Investing in Europe February 2008 This document is for Professional Clients only and is not for consumer use

Investment Topics Investing in Europe Continental Europe, along with other developed economies, faces economic headwinds in 2008, as US growth slows, global credit conditions tighten and industrial and consumer confidence soften. However, after a bout of equity market weakness in January, European markets have become more realistic both about corporate earnings expectations and valuation. In aggregate, continental European equity markets trade at around eleven times expected 2008 earnings, which we see as cheap on a historical basis and compared

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Investment Topics Investing in Europe – February 2008

with other developed markets. However, we think the sectors which benefited the most from easy money and strong global growth in Europe’s market rise from early 2003 to mid2007 – for instance, banks and industrial cyclical companies – will remain under pressure. By contrast companies with good earnings visibility and healthy balance sheets are likely to do well. We favour, in particular, large cap stocks paying high dividend yields in the telecommunications, health care, energy and utilities sectors.

An overall recession in the continental European economy is likely to be avoided although we expect the industrial sector of the economy to slow. The eurozone purchasing managers’ index, which has softened recently, provides one indication of this weakening. It tends to have a close relationship with the trend in overall industrial output a few months later (see Figure 2). In Europe, a large part of industrial activity is orientated towards exports, which are also clearly slowing, especially those to the US (see Figure 3) but also to emerging markets, which have been particularly fast-growing export markets for the Eurozone in recent years. ...despite some factors lending support. The outlook is not universally gloomy. In the medium term there are two structural factors which will lend support to European growth. One we have emphasised for some time is that European consumers generally have lower levels of debt than their US and UK counterparts (see Figure 4). Moreover, that debt tends to be at long-term fixed rates of interest rather than short-term variable rates, meaning that European consumers are much less sensitive to fluctuations in short-term interest rates than their UK and US counterparts. The widening of EU membership is also one potential support for growth in the long term: many relatively low income countries, with high growth rates, are now full members of the EU (see Figure 5) and other emerging European countries have close links with the EU. This will provide both a stimulus to demand as well as to the supply side of the European economy as many of those countries are relatively lowcost producers. However, on balance, we think it is right to be cautious about the prospects for overall economic growth in 2008.

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Investment Topics Investing in Europe – February 2008

1. Eurozone GDP growth forecasts Consensus forecasts for growth in: 2006

2007

4. European mortgage debt As percentage share of GDP, end 2006

2008 Mortgage debt (% GDP)

% change on year 120

3.0

100 2.5

80

2.0

40

60

20 1.5

Jan 08

Denmark UK US Netherlands Ireland Spain Germany Sweden Belgium France Greece Austria Italy Czech Hungary

Global economic headwinds will depress European growth... In common with other developed economies around the world, continental European markets face economic headwinds in 2008. In particular, economic growth is likely to slow as a result of a weaker trend in the US economy, globally tighter credit conditions and a less confident mood amongst consumers and industrial companies. Consensus forecasts for eurozone GDP growth in 2008 have already been reduced (see Figure 1) and we expect the overall growth rate for the year to be between 1.7% and 1.8%.

Source: The Economist Poll of Forecasters; 18 January 2008

Source: The Economist, 22 September 2007; data as at end 2006 (latest available data).

2. Eurozone PMI & production 1998 - 2007

5. Emerging EU in 2008 Forecast GDP growth & per capita rates

0 1.0 Jan 05

Jan Jan 06 07 Month in which forecast was made

New EU members Emerging European countries High income countries

Purchasing Managers’ Index (lh side) Industrial production, % change on year (rh side)

2008 growth rate (%) 8 LV

Index

%

64

7

62

6

7

60

5

6

58

4

56

3

54

2

52

1

50

0

48

-1

46

-2

44

98 99 00 01 02 03 04 05 06 07 08

-3

Source: Reuters Ecowin. PMI data to 31 December 2007, production data to 30 November 2007

6m/6m, % 20 15 10 5 0 -5 -10 02

03

04

05

06

07

Source: Credit Suisse. Data to 31 December 2007

4

P

D B

E I

2 1

S

GR

H 3

0

A

F

IRL

FIN NL DK

10 20 30 40 50 60 2008 GDP per capita (US$ 000s)

Key to countries: IRL Ireland DK Denmark S Sweden NL Netherlands FIN Finland A Austria B Belgium F France D Germany

Eastern Europe, Russia and Turkey US Asia ex Japan

01

SK EST BG RO HR TR SLO PL CZ

70

Source: Data from The World in 2008 (The Economist), published November 2007

3. Eurozone export growth slowing Eurozone export growth by source

-15 00

5

LT UA RUS

08

I GR E P SLO CZ EST SK H

Italy Greece Spain Portugal Slovenia Czech Rep. Estonia Slovakia Hungary

LV Latvia LT Lithuania PL Poland RO Romania BG Bulgaria RUS Russia TR Turkey UA Ukraine HR Croatia

The market conditions which drove the advance in 2003-2007... In stockmarkets, we think that conditions in 2008 will be very different to those which have been seen in recent years. Broadly, the period from 2003 until summer 2007 saw the European economy boosted by easy monetary conditions and solid global demand. Easy monetary conditions favoured those companies with a high degree of financial leverage; and strong global growth provided a boost to companies with high operational leverage. Banks, small cap and industrial cyclical companies benefited the most. ...were different to those which we expect for 2008 For 2008, we think that slower economic growth and tighter credit conditions will mean we will see a return to a world in which risk is more appropriately priced in financial markets. In those circumstances, we expect companies with sustainable earnings and sound balance sheets to perform better than the market average. The good news is that, as a result of the long-running neglect of many large cap blue-chip companies during the 2003-2007 rally, there is still a range of such companies available at reasonable valuations. Attractive valuations in mega caps... Most significantly, mega cap stocks are cheap in relation to other areas of the market, trading in aggregate on around eleven times expected earnings in 2008 (see Figure 6). These stocks also tend to be those which are paying relatively high dividend yields (see Figure 7). In recent years European companies have placed a much greater emphasis on the payment of dividends and in a sense are now emulating the earlier trend in that direction in the UK. Dividend growth in Europe (excluding the UK) has, indeed, recently been faster than in the UK (see Figure 8). That dividend growth is well supported by the cash flow generated by European companies (see Figure 9). With the cash flow yield almost twice the dividend yield, there is good support for dividend payments. At the individual company level, we continue to favour quality companies with good earnings visibility and growth which will provide a firm foundation for future dividend growth and higher returns to shareholders. This points us in the direction of the telecoms, healthcare, energy and utilities sectors and leads us to avoid exposure to most industrial cyclical and financial companies. The sectoral behaviour of the market has recently started to favour that stance and it is a trend which we expect to continue in 2008.

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Investment Topics Investing in Europe – February 2008

6. European valuations Consensus by market capitalisation 2007 2008 Estimates 2009 Price/earnings ratio 17

9. European dividend yields vs. cashflow June 1990 - December 2007

}

Europe ex UK free cashflow (FCF) yield* Europe ex UK dividend yield* % 8

16

7

15 14

6

13

5

12

4

11

3

10

2

9 8

1 Mega Cap Large Cap (>$59.4bn) (>$14.6bn)

Mid Cap (>$5.0bn)

Small Cap

Source: MSCI, IBES, Worldscope, Morgan Stanley as at 19 February 2008

7. European valuations Consensus by dividend yield 2007 2008 Estimates 2009 Dividend yield (%) 5.0

}

4.5 4.0 3.5 3.0 2.5 2.0

*excludes financials

Mega Cap Large Cap (>$59.4bn) (>$14.6bn)

Mid Cap (>$5.0bn)

Small Cap

Source: MSCI, IBES, Worldscope, Morgan Stanley as at 19 February 2008

8. European versus UK dividend growth 31 January 1998 - 31 December 2007 Europe ex UK UK % dividend growth 50 40 30 20 10 0 -10 -20 -30 98 99 00 01

02 03 04 05 06 07 08

Source: Thomson Datastream to 31 December 2007

0 90 92

94 96 98 00 02

04 06 08

Source: Credit Suisse. Data to 11 December 2007

...in telecommunications... The telecommunications sector, which has started to outperform strongly in the last nine months, kicked off this process of rotation towards more defensive companies. The sector was neglected for a long time after the collapse in confidence and balance sheets after the dotcom bubble. Today, most telecom stocks enjoy strong free cash flows and a decent outlook for revenues. While many of them have seen impressive runs, we believe the sector still offers a reasonable valuation and very attractive dividend yields. ...and in healthcare and energy... Two other previously neglected sectors which, we believe, offer attractive current earnings and valuations are health care and energy. Certainly, their earlier underperformance was justified by deeprooted issues. Large cap pharmaceutical companies are faced with a dip in their product pipelines in the next five to ten years. Concerns about greater pressure on drug pricing if there were to be a new Democrat President in the US have also weighed on the sector. Meanwhile, energy companies have disappointed investors by failing to translate record-high oil prices into earnings growth, as higher costs and taxes have driven a wedge between revenues and profits. However, these concerns are now reflected in the price of companies in these sectors. Moreover, the earnings of pharmaceutical companies should show resilience in the face of weaker economic growth. And given that major oil stocks discount an oil price of less than USD 50 per barrel, oil stocks are unlikely to suffer much if a global economic slowdown were to hurt the oil price. ...but these are not the only opportunities This is not to say that all the attractive opportunities are in the mega cap stocks. Aggregate valuations for small and mid cap stocks are now much more attractive than they were in mid-2007 when their valuations had been driven up, particularly by the prevalence of private equity interest. On the basis of consensus expectations for 2008, European small cap companies trade on a price/earnings multiple of 12 times, with a dividend yield of around 4%. The notable opportunities that have arisen as a result of the January turbulence are in two main areas. First, companies which offer a high level of dividend yield and where the company’s cash position is strong enough also to support a strong programme of share buybacks. In this category we would include companies such as Elisa, a Finnish telecoms company, Fred Olsen, an oil service company and DBAG. Second, companies with resilient business models and earnings, where their stock prices have been unjustifiably marked lower as a result of the recent market weakness. 1

Structurally, we also see opportunities due to the fact that the small and mid cap sector is relatively underdeveloped, with the potential for new companies to come to market. Wary of bank exposure We continue to be wary of exposure to banks. They have already underperformed the market since the problems in credit and money markets emerged in mid-2007, but it remains too early to call the bottom in those stocks. Their current issues apart, we think that banks have probably reached the end of what was a twenty-year trend improvement driven by the secular decline in interest rates and rise in leverage. This alone casts doubts over the sustainability of their returns on equity. In addition, their heavily geared balance sheets are now being buffeted by the collapse in value of several asset classes. Whilst the sub-prime mortgage issues originated in the US, it is clear that many European banks also had exposure to these assets. Much of this subprime exposure may now have been acknowledged, but other assetbacked markets have been affected too and further asset write-downs by banks would not come as a surprise. With less spare liquidity and softer economic growth, most banks will suffer from weaker, or no, revenue growth. It is not clear that these risks are fully reflected in their valuations yet. Hence, our exposure to this sector is, for now, limited and selective. A longer-term perspective on the importance of dividends Several studies of stock market returns have demonstrated the importance of dividends to total returns.1 This phenomenon is seen in the European markets and is demonstrated in Figure 10 where we show the performance of the MSCI Europe ex UK index over the last twenty years. Without dividends reinvested the total return over that time period was 580% (a compound annual growth rate of 10.1% p.a.) whereas with dividends reinvested the total return was 992% (a compound annual growth rate of 12.7% p.a.). We would also stress the importance of remaining fully invested, a point which is demonstrated in Figure 11. This shows that the annual average total return over that 20-year period of 12.7% per year is seriously eroded if an investor misses the best days in the market. By missing the best ten days of market performance, the investor’s return is reduced to an average 7.3% pa; and missing the best 30 days’ of returns reduces the average annual return to 1%. These points: the importance of dividends to total return; the influence of reinvestment of dividends on total return; and of remaining fully invested

See, for example, the ABN AMRO Global Investment Yearbook, 2007

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Investment Topics Investing in Europe – February 2008

10. Why dividends are important MSCI Europe ex UK Index % cumulative capital return since 31 Dec 1987 % cumulative total return since 31 Dec 1987 % 1000 900 20-year total return 992% 800 700 600 500 400 300 200 20-year capital return 580% 100 0 88 90 92 94 96 98 00 02 04 06 89 91 93 95 97 99 01 03 05 07 For illustrative purposes only. No transaction costs included. Please note investors would not have been able to invest in this index over the time period shown Source: Thomson Datastream on a total return basis in sterling terms as at 31 December 2007.

11. It pays to remain fully invested: Average and cumulative returns from the MSCI Europe ex UK index on 31 Dec 1987 Period of investment

Cumulative total Average annual total return to 31 Dec return (%) 2007 (%)

Fully invested

12.7

991.9

Miss the 10 best days

7.3

311.7

Miss the 20 best days

3.7

106.9

Miss the 30 best days

1.0

21.9

Miss the 40 best days

-1.3

-22.6

Miss the 60 best days

-5.0

-64.2

For illustrative purposes only. No transaction costs included. Please note investors would not have been able to invest in this index over the time period shown Source: Thomson Datastream on a total return basis in sterling terms as at 31 December 2007.

are ones which we stress in relation to our (UK) Income and High Income Funds. Our recently-launched European Equity Income Fund adopts a similar philosophy, with a concentration on investing in companies paying or having the ability to pay a high and rising level of income to shareholders. Conclusion The economic environment in continental Europe will be more challenging in 2008. Sectors of the equity market that benefited from the period of easy money and strong growth from 2003 to mid-2007 will, we think, remain vulnerable. In particular, we remain wary of banks and industrial cyclical companies. In contrast, we think there is good value in large, dividend paying companies as well as selected opportunities in the small and mid cap sector. The importance of dividends to total return is seen in Europe, as in many other countries, and in that context we have recently launched a new Invesco Perpetual European Equity Income Fund. This complements our range of European investment products including the Invesco Perpetual European Equity Fund, the Invesco Perpetual European Smaller Companies Fund and the Invesco Perpetual European Opportunities Fund.

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Investment Topics Investing in Europe – February 2008

Further Information Contact us Invesco Perpetual Broker Services Telephone 0800 028 2121 www.invescoperpetual.co.uk Invesco Perpetual UK Institutional team Telephone 0207 065 3489 www.invescoperpetual.co.uk/institutional The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Past performance is not a guide to future returns. Where Invesco Perpetual has expressed views and opinions, these may change. Where specific stocks have been mentioned, there is no guarantee that these securities will be held by Invesco Perpetual funds in the future. Please refer to the latest Full Prospectus, Simplified Prospectus and PEP & ISA Key Features and latest Annual or Interim Short Reports for more information on our funds. Further information on our products is available using the contact details shown. This document is for Professionals Clients only and is not for consumer use. Telephone calls may be recorded. Invesco Perpetual is a business name of Invesco Asset Management Limited Authorised and regulated by the Financial Services Authority Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK 36995/PDF/010208

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Investment Topics Investing in Europe – February 2008