 2022
Performance record
| As at 31 August 2022 | As at 31 August 2021 | ||
| Net assets (£000)1 | 483,799 | 651,731 | |
| Net asset value per ordinary share (pence) | 475.72 | 678.49 | |
| Ordinary share price (mid-market) (pence) | 456.00 | 692.00 | |
| (Discount)/premium to cum income net asset value2 | (4.1%) | 2.0% | |
| FTSE World Europe ex UK Index | 1654.61 | 1869.96 | |
| ======== | ======== |
| For the year ended 31 August 2022 | For the year ended 31 August 2021 | ||
| Performance (with dividends reinvested) | |||
| Net asset value per share2 | -29.2% | 49.4% | |
| Ordinary share price2 | -33.4% | 56.8% | |
| FTSE World Europe ex UK Index | -11.5% | 27.4% | |
| ======== | ======== |
| For the year ended 31 August 2022 | For the year ended 31 August 2021 | Change % | |
| Revenue | |||
| Net profit on ordinary activities after taxation (£000) | 7,728 | 3,595 | 115.0 |
| Revenue earnings per ordinary share (pence) | 7.65 | 4.13 | 85.2 |
| ————– | ————– | ————– | |
| Dividends (pence) | |||
| Interim dividend | 1.75 | 1.75 | – |
| Final dividend | 4.85 | 4.55 | 6.6 |
| ————– | ————– | ————– | |
| Total dividends paid/payable | 6.60 | 6.30 | 4.8 |
| ======== | ======== | ======== |
Sources: BlackRock and Datastream.
Performance with dividends reinvested in Sterling terms, rebased to 100 at 1 September 2012.
1 The change in net assets reflects proceeds from share issuance, payments for shares repurchased into treasury, market movements and dividends paid.
2 Alternative Performance Measures, see Glossary in the Annual Report and Financial Statements.
CHAIRMAN’S STATEMENT
INTRODUCTION
The past year has been quite an extraordinary one for world markets as a whole, largely as a result of the Russian invasion of Ukraine. This has had a very pronounced impact on energy and food prices and has driven the already ongoing rotation from growth stocks to value stocks. It has had a material adverse short-term impact on the value of our portfolio. However, the longer-term performance of our portfolio remains strong.
MARKET OVERVIEW
European markets have faced a challenging environment during the Company’s financial year, dominated by significant geo-political uncertainty and heightened market volatility. Following the COVID-19 pandemic, supply side bottlenecks and rising prices have been further stressed by the tragic and devastating events following Russia’s invasion of Ukraine. Food supplies and energy needs affected by the disruption have become key concerns. For Europe, the main issue is how to keep a steady supply of oil and gas and a cap on prices to sustain the region given that most European countries are net importers with much of the energy coming from Russia.
A long period of steady growth and low inflation appears to be over, as central banks continue to raise interest rates to contain inflation. High inflation is due to many different factors including the rising cost of food and high energy prices, surging household demand in response to the loose fiscal and monetary policies following COVID-19, as well as supply chain shortages due to the pandemic.
PERFORMANCE
In the year under review, the Company’s net asset value per share (NAV) decreased by 29.2%, significantly underperforming the FTSE World Europe ex UK Index (the reference index), which fell by 11.5%. Some of this underperformance was directly attributable to the write down of our holdings in Russian stocks which were 6.1% of the Company’s net assets as at 31 January 2022. The Company’s share price decreased by 33.4% over the same period (all percentages calculated in Sterling terms with dividends reinvested). The wide disparity versus the reference index return reflects the Portfolio Managers’ views of backing their convictions over the longer term, whilst seeing through short-term market turbulence. More details on the portfolio’s performance, its positioning and the significant contributors and detractors during the year are given in the Investment Manager’s Report below.
Since the financial year end and up to close of business on 31 October 2022, the Company’s NAV has decreased by 1.4% compared with a fall in the FTSE World Europe ex UK Index of 0.8% over the same period.
REVENUE EARNINGS AND DIVIDENDS
Your Company’s total revenues each year are a reflection of the dividends we receive from portfolio companies. The revenue return per share for the year ended 31 August 2022 amounted to 7.65p per share, which compares with 4.13p per share for the previous year, a rise of 85.2%. This is mainly due to a significant increase in special dividends received by the Company in the current period and the lower level of dividends received in the year to 31 August 2021, as the COVID-19 pandemic hit portfolio companies’ revenue streams.
In April, the Board declared an interim dividend of 1.75p per share (2021: 1.75p) and the Board is proposing the payment of a final dividend of 4.85p per share for the year (2021: 4.55p). This, together with the interim dividend, makes a total dividend for the year of 6.60p per share (2021: 6.30p), an increase of 4.8%. The dividend will be funded from revenue received in the year. Subject to shareholder approval, the dividend will be paid on 16 December 2022 to shareholders on the Company’s register on 18 November 2022, the ex-dividend date being 17 November 2022.
DISCOUNT/PREMIUM
The Directors recognise the importance to investors that the market price of the Company’s shares should not trade at a significant premium or discount to the underlying NAV. Accordingly, in normal market conditions, the Board may use the Company’s share buy back and share issue powers, or operate six monthly tender offers, to ensure that the share price does not go to an excessive discount or premium to the underlying NAV. Resolutions to renew the Company’s semi-annual tender offers and the authorities to issue and buy back shares will be put to shareholders at the forthcoming Annual General Meeting.
Over the year to 31 August 2022, the Company’s shares have traded at an average discount of 1.4% and within a range of an 8.8% discount to a 4.1% premium. The Company allotted 4,300,000 new ordinary shares and reissued 1,945,000 ordinary shares from treasury at an average premium over NAV of 2.0%, at an average price of 681.34p per share for a net consideration of £42,550,000. In addition, the Company purchased 601,558 ordinary shares at an average price of 467.45p per share and an average discount of 5.5% for a total cost of £2,812,000. Since the year end up to 3 November 2022, a further 698,692 ordinary shares have been bought back at an average price of 431.66p per share for a total cost of £3,016,000. All shares have been placed in treasury.
As reported in the Half Yearly Financial Report, the Directors exercised their discretion not to operate the half yearly tender offers in November 2021 and May 2022. It was also announced on 20 September 2022 that the Board had decided not to implement a semi-annual tender offer in November 2022. Over the six-month period to 31 August 2022, the average discount to NAV (cum income) was 4.5%. The Board therefore concluded that it was not in the interests of shareholders, as a whole, to implement the latest semi-annual tender offer.
SHAREHOLDER COMMUNICATION
We appreciate how important access to regular information is to our shareholders. To supplement our website, we offer shareholders the ability to sign up to the Trust Matters newsletter which includes information on the Company, as well as news, views and insights. Further information on how to sign up is included on the inside cover of the Annual Report and Financial Statements.
OUTLOOK
European equity markets have faced a confluence of challenging and rapidly evolving factors so far this year and global macroeconomic fundamentals continue to deteriorate, with the prospect of developed markets edging closer to recession. In Europe, inflation is being acutely felt as the Russia-Ukraine conflict has pushed gas prices to new highs, triggering a cost of living crisis. The tragic war in Ukraine is also likely to be protracted, with no immediate peaceful solution in sight, but we should not underestimate the strengthened unity in Europe in the face of Russia’s aggression.
Investors are contending with multiple headwinds in Europe. In light of the war in Ukraine, the situation in Russia remains unclear and our holdings in Russian stocks have been written down to a nominal value. Nonetheless, European equities continue to trade at a discount to global peers, providing attractive investment opportunities for our Portfolio Managers. The Company’s portfolio is also weighted towards companies with well capitalised balance sheets and exceptional businesses that are able to adapt to the shifting market dynamics.
MANAGEMENT FEES
Your Board has reviewed the level of fees paid to your Manager and considers these to be high relative to market levels. We have engaged with the Manager on this and discussions are currently taking place.
ANNUAL GENERAL MEETING (AGM)
The AGM of the Company will be held at 12 Throgmorton Avenue, London EC2N 2DL on Thursday, 8 December 2022 at 12 noon. Details of the business of the meeting are set out in the Notice of Annual General Meeting in the Annual Report and Financial Statements.
UK Government restrictions on public gatherings are no longer in force in connection with COVID-19 and we therefore intend to hold the AGM in the normal way with physical attendance by shareholders. However, shareholders should be aware that it is possible that restrictions could be reimposed prior to the date of the AGM. BlackRock requests that shareholders intending to attend should comply with their COVID-19 safety protocols before entering the venue. At the time of writing, visitors are not permitted in BlackRock’s offices if they have tested positive for COVID-19 in the past 10 days, are experiencing COVID-19 related symptoms, or are subject to government requirements for self-isolation or quarantine.
ERIC SANDERSON
Chairman
3 November 2022
INVESTMENT MANAGER’S REPORT
OVERVIEW
The Company’s performance was negative over the year as the share price decreased by 33.4% and the underlying NAV decreased by 29.2% in the twelve months to 31 August 2022. By way of comparison, the FTSE World Europe ex UK Index fell by 11.5% over the same period (all percentages calculated in Sterling terms with dividends reinvested).
The period under review, particularly from the start of 2022, turned out quite differently from what many market participants, including ourselves, had expected. Our market outlook for 2022 assumed gradual normalisation of growth in earnings post the strong recovery in 2020 and most of 2021 and with that an easing of supply chain disruptions and inflation numbers softening. European markets were instead hit by a perfect storm as the natural ebbing of the economy was compounded by continued COVID-19 restrictions in China, stubborn supply chain difficulties and the war in Ukraine inducing a new source of inflation into the global system.
Equity investors had to come to grips with a significant change in monetary policy. To put the scale of those changes in monetary policy into some context, we would point to the fact that as recently as June 2021 the Federal Reserve (the Fed) was not expected to move interest rates until the second half of 2024. At the time of writing, the Fed has aggressively raised rates five times with Fed fund rates now priced to finish 2022 at 4.4%, a move of historic dimensions in both pace and scale. The European Central Bank is following suit with the Euro area interest rate projected to trend around 3.5% in 2023 and 2.75% in 2024.
These factors led to a sharp market sell-off, with broad-based indices like the Euro Stoxx 600 down by 20% from January to the end of August 2022. Investors also had to contend with an extreme skew of return distributions within the market: of 20 industry groups, only energy posted positive returns over the period. In this environment, style characteristics have been a far more important component for the outcome of single stocks over the year than their own fundamentals.
This extreme change in market leadership disproportionately penalised portfolios which focus on owning higher quality companies offering attractive growth and high returns. In previous annual reports, we repeatedly pointed out that market volatility can often serve as a test of an investors’ investment philosophy. Our approach to constructing portfolios is resolutely fundamental from the bottom-up.
While our approach absolutely involves being macro aware, we ultimately seek to identify end markets and income streams that allow us to own best in class operators that are set to benefit from structural demand trends on a multi-year basis. With this in mind, we aim to identify exceptional businesses with clearly articulated strategies, high returns on capital, strong free cash-flow generation, and options to deploy capital into growth projects at attractive returns.
Our target holding period is three to five years and even in a tumultuous year like the one under review, portfolio turnover only amounted to 20%, very much consistent with this stated target. This is based on the belief that the recipe for creating wealth through investing is relatively simple: it requires a combination of high returns, growth and time.
Too often, one observes investors not allowing the management teams of portfolio companies sufficient time to deliver on the strategies that they have carefully laid out. Our approach is different in the sense that once we have identified a winning franchise, we aim to run large positions and continue to own a business for as long as the fundamentals continue to support our view of the superior earnings power of that company. Understandably, this can be painful over shorter time periods, yet there was no doubt in our mind that running a low turnover strategy with a relatively concentrated portfolio would experience periodic performance drawdowns from time to time.
PORTFOLIO
In a difficult year, there were three main drivers of underperformance. Firstly, Russian companies held as part of our Emerging Europe allocation. Secondly, companies with long duration income streams where business fundamentals remain intact, but share prices were, in our view, punished disproportionately as interest rates rose. Thirdly, a smaller group of companies where our assessment of the business fundamentals was incorrect.
Coming first to Russia, the Company has since inception invested a portion of its assets in Emerging European markets, with Russia forming a significant part of this. This allocation has in the past offered access to fast growing markets at low valuations and hence a differentiated source of capital appreciation. Following the Russian invasion of Ukraine in February, BlackRock’s Pricing Committee wrote down the value of Russian securities across all portfolios. As of 31 January 2022, the Company held 6.1% of its net assets in Russian companies, all of which are now valued at nil. Whilst there likely remains some intrinsic value in these businesses, it is difficult to see how this could be realised.
In considering the second group of companies, we found that the negative share price returns were driven by a change in the valuation multiple ascribed to future profits rather than any expectation that those profits will fail to materialise. On the contrary, the operational performance of these businesses remains strong, meeting or surpassing market expectations and in many cases we believe their competitive positions are strengthening rather than weakening. Thus, in our view share prices have become disconnected from fundamentals.
Lonza is a prime example with the share price having fallen by close to 25% in the year to date. The Swiss company is a global leader in contract manufacturing of high-end biological drugs, as well as in fast growing and emerging areas such as cell and gene therapy. Its barriers to entry are wide ranging and include manufacturing expertise, its ability to spend on capital expenditure to build new capacity, and customer relationships with manufacturers written into the drug filings with regulators. We expect Lonza’s biologics business, which is the highest margin part of the group, to remain the growth engine at mid-teens for the midterm. Impressively, any incremental capacity they build earns returns on invested capital of close to 30% in our estimation. Lonza’s global production capacity is sold out for the next four years, which is not only giving the company real pricing power but also provides strong visibility on its earnings trajectory overall. Whilst Lonza’s share price has been disappointing over the past year, we believe that the company’s potential to outgrow the market over time remains highly promising.
Similarly, Dutch payment company Adyen, down over 40% over the last year, suffered a sell-off in line with other tech names, which investors sold with the rise of interest rates globally. In our view this short-term reaction by the market is ignoring the long-term potential of the business. Its best-in-class payment platform has taken the lucrative payment processing industry by storm. Adyen smoothly integrates the full payments stack – gateway, risk management, processing, issuing, acquiring and settlement – on a single platform and does that via multiple sales channels (online, mobile and offline channels) and via different currencies. For merchants, Adyen’s modern platform is straightforward to onboard and with its unified technology platform it provides a cost and product capability advantage. Due to its global reach, some of the world’s largest merchants use Adyen. The vast majority of revenues currently come from North America and Europe, but we see potential for geographical as well as mid-market expansion in years to come. The company recently reported 60% volume growth, with revenues and profits also seeing healthy improvements year-on-year. Some 80% of their revenue growth has been coming from existing clients and alongside this they have acquired new high-quality clients which themselves are growing faster than the industry overall.
In contrast to the cases above, our investment in NetCompany is an example of an investment where the fundamentals deteriorated and is a good example of us not ‘falling in love’ with a stock. A key element of our process is the constant reassessment of existing portfolio holdings, seeking to gain deeper and deeper insights and being prepared to change our assessment should the fundamentals require us to do so. NetCompany, once one of the Company’s high conviction ideas, saw a significant change after the company announced the acquisition of Intrasoft. Our original attraction to the company was based on the entrepreneurial founder-led culture and positioning in specific markets in the Nordics, the UK and the Netherlands. The acquisition brought a lot of exposure to other geographies in Europe and we felt NetCompany would have difficultly integrating this new business due to its size and operational complexity. In our view, the deal was growth and margin dilutive as Intrasoft grew 5% to 10% in previous years compared to 20% for NetCompany and was operating at much lower margins. Unlike smaller acquisitions they had done in the past, we took the view management would struggle to integrate Intrasoft successfully given its size. After initially reducing our position size, we exited the position as evidence of deteriorating operational performance came through.
More positive to see are some of our high conviction names that performed well over the period despite the extreme market volatility. Worth highlighting is a position in diabetes specialist NovoNordisk which was the top performer over the period. We have owned the shares since 2017 and have grown with the company over the years. Novo Nordisk is one of two dominant players in the global diabetes market, while also offering attractive exposure to the nascent obesity drug market, which in combination leaves this business in a sweet spot with attractive growth for the next few years driven by the continued launch of Ozempic (injectable GLP-1, diabetes drug) as well as roll out of Rybelsus (oral GLP-1, Rybelsus) and Wegovy (injectable GLP-1, obesity treatment). In addition, there should also be a steady flow of pipeline readouts over the coming years (e.g. haemophilia, long acting insulin, more in diabetes and obesity) to support the investment case.
Other great examples of well-run companies with impressive brand management and pricing power are Hermès and LVMH, both amongst the top performers and both companies we would classify as ‘European royalty’. It takes Hermès close to five years to train their craftspeople to build the various different handbags and leather goods by hand and the company enjoys up to four year waiting lists of their iconic handbags like the Birkin bag, leaving demand far outweighing supply. Hermès is a largely family-owned business and has been run in a conservative fashion for generations with strategic decisions taken with the longest of timeframes in mind. There is also a degree of resilience in a downturn as Hermès’ client base typically is less sensitive to weaker economic environments, exemplified by organic growth staying positive throughout the 2008/2009 financial crisis.
OUTLOOK
The macroeconomic environment may remain uncertain over the coming months given heightened geopolitical tensions and sticky inflation forcing central banks to tighten into slowing economies. As clients frequently ask us where and when interest rates will peak, we admit to having no strong views on this topic. What seems more certain is that powerful structural trends will continue to underpin the earnings of some of the world’s leading businesses which call Europe home. Current concerns about energy security have accelerated the need to decarbonise the global economy and we still believe that a number of portfolio holdings will be long-term beneficiaries. Linked to this, we continue to believe in the large potential profit pools available as a result of the electrification of transportation where a number of portfolio companies in the technology sector act as enablers of that shift from combustion engine cars to electric vehicles. Advances in health care and life sciences will continue to drive product innovation and the specialisation of complex production processes, all areas where Europe is well positioned. Importantly, these powerful changes are unlikely to be disrupted or stopped by higher interest rates.
More generally, when looking at the health of the corporate sector, we find corporate balance sheets in decent shape and in much better positions than in previous downturns. Corporates have spent the last decade deleveraging balance sheets and interest coverage is significantly higher than during the Global Financial Crisis or other prior periods associated with deep recessions or prolonged bear markets. Corporate spending intentions also remain healthy and this spend is often linked to transformational capital expenditure in areas like digitalisation, re-shoring of supply chains or the energy transition, again benefiting many of our portfolio holdings.
Likewise, the consumer seems in a better position than sentiment would currently suggest. Employment is at record highs, wages are well-supported and households’ higher-than-average savings should provide some cushion for the squeeze on disposable incomes that is undoubtedly occurring right now. With the help of our in-house data scientist, we closely monitor developments around consumer spending.
This year’s performance should be seen in the context of having delivered cumulative outperformance relative to the market of 10% and 26% over three and five years, respectively, as at the end of August 2022. We remain of the view that over the medium to longer term, this Company and the businesses it owns can make a real difference for clients and nothing we have seen this year has changed that assessment.
Despite the painful impact from short-term market moves that we have suffered from over the past year, we are convinced that over the medium and long term, share prices are driven by growth in earnings and dividends. Hence, for the long-term investor, volatility like experienced recently, creates opportunities to buy assets that have the potential to create significant amounts of shareholder value at much lower valuations. We would encourage investors to think like owners in businesses rather than traders of shares, as there is no doubt in our minds that this will deliver the strongest returns over time.
Finally, as 2022 is drawing to a close, we observe extremely bearish sentiment and positioning towards European equities, leaving the market, as well as many of the best-in-class companies we own, trading at highly depressed valuations not seen in years. While taking a measured approach to adding risk to the portfolio appears prudent for now, we are also cognisant of Warren Buffett’s old adage ‘to be greedy when others are fearful’. It certainly feels like fear is abundant right now when history has proven time and again that capitalism and human ingenuity finds answers to what appear to be insurmountable problems. Here is to 2023 turning out more profitably than currently forecast by some. We are absolutely intent on capitalising on opportunities that may be presented in European equities by keeping a positive mindset and a firm view on the medium to long-term income streams underwriting our investments.
STEFAN GRIES AND SAM VECHT
BLACKROCK INVESTMENT MANAGEMENT (UK) LIMITED
3 November 2022