European equities have risen on a turnaround in economic sentiment in the region and global tailwinds from the US and Japan. Yet whilst European equities are not as glaringly cheap as they were, pockets of value do persist. Globally focused European companies have driven recent equity returns in the region, and European-centered businesses that have survived and which are able to exert pricing power in what are now less competitive market segments are likely to benefit. It is the market view of Ken Hsia, European Equity Portfolio Manager and member of the Investec Global 4Factor Equity.
Where is Europe in stock market terms?
Europe’s economy appears to be slowly recovering. The recovery is still fragile and the disparity between countries is stark, as highlighted by France, which saw its PMI slip to 48.0 in November 2013. Meanwhile, gross domestic product (GDP) per capita for many major European economies, except Germany, are still some way below 2007 pre-crisis levels.
Yet whilst European equity markets have risen over the past two years, only a few stock markets have exceeded their 2007 peaks, and the MSCI Pan Europe Index is still 30% off peak levels. It is not surprising that Denmark and Switzerland, home to some of the highest quality companies, have breached previous stock market peaks.
What are the drivers of opportunity?
A closer analysis of the MSCI Europe Index reveals that the biggest constituents are global leaders such as Nestlé, HSBC, Roche Holdings and Vodafone. These companies have a global revenue footprint that is not heavily influenced by their European operations. These global businesses are numerous, not exclusively large cap, and are often not well known outside their area of expertise. They remain a compelling reason to invest in European equities.
There is great scope for margin improvement in Europe. In tandem with global growth, we are seeing signs that European earnings are improving. This is attributable, in part, to some industries taking action to tackle low capacity utilization by implementing rationalization plans, taking out costs and stripping out excess capacity, so that supply becomes balanced with demand. The end result is often fewer competitors, which is good for the survivors.
Low capacity utilization remains an issue in many European markets. As a result, and as profitability improves, Investec believes we will see deleveraging of corporate balance sheets as the need to invest will remain tempered. Deleveraging has the impact of transferring value from debt holders to equity holders, but should share buybacks occur this has the dual effect of enhancing return metrics and showing good capital discipline, which generally sees investors mark the company’s shares up.
European equities were trading at a 15% discount to developed market equities in 2012. Strong market movements have since narrowed the gap substantially and on a forward P/E basis European equities definitely look more fairly valued in aggregate. However, Investec believes that compared to history, on a P/BV basis, European valuations can lift from here, especially as Europe already ranks well on returns and risk.
What are the risks?
The most obvious risk is instability in the euro zone. However, there is no evidence of this presently. A central assumption surrounding our investment case is stability in the region (and indeed globally). We continue to see bond yields of those countries with stretched public balance sheets fall indicating investors are becoming ‘less stressed’.
Macroeconomic risks are still a factor – for example we are somewhat wary of the re-rating of certain southern European stocks we have seen during 2013. We believe a disciplined evidence-based investment approach should ensure one gets the balance between conviction and more hopeful optimism right. The biggest risk is the gradual withdrawal of stimulus by the US Federal Reserve and the influence that has on all markets. In this environment, our view is that a bottom-up stock-picking approach is beneficial given its focus on company-specific risk over market risk.