European equities and economy following different paths

The MSCI Pan Euro index rallied by 6 per cent in January, some 20-25 per cent off its low-point in 2011, and while many investors, particularly in the US, are still very nervous about the region, fund managers operating in this space tend to believe the re-rating will continue this year.

With the Euro Stoxx currently trading at just 9 times earnings and yields approaching 5 per cent, many argue there are some wonderful opportunities for stockpickers, while a great deal of bad news is already priced in and the risks are well known and understood.

The scale of any rerating could be significant. The S&P and MSCI Europe have diverged by some 30 per cent over two to two and a half years, estimates Rory Bateman, head of European equities at Schroders, indicating a real opportunity. Global equity funds are at their most underweight in European equities for four to five years, and so the adjustment, when it comes, could be big.

BOOMING EXPORTS

This bifurcation between the macro economic background in Europe and the region’s stockmarkets is largely a consequence of Europe’s thriving export market. For example, 50 per cent of sales made by German companies are to the rest of the world, and the current weak euro is a great support, says Richard Scrope, fund manager at Williams de Broë.

“The general cautiousness about Europe’s difficulties has led to low company price to book valuations yet companies have strong balance sheets and have recapitalised a great deal since 2008, while there has been no significant change in their business model, so there are great opportunities on a stock by stock basis,” he says.

“Neither should one forget income investors. Many European stocks offer incredibly good dividend yields compared with fixed income, cash and equity markets in other developed markets. The MSCI Europe ex UK index is paying 4.5 per cent.”

Another reason for this schizophrenia towards Continental Europe is that its domestic investors remain more focused on fixed interest than on equities and are not supporting the market. Greg Jones, director of wholesale distribution, Continental Europe & Latin America at Henderson, points out that a typical continental investor’s portfolio might be 40 per cent fixed interest, 40 per cent liquid funds and only around 20 per cent in equities – very different from the UK’s cult of the equity, while investors in the US look across at Europe and make unfavourable comparisons with the risk/reward profile of emerging Asia.

GREEK RESOLUTION

“Clearly Europe is crawling towards a short-term solution on Greece,” says Matthew Leeman, managing director of the European equity team at Morgan Stanley.

“Nevertheless the wider issues in the sovereigns still remain – it’s a two-fold problem – not just the level and the concentration of debt but how to stimulate some growth. I expect economic growth to stabilise across the zone – even the US has posted better figures than anticipated recently – yet the market expects Europe to go into recession despite Europe’s large exposure to areas outside the domestic economy through the export sector. Growth forecasts have been pared back. Even if it is in a technical recession, it is going to be a shallow one.”

Almost to a man, fund managers in this space are focused on mega cap stocks with global brands that have strong sales to emerging Asia. Many of these stocks were until very recently at 30 to 40 year lows, representing marvellous value.

“These are some of the best companies in the world with multinational exposure, some of which are on single digit PEs and trading at a clear discount to their global peers,” says Raj Tanna, equity strategist for Emea at JP Morgan Private Bank.

“It is a fantastic time to be looking to buy these franchises, a large proportion of which also pay sustainable dividend yields of 5 to 6 per cent.”

Unilever is a classic example with 73 per cent of its sales outside the eurozone and 53 per cent of its sales in emerging markets. It is providing top line growth of 5 to 6 per cent against a backdrop of minus 0.5 to 1 per cent European GDP growth. The destiny of such companies is not determined by fact that they are European.

The fortunes of these stocks depend on growth in emerging Asia and the US, and there is widespread confidence that demand will continue to be strong. “China will consume more and more – currently just 30 per cent of its GDP is domestic consumption compared with a 65-70 per cent domestic consumption to GDP ratio for the US and 60-65 per cent for the UK. This is a huge gap and many industries will benefit,” says Nicolas Walewski, manager of Alken European Opportunity fund.

He is overweight the auto sector in the belief that China’s consumption of better quality cars is growing, and likes “names such as Porsche, BMW and Volkswagen with a lot of know-how and brand power, making it difficult for others to compete”.

The argument for Volkswagen, for example, is it has 11.5 per cent free cash flow, a 5.5 per cent dividend yield and is trading on 0.4 times enterprise value (EV) to sales, with a massive 25 per cent global market share. Similarly Daimler is trading on 0.3-0.4 EV sales, indicating the market is expecting margins through the cycle of 5 per cent. The argument is that if truck makers like Skoda can make margins in the teens, and BMW can make double digit margins, there is no structural reason why Daimler cannot post margins close to 10 per cent.

The counter arguments, however, are that the auto sector suffers from overcapacity, has little pricing power and in the last few years has been hurt by the rising cost of steel and weak demand from developed markets.

The luxury market should also grow exponentially. According to World Bank estimates, the number of middle income consumers will increase by over 800m between 2000 and 2030 and developing countries should account for 93 per cent of the global middle class in 2030, up from 56 per cent in 2000.

“These are aspiration-driven consumers who want to be recognised,” says Mr Walewski. As a result of this, he favours luxury goods companies such as Louis Vuitton and Richemont, which have Tag Heuer and Cartier amongst their brands.

BOUNCING BACK

Year to date, cyclicals such as consumer discretionary, financials, and industrials, have certainly bounced back. For example, autos rose 22 per cent in January, while telecoms slid 3 per cent. Financials have benefitted enormously from the LTRO (Long-Term Refinancing Operation) which has boosted confidence and significantly reduced tail risk. That Italy was able to sell 10 year bonds in January at 10 bspts below 6 per cent, compared with 7 per cent at the end of December and Unicredit got its rights issue away, trading at 0.6 to book value, are good indications of LTRO’s surprise success.

“There can be some over-enthusiasm for certain parts of the market early on in the year,” says JP Morgan’s Mr Tanna.

“The performance of cyclical sectors versus defensive sectors year to date has, however, been particularly extreme versus previous years,” he explains. “Some of this is clearly an unwind of the sector performance in 2011, which was heavily skewed in favour of the defensives but still feels excessive. As a result, we would currently be looking for opportunities to add to attractively valued stocks we like in the defensive areas of the market such as consumer staples, telecoms and pharmaceuticals.”

He also particularly likes the oil and gas sector where crude oil faces longer term supply challenges and in the short term is being influenced by the unstable political situation in Iran, Syria and Iraq. All of the oil majors in Europe have dividend yields of around 6 per cent supported by double digit free cashflow yields, and underleveraged balance sheets.

Some value stocks are still lowly rated and on a price to book basis, or on EV to sales, are in many cases cheaper than March 2009.

One issue has been coined “large cap mania”. John Surplice, European equities fund manager at Invesco, is concerned about the large cap quality and momentum stocks that outperformed value stocks in 2011. “It is harder to have confidence in value investing when earnings revisions are very negative, as has been the case in H2 2011, which is why people hide in the big obvious companies and their PEs and multiples go up relative to the rest of the market, but like an elastic band they can only go up so far.”

Mr Surplice believes there will be a return to value stocks as risk premiums come down (they have already started to see this at the beginning of 2012) and as the pace of negative earnings revisions reduces, the market will change from being so defensively positioned with an aim just to preserve capital and seek out value opportunities. This could be the next inflexion point.

“This is the next good hunting ground,” he says, “if you think the sovereign crisis is muddy-able-through-able.”

Either way, it will not be plain sailing from here. “What was clear in volatile 2011 was that political considerations were important to eventual outcomes,” says Gaby Gourgey, institutional portfolio manager for MFS Meridian Funds European Equity.

“Europe continued to drown in debt last year,” she explains. “Total debt to GDP, which was 160 per cent in 1980, rose to 320 per cent in 2010. Private householders are also staggering under enormous debt. Growth in these markets will be impossible to achieve for various political reasons such as requiring labour reform which is very politically charged. Growth also requires to companies to invest in capital stock at a time when it is tough to do that because demand is sluggish.”

VIEW FROM MORNINGSTAR

Still lagging

While the S&P 500 has been moving into positive territory over the past year, the rebound among European equities in 2012 is not yet enough to convert the one year return for Euro large caps into black ink. Despite good returns from companies such as Pirelli, GlaxoSmithKline and Imperial Tobacco, Europe’s markets are still suffering, with financial stocks – particularly southern European companies such as BNP Paribas and Hellenic Telecom – dragging down the return.

It is logical to find the same spread of returns for mutual funds invested in European equities. For the 12 months ending 26 January, the Morningstar European Large Cap Blend Equity category lost an average of 8.18 per cent. However, beyond that figure, it is possible to find funds that have succeeded during the same period.

One such fund is BL Equities Europe EUR. Fund manager Ivan Bouillot has taken a consistent approach since being appointed in 2004. He only selects in areas he can understand, which is why the fund has a limited amount of financial companies, since they have complex income streams. Additionally, Mr Bouillot attaches great importance to the company’s strategic autonomy, meaning that the company must be able to control its own outcomes without the price being driven too much by external, uncontrollable factors. The fund has maintained a first decile position over one, three, and five years.

The Schroder ISF European Special, returned -4 per cent over one year, and since its process is not benchmark-driven, it may differ from the index at both the sector and the country level. Over the past five years, the fund has lost 13.64 per cent against a category average of -24 per cent.

Frederic Lorenzini, director of research, Morningstar France

Value abounds in quality companies

“The point I make to clients is not to confuse the European economy with European stockmarkets ,” says Matthew Leeman, managing director of the European equity team at Morgan Stanley.

“At different points in history Europe has underperformed the US in terms of GDP while European equity markets have outperformed those in the US. GDP is not a good predictor,” he adds.

“Europe abounds with world leading high quality companies with strong franchises and good cashflow generation, that are trading at a discount to their peers around the globe.”

This is a market for fund managers focusing on stock selection and company fundamentals, not top down macro management and large country bets.

“Investors are better served looking at Europe from the bottom up, but there is no need to over-engineer their access to European equities as these are large cap, big recognisable names,” says Leo Grohowski, wealth management CIO at BNY Mellon.

“That said, after a challenging year for active managers I think this should be a better year for active rather than passive management. Fundamentals and valuations were in the ‘Time Out’ box last year and a lot of investments were tainted by the risk off and risk on approach. There is a preoccupation with policy news flow on a daily basis. This means all global investors are digesting the same news day in and day out so correlations were high,” explains Mr Grohowski.

“There has been some fatigue with these headlines and a sense that investors want to focus on fundamentals. Investors could now be rewarded at these prices, as correlations may move towards a more normal range this year.”

Frédérique Carrier, director and European equities specialist at RBC Wealth Management, warns however that a number of factors could give rise to another round of painful volatility, such as for example the French election. Its advice to clients has been to own a selection of companies that are resilient owing to factors such as their pricing power, a particular expertise and those in businesses that require repeat purchases.