Cyclical and Defensive Opportunities Continued to Emerge

A wider variety of opportunities that we could exploit continued to emerge as macroeconomic conditions became more challenging and markets more prone to sudden shifts in sentiment. Once again, there was a mix of high-quality defensive and cyclical names with durable earnings and strong balance sheets that became more attractively valued as market volatility continued into the third quarter.

• We added to industrials and business services, moving back to a modest overweight, and continued to adjust our bank holdings, seeking high-quality names that are liquid, are strong, and earn a diversified income.
• While we raised our exposure to real estate to a modest overweight, we deepened our large underweight in consumer staples, where most names now look expensive.
• We seek a relatively balanced portfolio in terms of exposures to possible economic scenarios, so that relative performance is not dependent on a particular "macro" environment.

Financials

We remain underweight financials as the outlook remains difficult, although valuations have become more attractive, especially for banks. We increased our overweight in insurance, investing in Sampo, a Finnish insurance company. We pared our underweight in banks, opening positions in Bankinter, a high-quality Spanish lender and asset manager; FinecoBank Banca, an Italian diversified financial institution that attracts deposits through its online bank; and Nordea Bank, the largest financial services provider in the Nordic region.

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Many banks are trading at historically low valuations amid weak demand for loans, persistently low interest rates, and a stringent regulatory environment. However, we remain cautious because the industry remains challenged by slowing economic growth, poor return on equity, and low capital generation. Consequently, our focus is on better-quality names, typically in more consolidated markets, resulting in a relatively more resilient return on equity.

Several of our investments also have the potential to improve returns due to self-help initiatives. One common theme is an objective to generate more defensive and sustainable returns from fee income, as opposed to lending or trading activities. Our investments include France's BNP Paribas and KBC, a leading Belgian bancassurer and financial company, which also has strong positions in central and Eastern Europe.

• Bankinter is among the best-capitalized banks in Europe, has a history of strong risk management, and is committed to a high payout ratio. Earnings are also bolstered by fee income from its asset management business, which means Bankinter is better able to reduce the impact of net interest margin erosion in the current prolonged low interest rate environment.
• FinecoBank is gaining more operational independence to exploit its unique position in the Italian market, as UniCredit reduces its controlling stake, and the online lender is taking market share from struggling local banks.
• We sold our shares in UBS, a wealth management, investment banking, and asset management company, because we believe slowing European economic growth and the prospect of an extended period of low interest rates are likely to curb earnings. Investment outflows have also picked up at UBS, and investment banking revenues have flagged.
• We also exited our investment in Austrian lender Erste Banking Group because the European slowdown is likely to weigh on the performance of its markets in central and Eastern Europe.

Industrials and Business Services

We moved to a modest overweight in industrials and business services in order to be better placed to benefit from any positive impact on markets from a resolution to global trade disputes and an improvement in business confidence. We added to our holding in Gea, a high-quality German engineering conglomerate that is a leader in food processing equipment, and initiated a holding in Sandvik, a Swedish engineering company that provides tools and solutions in the fields of mining, metal cutting, and advanced materials. Although cyclical names have lost their allure in the European slowdown, we continue to invest in high-quality businesses with strong industry positions and durable earnings that are now more realistically valued.

• In our view, the long-term potential of Gea is not reflected in the price of the shares, which have been depressed by poor execution in recent years. The underlying business performance is now showing signs of improving under a new chief executive officer and chief financial officer, who have a credible restructuring strategy.

Consumer Staples

We further deepened our underweight in consumer staples, our largest underweight, exiting our holding in Essity Aktiebolag, a global hygiene products company. Valuations are now generally expensive in the sector as market volatility fueled demand for defensive stocks. Otherwise, the sector offers good earnings growth visibility, strong returns, and healthy dividends.

• We exited our position in Essity Aktiebolag, taking profits after a strong run. In our view, the margin-improvement thesis has largely played out and is factored into the share price. Raw material prices have also started to decline, and the company could find it more challenging to maintain price increases. Consequently, the shares may struggle to rise much further.

Communication Services

We reduced our overweight in communication services, selling our holding in Iliad, a leading provider of mobile and broadband services in France, and trimming our position in Cellnex Telecom, a Spanish company engaged in the wireless transmissions business, taking some profits after strong performance. The company, a high-conviction investment, is still our largest holding in the sector.

• We exited Iliad to raise funds for more interesting opportunities.� While the French business, the mainstay of operations, is showing signs of recovery, losses in the new Italian business were unexpectedly high in the first half and could curb growth over the medium term.

Real Estate

As we seek to maintain a balanced portfolio to counter market volatility, we have raised our exposure to the real estate sector, moving to a modest overweight. In the third quarter, we added Belgium-based real estate investment trust Warehouses de Pauw, which operates logistics warehouses and distribution and storage facilities in the Netherlands, Romania, France, and Benelux.

• Warehouses de Pauw attracted us because it is a well-run company with strong development expertise, enabling it to deliver above-normal returns. The company is also expanding into Romania, a fast-growing economy that is planning extensive infrastructure investments.

Consumer Discretionary

We pared our overweight allocation in consumer discretionary, trimming Daimler, a leading global manufacturer of premium automobiles and trucks, and Zalando, Europe's largest online retailer. The gloomy global trade environment is affecting key industries such as autos, and the consequent uncertainty and slowing economic growth is depressing consumer-related industries.�We still own shares in auto components company Autoliv, a best-in-class supplier of automotive safety systems. In retail, we also hold SEB, a France-based household equipment manufacturer that has leading global brands, which are coping resiliently amid slowing economic growth.