Why would you describe this strategy as a fund to watch?
The VT Downing Unconstrained European Income Fund was launched in November 2020 to offer clients a portfolio that complements existing funds and provide long term alpha by hunting freely across the investment universe for ideas. As the fund reaches its three-year anniversary, the managers are excited by what they view as the most dynamic investment conditions they have seen in many years.
What are these tailwinds? Small and mid cap stocks have underperformed over the last two years to a degree that is unusual both in severity and length. The valuations on offer right now are the cheapest they have been in about twenty years. More importantly, Europe is leading the way in the shift to renewable energy and decarbonisation as we fight climate change. This is causing the biggest reallocation of capital since the industrial revolution. Never has the world seen such a radical reshaping of industry supply chains as we are witnessing today.
Combined, these tailwinds are providing huge opportunities across the European market which the fund is well positioned to capture.
Can you give a brief overview of your strategy in terms of what you are trying to achieve for investors, your investment process and the make-up of the investment team?
Our strategy aims to generate an attractive total return for our clients, one which balances capital growth over the next five years with an attractive income stream that will grow faster than inflation. We think we can play a role in clients’ portfolios by providing sources of alpha that are often different, and hence complementary, to those of many other managers.
We believe that it is important for fund managers to have a clear understanding of the market inefficiencies they are looking to take advantage of. In our case we try either to get a behavioural advantage in well-known, but contrarian stocks or an informational advantage in ‘under the radar’ ideas that other managers won’t or can’t own for various reasons.
Contrarian opportunities sometimes appear in high-quality, but usually high priced companies when the market has fallen out of love with them. This could be due to the sector they are in or simply the country they are listed in. Here, the patient investor can wait for an investment thesis to play out over time. Following an unconstrained approach (i.e. not being bound by market capitalisation, country or sector allocations) also allows us to focus on lesser-known, under-researched companies where our intensive in-house research can provide a distinct informational edge.
What is your outlook for the fund and how are you positioning your portfolio as we move into 2024?
Looking at blue chip indexes, equities have seemingly performed pretty well. But beneath the surface, smaller companies have been battered. Risk aversion has seen small and mid caps sold to fund flows to large caps, with passives and ETFs exacerbating this move. Since the beginning of 2021, mega caps are up 27% in comparison to small caps which are down 14%. Valuations of smaller companies are at multi-decade lows compared with large caps, despite their superior growth potential.
With two-thirds of our fund invested in small and mid-caps, this has been a frustrating headwind. However looking forward, we believe this remains the biggest source of opportunity. Smaller companies have generated superior returns over the long term, and we expect the future to be no different.
Furthermore, Europe is at the forefront of a once-in-a-generation theme that could see a number of these small, and not well-known companies, be the winners of the future. The green energy transition is the biggest reallocation of capital since the Industrial Revolution. Net zero targets will see trillions spent on rebuilding the world’s energy infrastructure. Ever since the Kyoto Protocol of 2005, Europe has been at the forefront of this move. With limited fossil fuel assets, Europe is striving for net zero. Russia’s isolation has made energy independence a political imperative. With this as a backdrop, a young industry is shooting up in support of the transition. Renewable energy and electric vehicle supply chains are being built from scratch, and carbon capture and hydrogen technologies although still in their infancy, are being developed at pace. The long-term investment opportunity is enormous.
Can you identify a couple of key investment opportunities for your fund you are playing at the moment in the portfolio? This could be at a stock, sector or thematic level.
The European market is full of leading industrial companies exposed to the energy transition. From Schneider Electric and its expertise in energy management, down through a long tail of companies that specialise in various critical niches, Europe is beginning to dominate many aspects of energy transition. Complex and dynamic supply chains make for great opportunities for a stock picker. We are scouring these supply chains, looking for tomorrow’s winners. These are not always the obvious plays. Many fly under the radar. For example, one of our preferred plays on electric vehicles is not lithium (as favoured by many investors), but dehumidification systems. With lithium being highly reactive to water, it needs to be processed in a dry room. In fact, c.20% of the capex of a gigafactory is the dry room, with a large amount spent on dehumidification systems. A small Swedish company, Munters (whose founder pioneered climate control) is at the forefront of developing and installing these solutions. It also leads the way in data centre cooling systems, an even more under-the-radar way to play AI given the number of data centres springing up. With a large proportion of the fund invested in similar companies, we are excited about many of the other plays along these various value chains.
Find out more at VT Downing European Unconstrained Income Fund | Downing Fund Managers
