Euroland looks to recovery

European stock markets have had a good year and have out-performed US equities since the start of 2005. In contrast, the US economy has out-performed the euroland, but the latter is showing signs of improvement.

Charles Dumas of Lombard Street Research says: “The euroland recovery remains at the stage of favourable surprises. The cumulative impact of two years of virtually zero real interest rates, considerable public budget easing, low and falling bond yields and good growth elsewhere in the world has stored up a pipeline of stimulus.

Sweet stage

“And the economy is at the sweet stage in the cycle when output remains below its potential but is beginning to grow above its potential rate. Inflation stays subdued – below 1.5 per cent ex-oil – while growth improves. While the European Central Bank is now highly unlikely to heed calls for lower rates, despite disappointing second quarter GDP data, there is not much chance of an increase soon.

“With private credit and broad money growth both at 8 per cent, there is scope for growth at above euroland’s admittedly paltry 1.5 per cent potential rate over the next year or so.”

Philippe Brugere-Trelat, manager of the Franklin Mutual European fund, says there are investment opportunities in European equities but investors should not expect the strong returns this year to continue without a period of consolidation.

“European equities have out-performed US markets in 2005 and yet economic growth is only around 1 per cent compared to 3 per cent in the US,” says Mr Brugere-Trelat. In the 12 months to 8 August 2005, for example, the S&P Europe 350 index returned 24.85 per cent while over the past three years the market returned 32.31 per cent.

Mr Brugere-Trelat attributes the strong equity returns over the past year to increased corporate earnings despite the difficult economic environment. One of the reasons for this, says Mr Brugere-Trelat, is the restructuring and cost reduction occurring at companies across the continent.

“I would not want to be too optimistic about the outlook for European equities,” says Mr Brugere-Trelat. “The increasing prices of energy, notably oil, and commodities will feed through into input costs. This will mean there is little pricing power left for companies which will reduce profit margins.”

Bottom-up stock picking

One characteristic shared by most European equity funds is their focus on bottom-up stock picking rather than taking a macro economic view and allocating holdings on a country basis.

This is the case with the Franklin Mutual European fund. Mr Brugere-Trelat says: “We look for companies that are priced at a significant discount to their intrinsic value. We also invest where we see value from a merger. In the Pernod Ricard and Allied Domecq merger, for example, we invested in both. The other area we invest is in distressed securities. But we do not take risks in these situations and look to protect against downside losses. The average holding period is in multiple years and we do not get concerned about the short-term performance of the fund.”

This emphasis on the long-term is reflected in the fund’s performance, adds Mr Brugere-Trelat. Over one year, the fund has returned 23.42 per cent against 24.95 per cent by the S&P Europe 350 index. But Franklin Mutual European has returned 42.22 per cent over the past three years and 35.98 per cent over the last five years compared to 32.31 per cent and -24.81 per cent by the index, respectively.

‘European equities are still attractive because there is likely to be moderate economic growth, we are in a low interest rate environment, valuations are undemanding and there is a healthy corporate sector’ Andrew Arbuthnott, Pioneer

Yet, despite the emphasis on stock picking, Mr Brugere-Trelat says there have been sector and country trends over the past few months. “The fund is overweight in the drinks and tobacco sector. This is because of the cash flow security of companies in this sector, the discount on valuations and good quality management.”

He adds that the fund is overweight in Germany because of the stock opportunities presented by the corporate restructuring in the country. “Germany is the European country most exposed to export markets. It is the second largest export market in the world and exports comprises 40 per cent of its GDP. But the restructuring has lowered costs and increased profits. The expected election victory by the CDU this year should lead to further economic reform.”

Michael Barakos, manager of the JPMF Europe Strategic Value fund, says that with the compression of relative equity values over the past year, it is harder to exploit relative value in European stock markets than over the past few years. “There is still relative value available in European stock markets, but it is harder to exploit because of the reduced differentials between equities.

“Unlike a couple of years ago, the typical value stocks are no longer at a discount of 20 to 30 per cent to the market. Now 80 per cent of stocks are on price to earnings ratios of between eight and 15 times and the average value stock is at around a 10 per cent discount to the market.”

Mr Barakos says the JPMF Europe Strategic Value fund has reduced its exposure to general retailers and house builders over the past few months. “Even if they look cheap many of these companies are not fundamentally sound and there have been some profit warnings. We are finding value among the European insurance companies.”

As the fund targets value stocks, Mr Barakos says it obviously performs best when value stocks are in favour. But he stresses that it focuses on the cheapest companies which are fundamentally sound and therefore can still outperform the index when growth stocks are in favour. “We identify the cheapest stocks but it is vital to avoid value traps. These are the companies that are cheap for a reason and deserve to be cheap.”

Over the past five years, the JPMF Strategic Value fund has returned 39.08 per cent, well ahead of the the S&P Europe 350 index, which dived deep into negative territory. This includes 2001 and 2002 when value stocks performed strongly. But the fund also returned 49.39 per cent over the past three years, which included 2003 when there was strong growth, compared to 32.31 per cent by the index. With the return to favour of growth stocks over the past year, the fund has returned 29.26 per cent, still ahead of the benchmark.

The JPMF Europe Strategic Value fund has a diversified portfolio with between 250 and 350 stocks. “We manage the fund on the premise that the cheapest stocks on average outperform the most expensive stocks. Having a diversified portfolio enables investors to capture this average outperformance as it can benefit from more of the opportunities,” says Mr Barakos.

The Pioneer Top European Players fund takes a different approach by having a concentrated portfolio. Andrew Arbuthnott, the fund’s manager, says it holds a maximum of 30 stocks. To be included, stocks must have a holding within the portfolio of 1.5 per cent greater than their index weighting. Thus, if a stock comprises 3 per cent of the MSCI Europe index, it must have a holding of at least 4.5 per cent in the Pioneer fund.

The intention behind this high conviction approach, says Mr Arbuthnott, is to try to capture as much capital growth as possible and for each stock to have a material difference on the fund’s performance. Intuitively, it would seem such a concentrated portfolio might increase risk relative to the benchmark. But Mr Arbuthnott says the fund’s volatility is 19.8 per cent against benchmark volatility of 20.8 per cent over the past three years.

The fund’s tracking error has been 4.2 per cent over the past three years. This is despite the fund having a mandate to have a tracking error of between 4 and 8 per cent.

According to Mr Arbuthnott, another advantage of a concentrated portfolio is that the fund does not require as much value in the stock market in general to generate returns. Despite this, he says European equities are still attractive. “This is because there is likely to be moderate economic growth, we are in a low interest rate environment, valuations are undemanding and there is a healthy corporate sector.”

The top five over-weight holdings in the fund are BNP Paribas, France Telecom, ENI, Société Générale and Royal Bank of Scotland. By far the largest fund in the sector is the Fidelity Funds European Growth fund, which has ?17.59bn in assets. Despite being around four times the size of the next biggest fund, it has still outperformed the index over one, three and five years.

Victoria Cheeseman, senior analyst at Fidelity, says the fund seeks companies with cheap valuations. Before investing in each stock, the fund looks at the risk and liquidity of that company. Ms Cheeseman says the fund, which has a diversified portfolio of 240 stocks, has been able to maintain outperformance by taking longer term holdings. The average holding is between one and a half to two years. It only invests in companies with a market capitalisation of below ?500m if it believes it will double in size.

Among the sectors where the Fidelity’s European Growth fund has been finding opportunities is energy, particularly oil refinery and oil services stocks, and television and radio stocks.

Equities attractive

Tom Stubbe Olsen, manager of the Nordea 1 Europ Value fund, says the corporate results in the first half of the year and cash/earnings yields compared to bond yields suggest equities are more attractive than fixed interest.

While focusing on company performance and fundamentals rather than macro economics to search for undervalued earnings power, Mr Stubbe Olsen says: “What we have noticed for some time now is that there seems to be a discrepancy between the performance of companies and the economy. Lately, we have observed some economic data that could point to higher economic growth in Europe but for the time being we think this conclusion is still premature.

“Looking at the continuously rising oil price, we are mainly concerned with the possible negative impact on consumer demand and corporate earnings that could possibly slow down economic recovery.”

He adds: “Overall, we believe the market conditions are supportive for European equities although we only invest in companies on a very selective basis. The models we are using to generate new investment ideas provides us with a number of interesting opportunities at the moment and we concentrate on researching these companies thoroughly for their earnings power. Lately, we have added to Credit Suisse, Gemplus, Micronas and Philips.

“Comparing the cash/earnings yield to the current bond yield seems to favour equities but we are also alert of the fact that the market appears to have a lot of liquidity. A lot of money is currently being returned to shareholders, as companies continue to buy back their own stock, engage in merger and acquisitions and profit from low borrowing costs.”

Robert Burdett, co-head of the Credit Suisse Portfolio Service, says he is positive on European equities and has been raising his exposure to the continent. “There are a number of elections coming up which add uncertainty but the economic and corporate environment has been improving from a low base.

“What has been interesting is that fund managers are mentioning allocations to Germany. Traditionally, they have stressed stock picking. With the exception of many being overweight Ireland, managers have not tended to talk about individual countries.”

Among the funds held by Mr Burdett are Frankfurt Portfolio Management (FPM), JO Hambro Capital Management Continental Europe, Artemis European Growth, MFS European Equity and Comgest Europe.

‘There is still relative value available in European stock markets, but it is harder to exploit because of the reduced differentials between equities’
Michael Barakos, JPMF