Fund introduction 

The fund has an objective to uncover stocks in Europe which have the potential for attractive absolute returns on a five-year view, which it then aggregates into a portfolio to compound absolute wealth over the medium-term.  

These returns are driven by fundamental change taking place both within the companies and in the environment external to them. Change is what unlocks the embedded value.  

We are convinced that at this stage of their ubiquity, index-relative concepts are unhelpful, and will fall out of favour if  the more difficult market backdrop we expect over the coming years comes to fruition. Following this logic then, an absolute return mindset is likely to become more potent. 

Being absolute mindset orientated suits our contrarian nature, and has the side-effect of often resulting in very different portfolios to the consensus peer portfolio. This is central to how we approach the fund. Although we have always tended to think in absolute terms around upside to stocks, we have taken the opportunity to really sharpen our thinking here and really be deliberate about our approach to risk management and portfolio construction in an absolute rather than market relative sense. We believe thinking in this way will lead to better outcomes. Stock picking takes place using a valuation-disciplined, flexible approach, and thinking about the range of possible outcomes for investee companies. The concept of the company lifecycle is relevant; on the basis we are prepared to invest in all stages of the lifecycle – analysing each investment opportunity idiosyncratically as appropriate to its stage in its cycle, rather than the rather fetishised and rigid single factor-based investment that has become so prevalent. The analysis of change, and how much of this change is priced into to the investment idea, is key. We sit within a team with a very strong European investment pedigree, and we have conducted thousands of company meetings over the last 20 years. We are not short of ideas!  

In a world that is increasingly driven by index-relative investment performance, where outperformance leads to asset-gathering, we are doubling down on our conviction that ‘index-relative’ is not the right way to approach risk management or indeed return maximization. In our experience,  it doesn’t lead to good investment decisions or indeed good client outcomes.  

Instead, our framework for thinking about risk and portfolio construction is what we call the business cycle framework. In practical terms, this means we bucket each investment into one of seven categories (‘style groups’) that reflects the likely behavior of that stock in different phases of the cycle. Other categorisations are also more or less important from time to time – portfolio construction is a multi-faceted process. This flexible and pragmatic approach ensures that the portfolio is coherent, rather than just a collection of stocks, while removing the tendency to hug the index. 

Historically we have often considered our skew relative to the market. It may be simpler to think in absolute terms, where a ‘neutral’ position would be a portfolio well diversified across each of those style groups. In practice this neutral skew would deviate as prospectively attractive opportunities (and conversely, over-valuation) tend to cluster in different areas of the market at different points in time. The skew should naturally gravitate towards these attractive clusters as the cycle evolves.  

In its simplest form this is a multi-cap, valuation-disciplined and change-orientated stock picking portfolio which acknowledges through its consideration of the cycle and flexible risk-management approach, that there are times to attack and times to defend.  

Current positioning 

The conundrum we are currently facing as European investors is that there are signs that the prior lost decade following the various crises, has led to some useful structural reforms, and that from a cyclical point of view, Europe is at a low ebb with potential for recovery. Aggregate valuations are relatively neutral but there is a large dispersion within that, with companies outside large cap, more favoured sectors, good value in absolute terms. 

Set against that we acknowledge that global markets trade on a far greater multiple of earnings, whether using historic, forecast or cyclically-adjusted profits, than almost any other time in their history  . A large part of the reason why economic growth has been relatively benign through the (mostly geopolitically driven) disruptions of recent times, especially last year, has been the relentless ability of the technology sector to continue to invest – much of the capital provided by financial markets rather than cash flow – which has been a large positive impulse on demand. This is of course at risk should the upward march of their share prices end, which can happen simply if the market calls time on the circularity¹, let alone if there is a true bear market with those companies at the nexus.  

On that basis we think the appropriate positioning is higher than neutral exposure to relatively resilient companies (typically Growth Defensive and Value Defensive in Business Cycle terms), which by dint of their starting valuations and profit improvements we think can generate compound returns of perhaps low double digits% in ‘normal’ markets, and tend to be historically relatively resilient in corrections and bear markets, because their earnings are less cyclically exposed.  

This somewhat cautious core to the portfolio is supplemented by higher conviction mid-cap positions, which typically have more domestic exposure. These holdings are unusually good value for the growth and returns on offer, in many cases offering the potential to become far larger companies over time, but without the associated premium starting multiples.  This is almost certainly because there has been a dearth of capital allocated to these areas over recent years, causing significant outflows and depressing share prices. We are more prepared than the average investor to be patient here, providing the fundamentals progress as we expect.  

We discussed the reasons for this positioning more extensively in our launch note in November.  

Managing FOMO… 

What don’t we own? Or another way of putting it, what doesn’t look attractive to us on our framework.  

Given that we have been clear about the use of the index as a risk-management tool and that therefore we only really care about what we do own, why this section at all? We think it might be useful to clients because it seems almost all own some of the many funds that have added to, and are overweight, these areas. This is confirmed to us on a regular basis in client meetings.  

We also spent many years in the last cycle advocating and being overweight banks when they were very unloved, so perhaps we have a somewhat broader perspective here than many do, and it may be of interest why our views have changed. 

But to start with, perhaps unsurprisingly, the rather hyped technology sector is an area we are struggling to make potential investment stack up.  Our analysis goes beyond the well-trodden valuation argument although this is of course very relevant. That AI will change the world is a consensus with which we don’t disagree . What we do fear is that there are areas of overinvestment which will struggle to make a return.  

Simple arithmetic illustrates the point. UBS, to use one proxy example oe a market participant, are forecasting $1.3tn p.a. of investment by 2030 from around $500bn today. Assuming the market is expecting further growth thereon (as the high multiples on AI infrastructure stocks strongly implies) this suggests that the expectation is that the next 10 years could see a total of perhaps $15tn of AI investment. For a 10% return that would require $1.5tn of profit p.a. Total S&P 500 net income for 2025 is $2.1tn. Seems like a lot might be priced in!  

Many other anecdotal and qualitative data points give us pause. For example, we also know that many industry insiders have expressed caution, and that much of the positive demand is driven in a circular fashion by the industry (using its negative cost of capital) funding itself. Phenomena such as these should make any investor nervous. 

We don’t expect this view to necessarily come right in the short term – clearly there is a huge amount of momentum behind the AI theme, and pockets of non-AI related tech capex are at a relatively low level after the covid hangover of the last few years. But we do think we are close enough to the ‘final innings’ to take a strong view. For good and bad, it has never been our style to invest in areas we perceive as overvalued, on the basis the music might keep playing a little longer. We have no exposure to these names. 

Perhaps more provocatively, we are very underweight banks, which have been totally rehabilitated in investor’s eyes. Most are now overweight, returns have been strong and valuations and profits have recovered. They do remain somewhat cheap… on currently expected levels of profitability. However we offer a few reasons why they appear to us somewhat near peak, and therefore why these valuations may prove to be a mirage: 

• Net Interest Margins (NIM) have expanded significantly through this recent rate cycle, as front-book margins were well above back-book. This is no longer the case, but expectations are for continued expansion. It is also not clear that banks can expand NIM without either demand destruction or substitution effects from other sources of funding. 

• Although a lot of consolidation has taken place, there is still in the most markets sufficient players to prevent oligopolistic behaviour, so competition is likely to pick up in many markets. 

• While the rate cycle has significantly benefited NIM, it hasn’t yet impacted provisioning (more people struggle to pay off loans at higher rates). If rates go higher, this becomes even more likely, if rates are lower provisioning may stay benign but NIM is likely to be impacted negatively.  

• However much they have strengthened their balance sheets (and they have, a lot), banks are inherently cyclical, and we have concerns about the geopolitical environment and potential for technology trends to become (potentially severe) economic headwinds. 

• They are an obvious target for political interference, particularly in a world of relatively high deficits and government debt levels. 

• Our final point is slightly nuanced and technical, but is really the key reason why we are taking a strong view that these stocks don’t offer great upside 

The calculation for valuing a bank is typically considered to be P/NAV = RoE/CoE. So for a 15% RoE bank at 10% cost of equity, the P/NAV should be 1.5x – if observed valuations are lower then these would be considered undervalued. Banks spent most of the last cycle in this undervalued range. To be clear, we wish to make a more powerful fundamental argument, not a valuation based one. 

Most banks now trade above what this mathematical identity would justify (on ROEs that are quite high/ peak). There are several possible reasons for this: 

• The market expects growth 

• The market expects ROE to improve 

• The cost of capital is lower than assumed.  

The reason why the first point is relevant is that the mathematically correct calculation for P/NAV multiple is actually P/NAV = (RoE – g)/ (CoE – g), where g is the expected long-term growth rate. In the doldrums of the last cycle where banks earnings were depressed and balance sheets being rebuilt, ‘g’ was commonly assumed to be 0, hence the simplified calculation shown in the first paragraph with which people tend to be more familiar.  

In practice, this expectation of growth is precisely why banks trade on high price to book multiples. 

To take a real example to illustrate, Santander (not held) trades on 1.8x book value, for a 15.5% RoE. This could be solved as an implied growth rate of:

1.8 = 15.5 – g / 10 – g 

g  = 3.1% 

This is where the analysis becomes interesting. Because the banks share prices imply growth, bank management need to demonstrate growth – and demonstrate more than the market is pricing in (in Santander’s case more than 3.1%), in order to get their share prices higher, stay on the right side of investors, and collect their incentives. And that means they need to deploy more capital to make more loans. But, of course, here is the conundrum. If all banks in a market such as Spain attempt to deploy more capital, they will lower returns in the very market they operate in, impinging the ability to grow. This is, by the way, classic market reflexivity. 

At current valuations we might just about ok – perhaps there is enough releveraging and economic growth in Santander’s markets to allow them to grow at 3% without harming those markets. But I doubt they can do much more without damaging returns – i.e. it is unlikely to our minds they can exceed what is priced in.  

Are other market participants of the same mindset as us? Perhaps a typical quote from a sell-side note will answer that question…”We still believe that SAN will deliver a 20% [RoE – recall it is currently 15.5%] by 2029E, but that the 2028 financial targets (set to be announced at the next CMD on 25 February) may be 100bps lower [i.e. 19% RoE].” 

So in summary we have unfortunately high expectations, potentially peaking profit and high valuations, with the usual cyclical risk that comes with the sector. These are the sort of risks we try and avoid and would caution clients from getting carried away no matter the recent performance of this sector.  

Slowly then suddenly – 10 years of Bank valuations 

Conclusion 

If the market continues to be led by further technology and banks outperformance (unusual bedfellows I know!), which are the consensus areas of overweight, the fund would underperform. Underperforming on this basis wouldn’t concern us because for the reasons described, we don’t think this is likely over the medium term. However we have high conviction in the upside for our stocks without taking excessive cyclical risk, and think we can generate attractive medium-term compound returns, providing we are correct on the fundamentals. These absolute compounded returns are what we think really matter in the final reckoning. In a geopolitically, demographically and valuation challenged world we suspect that are we able to achieve that goal, it will represent a welcome outcome for shareholders in the fund.  

[1] Source: Bloomberg, as at 16^th January 2026.