European Fund: Europe's next chapter

Your capital is at risk. Past performance is not a guide to future returns.

Tom Hodges (TH): Okay, welcome everyone to this webinar, Europe's Next Chapter. My name is Tom Hodges. I am an investment specialist on the European equities team here at Baillie Gifford.

And now in previous webinars, we've taken the opportunity to talk about various things like underrated innovation across Europe or run you through performance and some transactions. But this time we're going be a little bit different. Change abounds in the current environment. Micro is being dominated by macro.  And European governments are being forced to confront some hard truths by geopolitics. And that's going to be the initial focus of this webinar. We're going to talk about what's changing in Europe, and then we're going to turn to what's not changing and how we think we can outperform in the current and coming environment. And to do that today, I am joined by Christopher Howarth, who's a portfolio manager on the European Fund alongside Stephen Paice and Chris Davis.

Before I go any further, some quick housekeeping. If you do have any questions, we'll be delighted to answer them, so please put them into the Q&A function at the top of your screen and we'll answer them at the end.  And a very brief introduction to the European Fund. I'm sure some of you are quite well familiar, but in the European team, we're trying to find Europe's best, most exceptional growth opportunities in Europe ex-UK. And we run about 230 million in this particular vehicle. The portfolio managers, as I said earlier, Christopher Howarth, Stephen Paice and Chris Davis. And we are very much bottom-up growth investors. And I think the output of that is seen somewhat in this top 10 holdings.  where you can find some companies which you may not find elsewhere. So Topicus, for example, Schibsted, which has just renamed itself Vend and Reply.

But given that we are bottom-up growth investors, you might be quite surprised to see this cast of characters on this slide. But it feels scarcely believable that through the 2000s, Europe actually outperformed the S&P 500. The S&P endured a bit of a lost decade as the technology companies and the discretionary companies which had come to dominate that index endured a really tough time post dot com bust.  And Europe lived it much larger on relatively higher growth and a weaker dollar. And so for global investors and for asset allocators, it was much more of a story of diversification. So I had a look at the Morningstar global equity growth category, and the average allocation to the US at that time was 38 percent in 2010.  And likewise, for Europe, including the UK, it was also 38 per cent. So very much a case of diversification.

But if you fast forward to now, and perhaps no prizes for which way things have gone, a yawning performance gap has led asset allocators or those global equity growth managers to put 63 per cent of their assets in the US versus 23 per cent for Europe and the UK. So from diversification to concentration. And there's multiple reasons for this, so yawning performance gap, as I mentioned. But if you were to ask me about the characteristic differences between the US market, the US economy and Europe, I think one of the big things that I point to is the tendency to spend and invest in the US versus in Europe, the tendency to save. So if you look at the response to the global financial crisis, what we saw in the US was a massive fiscal expansion, a massive recovery package, which really helped to propel growth going forward over those next few years. Whereas in Europe, what we saw was austerity and massive bank capital requirements increases. But things have started to change and it's taken a bit of time for Europe to wake up and smell the coffee, but it seems to finally be happening. And it really owes to this motley crew that you can see on screen.

And it's been trade wars, tariffs and actual wars  that have ultimately prompted this. The gentleman in the top left of that quadrant, Friedrich Merz, has led Germany to abandon its cherished black zero in favour of massive fiscal expansion, particularly investment in infrastructure and defence, about 500 billion euros worth, so roughly equivalent to 20 per cent of GDP over the next 10 years.  and other countries might follow. And perhaps the outlier on this slide, Margaret Thatcher, she may not have realized it in 1986 when she posed in this German tank, that she might become a bit of a trendsetter. So as we've been hearing in the last couple of days, it might be more commonplace to see Keir Starmer in a submarine, Emmanuel Macron with a missile launcher, or even Donald Tusk  in a tank. And who'd have thought it would be Donald Trump and J.D. Vance to actually prompt Europe to make itself great again. But that's certainly starting to come through in terms of mindset anyway.

So what we can, what we should expect over the coming decade is more infrastructure spending, more discussion of energy security, further integration of our capital markets.  And this will really benefit national champions, European companies which can deliver on these projects.  Whilst Europe has endured somewhat of a lost decade itself, it's certainly becoming much more interesting and you're really starting to see that come through in flows, which have disproportionately gone to passive so far, but hopefully that will push through into active over time. So how does this play out in the next six to 12 months?  Frankly, your guess is as good as mine. Rhetoric must meet reality. And trade war escalations and de-escalations seem to be coming around like London buses right now. But the long term direction of travel is certainly getting clearer. And Europe is a market and an economy which is one to watch.  So Europe's new chapter is just starting to get going, but there's certainly an elephant in the room with this webinar.

We in the European fund and the European team, we are in need of embarking on somewhat of a new chapter ourselves after several years of poor performance. And to talk about that, I'll now hand over to one of the fund's portfolio managers, Christopher Howarth.

Christopher Howarth (CH): Thank you very much, Tom. And as Thomas says, the elephant in the room is that we've underperformed, and there's no way to sugarcoat that. The question you'll be asking us is how we're going to start outperforming again. And the way that we're going to do this is by sticking to our growth philosophy. Now, growth might be out of favour right now, but we know that over the long term, there's an indisputable correlation between earnings growth and share price returns. Swings in valuation can be painful, but growth in fundamentals eventually dominates.  And the companies which grow their earnings the fastest tend to generate the best relative returns. It's quite simple. And the difference between the winners on the right and the losers on the left is quite stark. So rule number one for us is to look for the companies and the conditions which can sustain well above average growth over long periods of time.

But it's also important not to overpay for this growth. Now buying into high expectations in life rarely pays off.  Now imagine, for example, Cristiano Ronaldo's surprise when, expecting to see his good looks immortalised in bronze, he instead saw this slightly molten version of his head at Madeira Airport. Or imagine the feelings of buying tickets to an immersive Willy Wonka experience, promising a world of pure imagination, when instead you find yourself in this frankly rather depressing looking warehouse in Glasgow.  So joking aside, just like in life, expectations matter in investment. As Michael Mauboussin has said, investing isn't just about understanding the fundamentals, it's about understanding what expectations are implied by the share price.  So the graphic on the next slide shows how the market rewards expectations versus reality. So the rows show returns for companies by quintile of delivered earnings growth, while the columns show the returns by quintile of expected earnings growth. Now, clearly the top row is generally a good place to be. It's, of course, always better to deliver on something than just to promise it.

But we know that growth creates the most value when the market doesn't expect it. So the top right-hand corner shows the returns for stocks that were expected to be in the bottom quintile of earnings growth that actually delivered growth in the top quintile. And conversely, the worst returns came from the stocks where the expectations were the highest, but where delivered growth was actually the lowest. And that's shown in the bottom left-hand corner.  So rule number two is to think differently to the market. And this requires some creative thinking and for investors to extend their time horizons. And that's because rule number three is to think and act long-term. As active investors, we're looking to exploit marketing efficiencies.  And in a world where information is abundant, it's difficult, if not impossible, to hold an informational advantage. And that's particularly when the sell side and hedge funds maintain highly detailed and spuriously precise models aimed at forecasting the next few quarters.

And where we can have more of an advantage is in thinking about investment cases in great companies over much longer periods of time than most market participants are willing or even able to.  Stock prices might fluctuate based on earnings beats or misses, but most of a stock's value lies years or even decades into the future. So getting the pace and the duration of growth roughly right matters much more than second-guessing consensus estimates. So there's no better example of why focusing on the short-term is a mistake than with Spotify. We've held Spotify in the OIC since its IPO in 2018, although our relationship with the company actually goes back several years before that.  In the early years, the shares were volatile, even frustrating to hold sometimes. Brokers worried about Spotify's high R&D expenditure and when it would turn a profit. And if we'd listened to consensus forecasts then, we might've sold our shares when they dropped below 100 euros in 2022. But throughout this period, monthly average users were growing impressively, as were Spotify's gross profits. Spotify's critics were ignoring the enormous operating leverage in its business model.

Ultimately, investors who looked beyond the quarterly noise were rewarded, as margins and cash generation soared. Now, we don't expect all of our holdings, which have seen a drawdown over the past few years, to rebound as strongly as Spotify. But we do think that there are several which have suffered from the extrapolation of short-term weakness. And this represents a real long-term opportunity once valuations rebound. So why do we have an edge in applying these three rules of outperformance?  Well, there are very few firms that are so explicitly focused on growth as Baillie Gifford is. We've got over 100 investors thinking about which companies and which industries could be the growth drivers of the future, right across the growth spectrum from super high growth to quality compounders and even income growth. Stephen, Chris, and I are constantly working with analysts from both those teams and our own to source a range of these growth opportunities. And as a firm, we're quite unusual in that we're an unlimited liability partnership.  This gives us a privileged opportunity to think differently, as we're not beholden to outside shareholders as a listed asset manager would be, or like a boutique that's owned by a larger institution.

It also gives us freedom to be different in the type of people that we hire and the perspectives that we take in. But most importantly, it gives us the license to think long-term about the companies that we hold. A good example of this is Atlas Copco, which we've owned for, I think, just over 35 years, and Ryanair, which we've owned for more than a decade.  And this often allows us to build deeper relationships with the managers of these businesses. And this is a source of insight that's often not available to shorter term investors. Now there will be periods when our edge appears weaker than at other times, but we're confident that we're on the right approach. The average investor's time horizon is only getting shorter and this creates inefficiencies that patient investors can exploit. So let's put some numbers on how our portfolio compares to the index and why we're confident in our performance from here.  So as you might expect, our portfolio offers higher growth than the index, but it achieves this with a stronger balance sheet as well, measured by net debt to equity. What you might not expect is that our holdings also have, on average, higher returns on capital, a measure of quality.

More growth, higher quality, and less leverage. We believe that this is a winning combination.  So what's missing? Well, over the past few years, valuations have compressed, particularly for growth stocks, and this has really hurt performance. On the chart, the difference between the two lines is the valuation premium on our portfolio compared to the market. And as you can see, since 2021, that valuation premium has narrowed, even as the growth differential between our holdings and the index, which is shown by the columns, has widened.  So our portfolio now trades on a lower valuation than it did in the past, and it has better forward-looking characteristics as well. So let's have a look at portfolio. So I mentioned Spotify earlier, but we also own other digital pioneers like the Dutch payments processing firm, Adyen, and the German mortgage platform, Hypoport. And one area that where Europe really stands out is in semiconductor capital equipment.

So the machines used to make microchips.  And as well as owning ASML, which is arguably the most important semiconductor equipment company in the world, we also own its less well-known cousin, ASM International, which we believe may be just as important as ASML over the coming decade.  ASM has an extremely dominant position in a process called atomic layer deposition, which is a technology for depositing atom level thick wafers of material on silicon wafers. And it's essential for making the type of chips which go into AI data centres, amongst other things.  Another company that I always enjoy talking about is Dino Polska. This is a rapidly growing chain of Polish supermarkets, and it's almost unknown outside Poland, but within Poland, it opens a new store every day on average, and it earns phenomenal returns on capital, thanks to operating in rural villages that are simply too small for competitors like Lidl to operate in. It's family owned, thinks with a very long time horizon, and it behaves more like a private company than a public one, which are all characteristics that we like.  we're capturing the growth of the healthcare industry through names like Novo Nordisk, which manufactures obesity drugs and insulin, and the Swiss drug manufacturer Lonza, and the Swedish biotechnology company Camurus. Camurus has spent 30 years developing a technology for turning existing generic drugs, the ones that are already on the market, into long-acting injectable formats, so they release a chemical over the course of about 30 days,  reapplying a patent and then commercializing them.

Its first commercial product is growing very profitably now in both Europe and the US. So as Tom said, Europe is going through a time of structural change which is going to play out over many years. Who knows what this will mean over the next few quarters, but we're confident that we can outperform by focusing on growth, thinking differently to the markets and thinking and acting long term.  And we're able to do these things because of our unusual partnership structure. And the output is a differentiated portfolio packed with names, which are exposed to structural growth drivers over the coming years. So we're not just calling for a cyclical rotation to Europe. We're looking forward to the fundamentally driven structural growth that Europe's best companies have to offer. Thank you.

TH: Well, thank you very much for that, Christopher. And I think it was very, very interesting. And now we sort of begin the Q&A function of this webinar. And please do submit any questions via the Q&A box. We do have a couple to go through so far. One question that was submitted in advance, Christopher, was reflecting on what style and what sort of part of the market cap spectrum people should be looking at for Europe in the next six to 12 months, but perhaps you can chime in on that shorter time period, but also a bit longer.

CH: Yeah, well, thank you very much. Now, of course, six to 12 months is a bit shorter term than we normally think about. But I think that what we have seen over the past few years is that there's been increasing market concentration in both US, Europe and in other markets. In Europe, there's been the term the granolas, which is the equivalent of the Magnificent Seven in the US.  This contains names like LVMH and several pharmaceutical companies. And some of these mega cap names have taken up a very large position of the index. And that's come at the expense of many of Europe's smaller and medium-sized companies. And so the gap between the valuations between smaller caps and large caps, they used to trade more at a premium, now it's at a significant discount. So I think it was at least a credible argument that we see a rebound in some of the smaller and the medium-sized cap  range businesses, and that would certainly help our portfolio, which is disproportionately allocated to those names.

But of course, I wouldn't want to make any predictions on a sort of six to 12 month time horizon. Longer term, of course, we're focused more on these sort of structural growth trends like healthcare and AI and semiconductors. 

TH: Thanks for that, Christopher. Another question, how do we reflect on performance over the past one to three years? What are the sort of key things that have driven that underperformance? And, you know, beyond just the sort of theoretical, why do you think this portfolio can outperform over the following period? 

CH: Yeah, so of course, the past few years has been very tough. It's certainly been a humbling experience for all of us. I think one of the key driver here has been the compression in valuations that occurred after the increase in interest rates, that rising interest rates, of course, depress asset prices, but they disproportionately affect asset prices where the majority of their value lies years or even decades into the future. So for growth stocks in particular, that was, that attributed to a significant derating.

And of course, we are optimistic that in the long run, fundamentals do tend to dominate. But certainly in the short run, that has been a significant headwind. It's possible that valuations will rebound. We tend to focus much more on the fundamentals, just because that's the thing that we believe that we have more of an insight into forecasting. But of course, if there was a valuation tailwind, then that would help as well. 

TH: And I think probably the other point about performance is that this has very much been a value market in Europe for the best part of three years. I think over the past three years, value has outperformed growth by about five percentage points per year. And that ostensibly has been banks and historically defence as well. Two areas where we've not had much exposure, perhaps. You've got some thoughts on that, Christopher?

CH: Yeah, so defence is a question that we've been hearing a lot more about recently. And recently, we've run a comprehensive review of the defence sector as part of our team analysis of growth industries. Now, this is an interesting and potentially controversial subject. We haven't owned any defence companies in the past.  That's for a variety of reasons, but it's certainly fair to say that over the past year that has really hurt our performance. We've seen the likes of Rheinmetall, which makes tanks, RENK, which makes gearboxes and others that re-rate very significantly on the basis of rising defence budgets.  So of course, the question is, would we own defence companies in the future?

 And the conclusion that we've come to is that while there's a lot of demand right now, these are not fundamentally good businesses. And I don't mean that with any sort of ethical judgment, just in terms of the customer base is predominantly governments who don't allow the defence companies typically to earn much above their cost of capital. And prior to Russia's invasion of Ukraine, these businesses were hardly earning much above their cost of capital.

So when you look at them now, there certainly is a lot of growth, very full order books that could take you out sort of five years or more into the future. But it becomes very difficult to argue that the current valuations that that isn't already priced in. So going back to the expectations versus reality slide earlier. So at the moment, we don't own any positions in defence, but it's certainly an area that we're actively monitoring. 

TH: I think that that comment extends roughly to banks as well. This has been very much a levered play on the interest rate cycle. You remember when I started working with European equity strategies back in 2015, banks were trading on something like 0.5 times their book value and now I think some of the cheaper ones you'd get at 1.2, so that argument for further upside, at least from valuation, becomes much harder. One question we've been getting very regularly from clients in meetings has been, what is it going to take for growth to outperform? I don't know if you've got thoughts on that.

CH: So, I think in the long run, of course, it will just be driven by fundamentals. Europe still has fantastic businesses, which throughout all of the macro headwinds over the past few years have continued to compound their earnings and cash flows very nicely. And eventually that has to come through in stock price returns. As Benjamin Graham said, in the long run, the stock market is a weighing machine rather than just a voting machine. Of course, in the short run, valuations play a bigger role.  Potentially, interest rates coming down would lift valuation significantly or a cyclical rotation to Europe. But these things are much harder to predict from a macro standpoint. It's much easier for us, and we believe we have more of an edge in forecasting how fundamentals will trend over the long term. 

TH: And I think as well, the other point really is that from a market breakdown with growth in Europe, it does tend to be that bit more cyclical. So whilst, you know, interest rates coming down, that will roughly help, you know, a natural real revamp of the order book for a number of these different industrial or medtech type businesses.  That can really see growth actually coming through as a consequence. That can really drive that reappreciation, that reappraisal of the growth style, and that will filter through to better performance for smaller mid-caps as well as some of those larger companies. And as Christopher mentioned during the webinar, we are disproportionately exposed, or at least more exposed than some of our competitors in this area.  We've also got one question around Spotify and how we were able to get to know them pre their direct listing. Maybe extend that question a bit further. Obviously, we also run an investment trust, the Baillie Gifford European Growth Trust, and we do invest in private companies in that vehicle. And obviously, Baillie Gifford is becoming much more known for  its private investing efforts. What do you, what benefit do you see in getting to know those companies much earlier and how does that make you a better public markets investor I suppose?

CH: So private companies, I think, are a real competitive advantage that we've been developing here at Baillie Gifford. We're finding that more and more businesses are choosing to stay private for longer. So this means that some of the best businesses in Europe are actually still private businesses. In the past, they might have gone to IPO at an earlier stage. Now they're choosing to stay private.  But of course, if we are able to provide a bridge between private and public investing, then that allows us to get to know the management team, to understand how the business works, how it operates, what its competitive advantage is in years before our competitors would be able to have the opportunity to buy the shares.  So in this case, we invested, I think it was in 2015. The shares saw significant upside actually before IPO. And it meant that we were able to go in at IPO with a much sort of better understanding of the business. But it also means that we can get to know businesses which then shed light on other businesses that we own.

So there's a sort of cross-pollination between some of the private businesses that we own and some of the public businesses that we have in the portfolio. 

TH: Thanks for that, Christopher. And if there are no further questions, I'll quickly sum up.  It's been a pretty torrid time to be a European investor over the past 17 years since the financial crisis, but Europe finally appears to be embarking on a new chapter where it's going to loosen the purse strings just as the US is reining in that spending. And we in the European team at Baillie Gifford, we're also hoping to embark on somewhat of a new chapter, a chapter of outperformance after a poor period. And the way that we can do that is focus on growth, think differently,  and also think long term. And if we're able to do that successfully, as our portfolio characteristics suggest that we are with higher growth, higher quality and lower leverage, a slightly modest premium, I suppose, to the market, then we're bettering our chances of doing so. And with that, thank you very much for your time.

Baillie Gifford European Fund

Annual past performance to 31 March each year (net%)

Source: FE, Revolution, MSCI. Total return net of charges, in sterling. Share class returns calculated using 10am prices, while the Index is calculated close-to-close.

*MSCI Europe ex UK Index.

**MSCI Europe ex UK Index (in sterling) plus at least 1.5% per annum over rolling five-year periods.

***IA Europe Excluding UK Sector. 

Past performance is not a guide to future returns.

The manager believes the MSCI Europe ex UK Index +1.5% is an appropriate benchmark given the investment policy of the Fund and the approach taken by the manager when investing. There is no guarantee that this objective will be achieved over any time period and actual investment returns may differ from this objective, particularly over shorter time periods. In addition, the manager believes an appropriate performance comparison for this Fund is the Investment Association Europe Excluding UK TR Sector.

Important information and risk factors

This communication was produced and approved in June 2025 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

This communication does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are not statements of fact and should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA).

Baillie Gifford & Co Limited is authorised and regulated by the Financial Conduct Authority. Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs. 

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is the OEICs’ Authorised Corporate Director and is an authorised Alternative Investment Fund Manager and Company Secretary of investment trusts. The trusts managed by Baillie Gifford & Co Limited are listed on the London Stock Exchange and are not authorised or regulated by the FCA.

Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the Fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.

The specific risks associated with the Fund include:

• ­Custody of assets involves a risk of loss if a custodian becomes insolvent or breaches duties of care.
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• The Fund has exposure to foreign currencies and changes in the rates of exchange will cause the value of any investment, and income from it, to fall as well as rise and you may not get back the amount invested.
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Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document, copies of which are available at www.bailliegifford.com, or the Prospectus which is available by calling the ACD.

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