At a glance n The
performance of European equities over the past two years shows stocks have disconnected from regional economics. Company fundamentals are, once again, driving markets.
valuation multiples can expand further, earnings growth looks poised to take over as the main driver of stock prices in 2014 and beyond. to other regions, European equities are attractively valued, including on a cyclically adjusted earnings basis.
European equities: investing in companies not countries After the macroeconomic gloom of recent years, it is no surprise that European equities remain subject to scepticism. Such scepticism represents an opportunity for investors however; valuations are attractive relative to other markets, while there are encouraging signs of economic improvement despite well-documented structural challenges. Critically, an investment in Europe is an investment in companies not countries. On this basis, a compelling case for investing in European stocks can be made, with the continent home to many world-class companies benefiting from strong fundamentals such as structurally growing markets, strong brands, healthy balance sheets and broadbased international exposure. More specifically, we think six key factors make the case for increased allocations to European equities.
macro situation in Europe has stabilised and there is mounting evidence of an emerging recovery.
attractive valuations, large cash reserves and normalising capital costs, conditions look ripe for a new round of market-supportive corporate activity.
after a long period of outflows, money has started to flow back into European equities.
Six key factors n European
companies have a strong record of delivering earnings growth in spite of lagging economic growth; n improving outlook for earnings growth and capital spending; n relative valuations are attractive; n aspects of the macro environment are improving; n companies will increasingly deploy their cash to buy other companies; n the market is being supported by increasing investment inflows.
Investing in European companies not economies Since the start of 2013, European equities (MSCI Europe) are up by 21% on a total return basis, while rising by 35% since 2012. A key reason for this is that company fundamentals (not macro events) are driving markets again, with investors increasingly learning that investing in European companies is distinct from investing in European governments or economies. As the charts below show, despite lagging economic growth, European earnings growth has beaten global earnings growth in the long run. Chart 1: Despite lagging economic growth...
Chart 2: Europe is ahead on earnings growth 7.0 6.5
EPS (Log scale)
Real GDP (Log scale)
4.9 Europe 4.7
4.5 1980 1985 1990 1995 2000 2005 2010
6.0 5.5 5.0 4.5
4.0 1980 1985 1990 1995 2000 2005 2010
Source: State Street as at April 2013. Note GDP growth is indexed and then converted using a log scale
02-2014 “A generally reliable determinant of stock performance is value creation and the good news is that many European companies have excelled in this regard despite the tough economic conditions of the past few years.” Paras Anand Head of Pan-European Equities
Two key factors help to explain this mismatch in Europe’s economic performance and European corporate performance. n Firstly,
many European companies are actually leading global companies that have compensated for weaker demand in markets closer to home by selling more of their products to faster-growing markets in other parts of the world. n Secondly, many European companies have proved remarkably adept at preserving their margins by boosting their efficiency via technological advances or via cutting labour costs. This helps to explain why the shares of many leading European companies, particularly well-known global brands like Audi, Volkswagen, Hermes, Nestle and Zara (Inditex) – have been able to excel despite well-publicised regional economic woes.
Earnings growth to take the baton from multiple expansion The chart below shows a typical equity cycle and events are broadly following the established pattern. We have been through prolonged despair and in recent months experienced a ‘hope’ phase of multiple expansion. This typically leads onto a much longer ‘growth’ phase where earnings are the main driver of returns. Specifically, Goldman Sachs is predicting 14% earnings growth for Stoxx 600 in 2014, implying a calendar return of 13.6%.1 Making a very similar argument about earnings taking over from multiple expansion as the main driver of returns, Nomura predicts a 14% price return for European equities in 2014.2 Chart 3: Typical phases of the European equity cycle – moving from ‘Hope’ to ‘Growth’ 60.0
■ Real earnings growth (%)
■ Average P/E multiple expansion (%)
■ Real price return (%)
-9.5 -19.0 -24.9
Despair (26 mths)
Hope (10 mths)
Growth (33 mths)
Optimism (14 mths)
Source: Goldman Sachs, November 2013
Attractive valuations A key supportive factor for European equities is their relatively cheap valuations. As the chart on the next page shows, Europe trades on a significantly lower PE multiple compared to both the US and Japanese markets, on both a trailing earnings and forward earnings basis. Another measure is the actual dividends paid by companies to their shareholders – on this measure, Europe’s 3.5% yield comfortably beats all other major regions, including emerging markets, while being nearly double Japan’s equity yield and 75% higher than the 2.0% equity yield available in the US. Chart 4: Selected valuation metrics by region P/E 12E
1. Goldman Sachs, European Strategy Outlook 2014, November 2013. 2. Nomura, 2014 European Strategy Outlook, November 2013.
Asia Pacific ex Japan
Source: Citigroup, September 2013
EPS YoY % 14E
02-2014 “Given the compelling valuations of European stocks versus other assets and regions, we are witnessing signs of improving fund flows into European equities. This is likely to support performance going forward.” Alexandra Hartmann Portfolio Manager, European equities
Many analysts’ favourite measure of valuation is the Shiller or Graham-Dodd PE ratio. This measure, which is also called the cyclically adjusted price-earnings ratio (CAPE), takes the average of the last 10 years’ earnings, thereby controlling for cyclicality or one-off effects. On this measure too, the European equity market is unambiguously the cheapest of the major regions. Chart 5: ‘Shiller’ Cyclically Adjusted PE – Europe is significantly cheaper than the US 60
40 30 20 10 0 01/83
Source: JP Morgan, September 2013
“The economic environment in Europe is improving. Gaps in competitiveness have reduced considerably and recessions have led to rapid import compression and a substantial correction of external account imbalances.”
Recovering confidence and macro stabilisation It is increasingly clear that the economic situation in Europe has stabilised and is gradually improving, albeit from a low base. Mario Draghi’s commitment to ‘do whatever it takes’ in July 2012 greatly diminished investor concerns about the euro. In turn, improving confidence has led to a significant and sustained period of ‘financial normalisation’. This is best evidenced by the sharp recovery in peripheral country bonds, with Spanish and Italian yields back almost to their pre-crisis levels. This provides a strong indication that Europe’s sovereign debt problem is coming under control.
Anas Chakra Portfolio Manager, FAST equities The signs of a positive inflection point in European economic data are broadening. For example, Spain’s strikingly high unemployment rate has begun to fall and the issue of large current account imbalances, identified by many commentators as one of the root causes of the European crisis, has now largely corrected. Despite these positive signs, monetary policy in Europe looks likely to stay highly supportive for a long time. Chart 6: Sharp decline in peripheral bond yields 45
Chart 7: Current account deficits have corrected significantly 10
Italy Ireland Greece Portugal Spain
40 35 30 25
0 -10 -20
5 0 2007
Spain Ireland Greece Portugal Italy 03/04
09/05 03/07 09/08 03/10 09/11 03/13
Source: Datastream, 14 November 2013
Conditions are ripe for a new round of corporate actvity In the past few years of economic uncertainty, it has been clear that European companies have proceeded with a great deal of caution, with accumulated profits effectively allowed to grow on balance sheets. However, given cheap valuations, the improving economic backdrop and returning confidence alluded to earlier, it appears increasingly likely that companies will start deploying their surplus cash to buy other companies. Added to this is the new factor of normalising capital costs – as market interest rates in the US and other economies steadily pick up, the opportunity cost of holding large amounts of cash also goes up, creating a further incentive for companies to put their cash to better use. Needless to say, increased corporate activity tends to be supportive of equity performance.
02-2014 “Over the next two to three years we will see more consolidation in Europe as companies worldwide use cash reserves to buy new businesses or hive off unwanted businesses. European companies are likely to play a strong role as targets as well as sponsors. The barriers to corporate activity in Europe continue to come down.” Paras Anand Head of Pan-European Equities
Chart 8: Selected European corporate deals Date
Source: FIL Limited and Bloomberg, September 2013
Rising inflows into european equities With all the negative headlines of the past few years, it is unsurprising that European equities have been the most unloved sector within global equities for some time. However, since last summer, it is clear that sentiment towards Europe has begun to improve from a structural low point. Data from Lipper shows that after 11 consecutive quarters of net outflows, quarterly flows into European funds (ex-UK) have been positive since the final quarter of 2012. Chart 9: Rising inflows into European equities
Net sales into Europe ex-UK funds across Europe, US$ billions 1.50
-2.8 -3.1 Q1 2008
Source: Lipper FMI, as at end September 2013
Will the flows be sustained? There are good reasons to believe so. Investor allocations to equities, including European equities, remain low by historical standards and considerably more flows would be needed just to make up for the US$167bn that was pulled out of European funds between mid-2007 and late 2012.3 Money should continue to flow back to Europe if we see evidence of the factors outlined earlier, namely earnings beating expectations, attractive valuations and further improvement in the macro backdrop. After the strong run-up in their domestic market, US investors, in particular, can be expected to become more favourably disposed to European equities from a risk-reward perspective.
The importance of taking an active approach in europe While the general case for investing in European equities is supported by good company (rather than country) fundamentals, investors should expect to see significant intra-sectoral and stock-level variations within the asset class. With increased discrimination between market-share winners and losers, the need for an active investment approach becomes especially clear. For example, over the last few years, successful investors in Europe increased their weighting to companies with good emerging markets exposure, such as the German automakers, and reduced their exposure to domestic demand-focused companies in peripheral countries. More recently, high-quality stocks have tended to earn a premium as sentiment has weakened on emerging market prospects. References 3. Nomura, 2014 European Strategy Outlook, November 2013.
02-2014 “Active share significantly predicts fund performance. Funds with high active share and previously strong track records significantly outperform their benchmarks before and after fees.” Martijn Cremers and Antti Petajisto Yale School of Management
At Fidelity, we believe investment decisions should be based on rigorous analysis and forward-looking research, rather than simply the size of companies in an index. This kind of research-based investing is only possible with an active approach – in a passive approach, all country, sector and individual stock exposures will necessarily be based on one factor: relative size within the index. The problem with such passive investing is that it is backward-looking and by definition allocates most heavily to the winners of the past. Academic studies4 show that the portfolio managers who typically outperform after fees tend to have high levels of ‘active money’.5 This is broadly a measure of the deviation from the cap-weighted representative stock market index.
Conclusion A compelling case can be made for investing in a portfolio of well-chosen, highquality European equities based on the recognition that investing in European companies is quite different from investing in European economies. This is borne out by recent market performance which has disconnected from macro events and returned to a more ‘normal’ focus on company fundamentals. Moreover, European companies’ ability to deliver good earnings growth despite lagging economically is well established. In addition, the improving outlook for European earnings growth, particularly as we move from the short hope phase to the longer growth phase of the equity cycle with the prospect of a capex recovery; the presence of attractive valuations; the increasing likelihood of a pick-up in M&A activity; and the bonus of improvements in the macro backdrop all combine to create a positive environment for European shares – one that is likely to be met with sustained and supportive investment flows. Against a backdrop of increasing sector and stock-level variation, we argue that an active, research-focused investment approach is certainly worthy of investor consideration.
References 4. Cremers, K.M.J and Petajisto, A. (2009) “How Active is your manager? A new measure that predicts performance”. 5. Active money’ is the sum of a fund’s overweight (including effective cash) when compared the market index.
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