No fear: tapping global growth through European stocks

What is your current view on European equity markets?

For the past several years, they have traded at a discount to both global and US stocks. In my view, that discount is not warranted. It stems partly from the widely held belief that Europe’s economic growth will lag other parts of the world in coming years. Yet investing in European stocks is as much a play on global as on regional economic growth.

Because European companies don’t have huge home markets, they are forced to internationalize at a relatively early stage in their development if they want to grow. As a result, they have become highly adept at crossing borders to expand their businesses. Many European firms have a robust presence in fast-growing emerging economies — like those in Asia — and are now reaping the rewards of having established their brands, products, and organizations in those countries early on.

Furthermore, this exposure to global growth can be achieved through holdings in firms that have high standards of corporate governance. That is a big plus, given that corporate governance standards are still being developed and implemented in emerging markets.

Another misperception among investors is that European markets have fared poorly in both absolute terms and relative to other regions. I think this misperception stems from reliance on a misleading market benchmark. The Euro Stoxx 50 Index, which many investors use as a proxy for the region’s equity markets, posted modestly negative returns for 2010 in euro terms and double-digit losses in US-dollar terms.

But if you examine broader, more representative indexes, like the MSCI Europe and the Stoxx Europe 600, you find that they were up in euro terms and flat in US-dollar terms over the same period. The Euro Stoxx 50 is heavily concentrated in mega-cap stocks and is restricted to companies headquartered in the eurozone. In the European portfolios I manage, a large number of our holdings are based outside the eurozone, in countries such as the UK, Sweden, Denmark, and Switzerland. Also, a disproportionately large part of the Euro Stoxx 50 is made up of financials, a sector hard hit in 2010 by sovereign debt concerns.

How is the sovereign debt crisis affecting your thinking about the region?

Investors have been very focused on sovereign debt issues in Europe, but of course Europe is not alone in dealing with this problem. After all, governments in other parts of the world, such as the US and Japan, also face high debt loads and ballooning deficits that stem from anti-recessionary stimulus in the short term and pension liabilities and health care costs in the long term.

The member states in the euro bloc along with the European Central Bank have tools to address the issue. And many of the companies in our investment universe, even the smaller ones, have global supply chains and customer bases, so whether the euro moves five cents higher or lower is not a critical issue. Of course, a prolongation or intensification of the crisis could pose long-term problems for the region.

Two key factors will be Germany’s actions and whether any of the PIGS countries may exit the EMU or enter into debt restructuring. Ultimately it is vital to come up with an effective long-term solution to the sovereign debt issue. An orderly way must be devised for a country to go into default. That is true not only at the national level in Europe, but also for sub-regions and municipalities within states and for countries in other parts of the world facing similar fiscal pressures.

From a short- or even medium-term perspective, I think fears generated by the sovereign debt crisis, especially when they spark massive sell-offs in specific markets, could actually create opportunities for investors. And by tamping down the euro, the crisis has helped the eurozone’s many small- and medium-sized exporters, particularly in its manufacturing heartland of Germany and adjacent countries, to stay competitive on price.

In which industries and sectors do European companies excel in global terms?

Some of the world leaders in industrial services are based in Europe, including companies that inspect and certify goods shipped across borders — anything from oil to toys to food. They are benefiting from the rebound in world trade and the globalization of supply chains. Many goods such as automobiles have extremely complex supply chains involving the transport of numerous components and subcomponents on multiple trips around the world. Every time a component is shipped across a border, there’s a potential need for inspection and testing.

Another industry where Europe has its share of prominent global firms is catering. As companies are forced to “get lean” in order to compete on a global basis, they focus on core activities and outsource non-core operations like employee dining facilities. Some of the world leaders in food-and-beverage catering for corporations, hospitals, and other organizations are based in Europe. The increasingly worldwide scope of competition across industries is good for these firms.

European firms also excel at the production and marketing of luxury goods. In fact, we are finding attractive secular growth companies in the luxury-goods industry. With globalization, the incomes of highly talented professionals are rising around the world. Demand for their skills is strong and supply is tight. This is true not just of emerging markets, but also countries like Germany, which currently has a deficit of 90,000 engineers. This trend is driving what we think will be a broad-based and lasting surge in demand for “aspirational” products.

Finally, some of the world’s pioneers in health care products and services are based in Europe. That is not surprising. Europe has been in the vanguard of the global phenomenon of population aging, which has given the region a head start in coming up with effective ways to address that trend. Some European health care companies have rolled out new technologies and products in their home region and then elsewhere.

Any other areas you are excited about?

I am extremely excited about a number of capital goods companies. While these stocks have had a phenomenal run recently, I think the sector is still appealing over a two- to three-year time frame based on some powerful and enduring drivers. One of those is a secular rise in the global demand for energy, which will propel increasing investment in the production of oil, gas, and coal. In coal, for example, we expect there will be massive investment in new mines, in expansion of existing mines, and in more efficient mining equipment over the next few years. Furthermore, the world’s manufacturing centers, in Asia and elsewhere, face ferocious pressures to enhance productivity, and will seek out the best production equipment to help them do that. Many of the world’s leading makers of high-quality industrial machinery are European.

What do you look for in a company?

The first thing I look for is a structural growth driver that could lead the company to outperform the market average over a three- to five-year time frame. By “structural” I mean any long-term advantage that a company can exploit over more than just a business cycle. That edge, for example, can take the form of a superior business model — in supply-chain management, marketing, branding, cost controls — or technological leadership.

The second thing I look for are barriers to entry, such as patents, trade restrictions — whether explicit or de facto such as safety regulations — and high start-up costs. In some industries, Asian competition is getting stronger for European players because barriers to entry have weakened. That usually results in thinning profit margins.

The third attribute I seek is attractive valuation, which is not hard to find these days in Europe; its markets are cheap by historical standards. And if a company has dominant market share in its industry, that’s another plus.

Can you share an example of one of your non-consensus views?

When I differ from consensus on a stock, it is usually not in my earnings estimates for the next quarter or two, but in my projections of its longer-term growth rate. The market tends to price stocks on the basis of mean reversion. The implicit assumption is that a firm can hold on to a competitive edge for only one to three years. So if you can identify companies that you think will be able to retain their advantage over a longer period, that can be really valuable.

In my experience, stocks of such companies can outperform the overall market for a long stretch — not only due to their faster-than-average revenue and earnings growth, but also because their price-to-earnings multiples expand as investors gradually develop an appreciation for their growth and start piling in. The investors who were on board early get a double boost: the stock’s price is lifted first by earnings growth, then eventually by the rising multiple attached to that growth.

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