Materials, banks and auto manufacturers are the three genuinely deep value sectors in Europe, according to Neptune Investment Management’s Rob Burnett. 
The FE Alpha Manager said talk of value’s demise in Europe this year has been greatly exaggerated by investors as there are pockets that have outperformed. However, he concedes that it is no longer as straightforward as it once was.
"We are in a fuzzy stage where some growth is weak and some is okay and it is the same with value. It is a bit more idiosyncratic,” Burnett said.
The value-driven Neptune European Opportunities fund has been the top performing fund over the last 12 months in the IA Europe ex UK sector, improving on gains made in the back half of 2016 throughout the year-to-date thanks to its exposure to certain value sectors.
Performance of fund vs sector and benchmark over 1yr
Source: FE Analytics
“In my head, the big underperformance of value has been the autos, energy has been weak, which you would have to describe as a kind of value sector, telecoms has been weak but we don’t overweight that,” the manager said.
“I would say it has been split: some value has been good, some value has been bad, but in our asset allocation and in our stock selection it has been quite good.”
Below, the manager outlines the three sectors he is seeing the best opportunities in for investors looking to take a value approach to European equities.
One thing that all three sectors – materials, banks and auto manufacturers – have in common is their dependency on an outside factor in one way or another.
“Commodity prices are important for miners, interest rates are important for the banks and Trump is also frustratingly important for other sectors like autos to an extent,” he said.
“All those three things are very relevant to the investment case. The killer point though, from my perspective, is about the asymmetry.”
Taking banks first, the manager said there is a zero per cent chance that interest rates can fall further from here.
“Obviously with interest rates they have declined more or less non-stop since 1982 with little upticks and here we are down at negative. We know in Europe for practical and theoretic reasons they cannot go lower.
“It can’t happen without the financial system suffering and the economy slowing. So further cuts in European interest rates would hinder the economy not help it.
“If there was a 50/50 chance that interest rates could go up or down I would be less keen to have a big proportion of the fund affected by interest rates.”
The £442m Neptune European Opportunities fund has a 37 per cent weighing to financials (its largest sector weighting) with the majority of this in banks.
“Banks have quietly been quite solid. They haven’t been spectacular but they’ve consolidated their gains at the back end of last year and they have outperformed this year,” Burnett said.
Performance of indices over 1yr
Source: FE Analytics
As the above shows, banks have been resilient in Europe this year, with the FTSE World Europe ex UK Banks index returning 41 per cent compared to the broader FTSE World Europe ex UK index’s 25.83 per cent return.
The manager noted: “My view generally is that there is a zero per cent probability that they [interest rates] go lower. To me the 50/50 is that they are either flat or they are rising.
“If they are flat there is still earnings growth because of fees and commission growth which is really quite good at the moment because of loan growth, cost-cutting and falling provision rates.
“So bad credit losses are still reducing, credit quality is still improving and has been for a few years, unemployment is falling and so bad debt costs are still falling.
“The earnings growth profile is kind of guaranteed positive for now even if interest rates are stable with a 5 times earnings growth a year. If interest rates rise that puts in upside gearing and you can get to 10, maybe even 15, per cent earnings growth.
“To me you have got close to the cheapest sector in banks on close to 10 times earnings with dividends of 5 per cent cash. That is not bad compared to what I am getting in my current account – which is zero.”
The second area the manager is bullish on and has contributed to his fund’s outperformance this year is the mining sector.
Again, the manager said if there was a 50/50 chance that commodity prices could plummet or go up he would also be less confident in having holdings exposed to commodity prices.
While it is more nuanced than interest rates, he said that “the beauty of investing in materials now is that you have also had a 10-year bear market in commodities”.
As the below shows, the Bloomberg Commodity index has fallen 20 per cent over the last decade and is 44.16 per cent below its peak in 2008.
Performance of index over 10yrs
Source: FE Analytics
“We had a crash in 2009, a brief rally in 2010 and 2011, and then they absolutely got annihilated in 2015. The sell-off in the commodity sector in 2015 and the first month of 2016 was equally savage as 2008,” Burnett said.
“Share prices in the Anglo Americans, Rios, Billitons or Antofagastas were down 80 per cent and the commodity prices collapsed as well.
“While we have had a bit of a recovery, especially in copper, which has really been quite strong, and iron ore has recovered too, there is still an asymmetry there in the sense that we have had a very significant decline already and we are still climbing in the foothills of the recovery.
“In all of the stocks that we own that thinking about asymmetries is the absolute bedrock of what we are trying to do. If the price is low, the earnings are low and we see the industry improving then that is great.”
The final sector is in the auto manufacturing sector, which has been an extremely poor performer year-to-date.
“Autos has been something that has cost us a bit in the last few months but we have only been building into autos this year so I didn’t really have much in autos at the beginning of the year. The weakness that the autos have exhibited, we haven’t really worn,” Burnett said.
He added that he is becoming “much more constructive on the autos at these prices”, which have fallen due to a combination of three factors: dieselgate, electric cars and autonomous driving.
“Those three things, dieselgate and two types of disruption is causing investors to let share prices go lower and lower,” the manager noted.
Yet despite these potential factors, he remains positive on the sector at current prices, which have sold some auto manufacturers down to around five times earnings.
“In autos I can’t say that the industry is getting better but the major reason to own autos now is price. The share prices are now ludicrously low,” he said.
“[The likes of] Volkswagen or Daimler are on five times earnings yet the earnings momentum has been increasing, so earnings estimates by analysts are rising yet the multiples are only coming down.
“In my experience I have never known share prices not to respond when valuations are very low and you have earnings momentum.
“The market is basically saying in Volkswagen’s case that you are going to get your money back in free cashflow in 10 to 15 years,” he added. “So you are basically saying that Volkswagen won’t exist in 20 years’ time.
“I don’t know if in five or 10 years’ time how it is going to pan out but at these prices and dividends the risks are incredibly low.”