Seeking European equities with international exposure

Participants

1. Florent Brones
Chief investment officer, BNP Paribas Wealth Management

2. Manuela D’Onofrio
Head of global investment strategy, Unicredit Private Banking

3. Daniel Hemmant
Senior portfolio manager, European equities, BNP Paribas Investment Partners

4. Alan Mudie
Chief investment officer, Union Bancaire Privée

5. François Savary,
Chief investment officer, Reyl & Cie

6. Matthew Stemp
Private banking and asset management team, Berenberg Bank

7. Archie Struthers
Head of investment solutions, Lloyds Banking Group

Moderator: Yuri Bender
 Editor-in-chief, PWM

Yuri Bender: Our subject today is ‘European Equities as a Private Client Investment’.  It is our aim to look at the economic background and rationale for investing in European equities, to identify the types of stocks we should be investing in, to hone the client conversation and finally to assess the long-term position of equities in client portfolios. 

We are hearing about the so-called ‘Great Rotation’ from bonds into equities, mentioned in reverential tones, as if we are talking about the Reformation or the Renaissance. Is this very much overdone and what kind of economic fundamentals is it based upon?

Manuela D’Onofrio: I always look at investment through relative valuations. Since January 2009 – when the Federal Reserve announced quantitative easing – we looked at corporate bonds and the valuation of equities and decided that, on a risk-adjusted basis, corporate bonds offered more value, so we started buying them. Then we scaled up high yield emerging market debt. As far as equities were concerned, we kept a neutral weight until September 2012, with a strong US bias, because with both an expansionary monetary and fiscal policy, it was a very easy call to make. 

In September 2012, when finally even the European Central Bank decided to implement a hidden quantitative easing, we thought this was the green light for equities, because you had very strong compression on spreads on investment grade, but also on high yield and emerging market debt. In relative terms, since September, we actually started to think equities offer more value than credits and bonds, for sure. We then went overweight equities and started to buy European equities, for the first time in many years, because of the European Central Bank announcement of the OMT – Outright Monetary Transactions to buy bonds issued by Eurozone-member states. 

After the announcement of the Bank of Japan’s adoption of the inflation target, we decided not to be short on Japanese equities any longer. We financed the increase in Japanese equity by scaling back emerging market equities because we have become a little sceptical that you can still play this asset class the way we used to; you have to be much more selective.

Just to make it easy for us, we are in a reflationary environment in which, in the long run, equities should return more value than bonds. But to talk about a ‘Grand Rotation,’ to be honest with you, I do not see institutional clients that exposed to equities, as yet. 

Alan Mudie: The ‘Great Rotation’ theory does not stand up to any rational analysis. In Europe and the US, money is still flowing into bond funds. Equity funds have seen inflows but nothing in comparison with what has been lost in terms of redemptions over the last few years. It appears that flows are coming out of cash rather than fixed income.  The ‘Great Rotation’ – with all due respect to you and your colleagues  is more of a media invention; it shows up on any sort of Google word search you do, but in terms of hard data I do not see any evidence. 

Yuri Bender: European equities have been out of favour, with investors worried about lacklustre GDP growth figures and risk of eurozone disintegration. Should they revisit allocations and invest in Europe?

Daniel Hemmant: One of the problems when you reallocate to US Treasuries, European equities or Asian equities, is that it tends to be done as a block. The reality is that, if we are talking about the ‘Great Rotation’ and you want to come out of bonds into equities, the easiest step across is probably into stable, high yielding, high dividend stocks. You do not get that if you buy an exchange traded fund (ETF) or if you just allocate to the market. That is a challenge for asset allocation in general.

More specifically, there is more to Europe than the eurozone and some Scandinavian economies are doing relatively well, though there is very little demonstrable long-term correlation between equity returns and GDP growth. 

The further back you take the analysis the worse it looks. Part of that is a reflection of the European equity market, where a considerable amount of revenues come from outside the eurozone. Certainly, at a national level, just because a company is listed in a specific market does not mean the majority of its activities are there. 

If you go down into much smaller cap stocks, then increasingly, they will have those national characteristics. The MSCI Europe is market cap weighted and, unsurprisingly, the market attaches more value to foreign earnings than it does to domestic earnings. 

You have a situation now where more than 50 per cent of sales for MSCI Europe come from outside Europe and the big increase in that is from emerging markets. I would not pretend Europe’s problems were solved or that we will see fantastic GDP growth. Our approach would be, I suppose inevitably, at a more stock specific level. It is not advisable to go just willy nilly and buy the market. 

Matthew Stemp: If you look at equity versus bonds, it is difficult to argue bonds are attractively valued, certainly regarding sovereign debt. If you compare European with US markets, they trade at significant discount. 

Given that Europe has been through one of its severest recessions in the last 100 years, given where valuations are starting and the lack of confidence in European markets and economies, it would not take a huge amount to turn around sentiment for Europe among investors. 

There is genuine value to be found at stock specific level within European markets. You can build a compelling case that both sentiment and, importantly, valuation are pointing to – while not exactly a resurgence – an opportunity for investors to take a harder look at European equities than they have over the last two years. 

One of the reasons I am more bullish than for some time is the knowledge that in UK institutional funds for the first time in many years, bonds form a greater allocation than equities. Historically, that has been a pretty good signal to do the opposite. 

Yuri Bender: What are the current themes you are sharing with private clients? 

François Savary: We are keen on M&A and trying to promote that. We provide clients with a selection of stocks we bundle together. Last year we decided to reduce bond exposure significantly and are still in the process of telling clients to get rid of bonds, down to the minimum they are comfortable with.

But we tell them not to be too hopeful on equities, that they should not forget risk is still significant and you do not want it everywhere in your portfolio by combining high yield, corporate bonds and equities, so we address this in the asset allocation. 

We are very keen on stockpicking. We remain underweight in Europe, believe political risk remains significant and that September could be a tough month. You will have German elections and maybe a second round of Italian elections, which could prove a catalyst for some re-thinking about European political risk.  

This is why we are more focused on selecting the right stocks for the future. We still have a lot of doubt about domestic Europe, as it will be a very, very long time before the economy accelerates and becomes significant. 

Archie Struthers: We have viewed equities markets as largely trading-orientated. What we have been talking to clients about is a move out of the risk-on, risk-off environment we have been stuck in for a number of years. While we have not exited that environment, the direction of travel is one where you are seeing more rationality in terms of investor behaviour, more balancing of the different themes and inputs that are going on. 

Political risk remains a particular concern. If you look at surveys of broad investor concern or tail risks, we are shifting from the paranoia of the known unknowns to a re-emergence of the paranoia of the unknowns unknowns, which is healthy. This means it is not just about the US fiscal cliff and/ or European solvency, and political behaviour as it pertains to economies. There are, in reality, other things going on out there in the risk space; the de-emphasis of risk-on, risk-off in Europe is important.

Alan Mudie: Until slightly more than a month ago, the figures suggested the market was normalising and we were moving away from this switchback ride which we have had since 2007. 

That is less clear-cut today. The sharp downward move in sterling and the yen has played through in equity markets in quite an important way. 

Similarly, the aftermath of the Italian election has sparked the re-emergence of risk-on, risk-off behaviour.  That being said, we have regular input from our in-house fund managers, who are saying the market is playing to their strengths in terms of stockpicking, which would tend to show we remain in the process of normalisation.

Daniel Hemmant: I cannot see anything normal about the current environment; I am not even sure what normal is anymore. You have got unprecedented monetary policy from every major central bank, Western and Japanese. You have fiscal policy that, frankly, has come to the end of the road compared to what has been done over the past 30 years. 

We are in a very unusual environment, and the surprise currently is that this is not translating into more market volatility than you might anticipate. In fixed income, central banks are basically buying up the market, so there is no surprise there is a lack of volatility there. The surprise has been over recent months in equities, that we have just shrugged off bad news and carried on up. That does start to smack of a liquidity-driven market, which, if you are investing based on fundamentals, is not an entirely comfortable place to be.

Our starting point is always industry structure. We like investing in companies that operate in well-structured industries. If a company has posted supernormal returns, why are those sustainable? Assuming you believe they are, and the barriers to entry around it are sufficiently high, then you expect that company to be able to reinvest in its business and perpetuate its growth over time. We are interested in industry-specific stories even more than stock-specific stories.

Yuri Bender: European equities investment has recently been dominated by defensive growth stocks, while prices of other riskier stocks have fallen due to a weaker economic backdrop. Do we see the whole class of once-battered so-called value stocks ready to re-emerge from this gloom?

Florent Brones: The concept of value is very important in Europe because European equity markets are extremely cheap from a quantitative point of view; whatever criteria you look at. But we have also this constraint: domestic stocks versus international companies. That will continue to be a stock selection driver.

The domestic part of the European market will continue to be under pressure. We do not see economic growth recovering before next year, but the markets will anticipate recovery and everything has its price when value stocks are as cheap as they are today. 

Just a small change of sentiment concerning future European economic growth could drive a significant rebound in equity prices. Money has to go somewhere and current bond yields, corporate and especially sovereigns, are too low.

Nominal rates are clearly below inflation rates so long-term investors should focus on that and say, ‘How are we going to protect capital over the long term with these types of yields?’ Sooner or later, the risk-on will come back but, for a very long period of time, not, as you said, risk-on, risk-off every couple of months or quarters.  Longer-term, if you want to protect your capital, with the real bond yields that we have today, we will have to take more risk. This is a very powerful driver for equities on a global basis. 

Daniel Hemmant: The difference in relative performance of growth and value in Europe over the last four years is stark. It is not because growth has done particularly well; it has not done badly, but value has been dreadful, because of earnings. There has been no particular re-rating of the two; it is just that the earnings performance, specifically of financials and, to a certain extent, telecoms and utilities, has been dire. The risk of continuing to pile in on an aggressive growth strategy that has done very well because it has excluded those areas, is that you start to get a rotation at some point. 

Alan Mudie: A strong case has been made by my colleagues that a lot of value has been generated by the under-performance we have had in European equities over the last few years. If I had to take a five-year view starting today, I could make a much stronger case that European stock indices would outperform US stock indices, than at any time in the last 15 years. 

Florent Brones: We have a list of stocks with a high proportion of international sales. Also, the dividend yield is significant. We like visible, high dividend yields with strong cash flows. We also like some international industrialised companies like Michelin, and in terms of financial stocks, the insurance industry, for instance, Allianz. In terms of more defensive stocks, we like the pharmacy sector, the drug companies, Novartis and Sanofi do have a defensive quality and significant yields. It is really possible to find good, solid, international companies in the European universe.

Alan Mudie: I am sceptical as to the strength of that argument.  It is something that we hear all the time, and I have any amount of people coming in to pitch the dividend income story to me.

I have yet to be convinced that high yielding equities per se are necessarily a winning strategy. Specific to European equities, last year was the first year for a number of years where dividends were cut in aggregate for listed European equities. We had a number of very high profile hits to dividend pay outs from extremely high yielding stocks. Simply buying high dividend yielders makes no sense; we focus on the quality of the business, the sustainability of its profitability, and the ability to pay and raise those dividends over time. That makes more sense to me. 

Florent Brones: The high yield theme is a good step forward for fixed income investors into the equity world. We insist upon the visibility of the dividend; it is not only the level of dividend, but the way the dividend is covered by the cash flow, the quality of the company. We do not have an obsession with the high dividend; we really have an obsession with the visibility of the dividend, and long-term visibility. 

Archie Struthers: You could add that you are taking a deliberate factor risk if you focus on dividends, because the side-effect is, for example, in the current environment there are very few banks paying dividends. You build in other exposures. Looking at the UK, income managers have had a really torrid time over the last few months, and it is not because of the stocks they own, it is because of the stocks they do not own. Where measured against broad markets they have been left behind, because they have not benefitted from the rally in banks, for example.

François Savary: We are still holding Nestlé, Swatch and Novartis, which may benefit from the scenario of a weakening Swiss franc over the next few months. But we believe there is room to switch to less defensive and more aggressive or cyclical names. We are in the process of convincing our clients there is room for the world economy to accelerate, mainly because the US is showing good signs of recovery. Then we can move on our proposal towards cyclical stocks.

We have lately decided to focus on countries with weakening currencies like the UK, where we are moving into more cyclical names, such as Rio Tinto. Although we intend to move from very defensive stockpicking to a more aggressive approach, we will do it step by step and we are not necessarily selling all the defensive stocks in Europe just yet. 

Florent Brones: We currently have lower systemic risk in the markets. If everybody agreed with that, it should have two implications; one is the equity risk premium should shrink, especially in Europe. It is clearly one of the main advantages of one of the positive factors bearing on Europe in the future. If we see a one or two points lower equity risk premium it will mean 15-20 per cent upside potential without any earnings growth, without any GDP recovery. That is very important to keep in mind.

The second point is about the implications in terms of sector selection, because, if you agree with this idea that systemic risk is disappearing, then the banking sector, especially in Europe, has a huge potential, due to the sharp discount of price to tangible book value, especially for Italian, French or Spanish banks.

Manuela D’Onofrio: The key common factor uniting clients is risk aversion. Since 2011 it has been difficult to convince our clients to take more risk in terms of equity exposure. For Italian clients, one principle that has driven our strategy from the very beginning was to diversify their portfolio out of Italy.

When they invest in equities they do not have to decide whether to buy Italian, German or French equities. Therefore during 2008 crisis and afterwards, they did quite well because their portfolio was not solely exposed to Italian assets. In 2011 and 2012 we delivered very good performance because of big exposure to credit risk.  They were very surprised by this, because they saw Italian government bonds losing money.

In a certain way, they now trust us when investing in equities, because we have a diversified approach, but it is very difficult to convince them to increase part of their exposure. Currently the average exposure to equities of an Italian customer is 20 per cent, but this is really the maximum we can get at this point from our customers. They are very concerned, because the real economy is doing very badly. We are in a clear credit crunch, and if you look at the Italian economy, which is mainly an economy of small and medium enterprises, when you have such a big credit crunch, due to the fact that banks are stingy in lending money, there is a real urgency for that issue to be addressed.

Alan Mudie: Our analysts, who cover the world on a sector basis, pick a basket of 10-12 stocks in their individual sectors, which aims to outperform the world sector index. In terms of country breakdown, we come up with more value and better quality companies in the US than elsewhere. Out of the 100-odd companies on our buy list, 50 per cent are North American, with around 35 per cent in Europe, including the UK and Switzerland.

Matthew Stemp: Where you can see some value below the big stock level is in some of the smaller and medium sized stocks within Europe, which perhaps have not attracted the attentions of international investors, in Italy and in Germany, with the Mittelstand companies. They are great exporters, very well run businesses, which have not typically appeared on international investors’ radars.  There are pockets, trying not to generalise, in the size band, as much as there is within the industry band.

What happens to currencies is clearly of major import to European exporters, and also what happens in Asia, because for many big European exporters the Asian story is as important, if not more important, than the US and the rest of Europe story, particularly in China, and some of the emerging economies in Asia. That is where a lot of European companies should be focusing. 

Manuela D’Onofrio: Since 2011, we have concentrated our portfolios on exporters. Looking at the first nine stocks in our equity portfolio, more than 60 per cent of their sales come from outside Europe. This is the main driver. Are we ready to tilt the portfolio, or at least start buying domestic stocks? Not really. We are not quite there yet. We would first like to see more willingness to relax fiscal policy in Europe. At the beginning of the year we bought companies more exposed to the cycle, because we think some sort of growth will come back in 2014. Our three recent picks  are Volvo, MAN and Publicis. 

Florent Brones: We are clearly optimistic about European equities, because we believe the equity risk premium compression is a long-term story; it will take years to correct this undervaluation of European equities. European equities are very cheap, because they are facing a wall of worry, and it is more difficult to explain why to ‘buy something’ when there are so many negative factors in place. We are in the middle of a big mutation in Europe towards more fiscal integration. But this is a long-term story and it will take years for Europe to reform itself and to move the European economic model towards something new. 

We are in this transition and equity prices are reflecting that. The sovereign crises have been an important topic for Europe, but current valuations are so cheap that we think this risk premium compression will be a driver for equities, so we buy value.

Matthew Stemp: Look through the short-term problems; focus on the long-term.  If we believe we are going to come out of this crisis, one of the issues that will come back on to the agenda is inflation. Money is virtually free, if not there is a price to holding it; there is a hell of a lot of liquidity that is being created out there. At some stage inflation is going to come back on to the agenda and I would much rather be holding equities than fixed interest instruments or cash, when people start to worry about inflation, which inevitably they will before we see it.

Archie Struthers: There are two things that heal: time and inflation, and both are ticking along in the context of Europe, so both of those things are additive to the medicine picture. For our clients, at the most basic level, it is getting into that long-term discussion, because I totally agree it is very much about looking through some of these less predictable, shorter-term uncertainties, and thinking about owning real assets in the broadest possible context. 

In a low growth environment, equities, in relative terms, are a good place to be looking; we are at certainly a 30-year low in bonds. While bonds play a part in a balanced or a diversified portfolio what worries me is the lack of genuine debate, at the customer level, around the perception of stored value, given the build up of some risks in real terms.