With many other stock exchanges, particularly in the US, breaking one record after the other, shouldn’t European equities be following suit? Is Europe less favoured by investors? The ‘old continent’ most definitely offers attractive investment opportunities.
We see sufficient reasons to invest in European equities now. Investors could be excused for thinking that the European equity market offers less potential, but appearances can be deceptive. Compared to other developed markets, such as the US, European corporate profitability is currently at a low point. But that’s precisely why now, on the eve of a recovery, there is an excellent opportunity to buy.
Exhibit 1: Average operating margins are extremely low at below 8%, which is typical for a crisis situation. Yet there is no crisis. Indeed quite the contrary: over the past three years many European economic indicators have consistently pointed upwards – the graph shows changes in the operating margin for the MSCI Europe index for the period between August 1985 and August 2016
Source: Bloomberg, MSCI Europe, as of September 2016
Should corporate profits follow that rising trend?
Yes, we see no structural barriers to profitability. Recovery is quite slow because we are coming out of an extremely painful financial crisis, a deep trough, that started in 2008/2009 and because it took a while for the central banks and politicians to take incisive action. What is more, we should not forget that some of the causes of the crisis lay outside Europe.
Many emerging economies, for instance, were contending with severe problems, which were reflected in the sales and profits of many European large cap companies, which is precisely the segment that includes the large multinationals we invest in. These countries too are showing signs of recovery. Overall, we would say that if there is a sustained revival in growth (and inflation), a profit recovery in Europe is the obvious next step, which should inject fresh momentum into the European stock exchanges.
As an investor, you would clearly want to be a step ahead of this
That is correct, but it is important not to buy into the entire market now. Some sectors have already been on a strong run, most notably various consumer staples such as food, personal care, spirits and tobacco. These have been bought up massively by investors who felt compelled by the ultra-loose monetary policy and accompanying ultra-low interest rates to chase after companies with safe (i.e. stable) sales and a steady dividend.
This search for yield has strongly driven up the prices of such equities, so these are now relatively expensive. In broad terms, we do not see much potential there. We would prefer to continue focusing on more cyclical large and mid-cap sectors. These are the front-runners of the recovery. We have already been doing so for 12 to 18 months now and it is consistent with a growth-driven investment strategy.
But surely there is more to it than valuations?
Of course. Our starting point is the structure of the market in which the company operates and how the company is positioned in that market. We know, after all, that companies that are well-positioned in a highly concentrated sector, e.g. market leaders with few competitors, are better able to defend their long-term profit levels. These are the companies we would be happy to invest in for four to five years.
During a period of economic growth or when you expect infrastructure expenditure to rise, for instance, leading construction and construction materials companies can offer interesting investment possibilities.
How do we look at investment opportunities?
Take Mediaset Espana Comunicacion. Like many Spanish equities, this company fell out of favour during the crisis, but it was part of a sector that was starting to consolidate. The combination of low valuations and mergers in the sector made this an attractive investment for us.
One example of a European company with a large exposure to emerging markets is Standard Chartered. This bank, and its share price, suffered a prolonged deep decline, but in view of its leading position in a growth market – cross-border bank services for Asian and African exporters – we have it in our portfolio anyway. So our assessment not only looks at the company in itself, but also at its position in the sector and versus its competitors, its long-term growth opportunities and sources and sustainability of growth, historical valuations and, above all, cash flows.
Does a stock picking approach mean that fund performance is hard to compare with that of a benchmark?
As stock pickers, we are contrarian investors. This has its advantages. For instance, we did not follow the flock when many investors poured into the aforementioned safe havens, which led to extremely high valuations in some sectors. We can also take a more detached approach towards market turbulence arising from, for instance, the persistent political uncertainty in Europe over events such as the Brexit referendum.
Actually, we think that, even without the UK, Europe still has a lot going for it. Issues such as these tend to affect stock exchange sentiment but, as noted, often have little impact on market leaders that are strong enough to stand their ground.
So because of your contrarian approach, performance can deviate rrom that of the market as a whole?
Admittedly, our seemingly conservative approach based on extremely in-depth research may cause us to temporarily lag behind the market index, but the important thing for us is to invest in solid, strongly-positioned companies, without paying too high a price for their high and stable returns on equity.
We are not insensitive to the opportunities that arise in turbulent markets, but we do not run with the pack. The basis for the portfolio remains the consistent adherence to our proven investment process, which focuses on long-term results. [divider] [/divider]
Stocks are mentioned solely for informational purposes. This does not constitute 1) an offer to buy or sell or a solicitation of an offer to buy or sell any security or financial instrument or 2) any investment advice. [divider] [/divider]
This article was written on 14 September 2016.