Newspaper headlines about Europe rarely make for happy reading. Rising unemployment rates, wavering economic growth, sovereign debt crises and political drama sound like a shopping list of negatives – hardly the sort of backdrop that makes for a favourable investment.

Yet, amid the tough economic environment the European equity market has done remarkably well. So well in fact, that the FTSE World Europe ex UK Total Return Index rose 17.8%¹ in 2012 in sterling terms. Not bad for a region that has spent much of the past few years reeling from one crisis to another.

Why are European equities doing so much better than the economy? First, it reflects the market taking some comfort from the pledge made in July 2012 by Mario Draghi, President of the European Central Bank (ECB), that the ECB would do “whatever it takes to preserve the euro”.  This was quickly followed up by the creation of Outright Monetary Transactions (OMT), a programme that effectively backstops eurozone governments by buying their short-term debt so long as they agree to stringent fiscal conditions.  

OMT’s existence alone has helped reduce one of the biggest tail risks facing European investors – denomination risk.  Investors have become less fearful that an investment in the troubled periphery will be repaid in devalued lire or pesetas, rather than euros.

It is perhaps no coincidence that just as the existential fears surrounding the eurozone have faded, the spotlight has fallen on the US and the wrangling over how to resolve the US federal budget deficit. Investors are quickly appreciating that Europe is not alone in needing to bring government spending under control.

Second, there is a gradual recognition that a domestic economy and the stock market are not always connected.  Several emerging markets, such as Indonesia and Russia, enjoyed strong economic growth last year but it did not follow that their stock markets were all winners. Taking this analogy further, just because a company is domiciled in a country does not mean its performance need reflect the local economy.

With careful stock selection it is possible to avoid the worst of the local economic headwinds and benefit from growing niche industries and more dynamic economies outside Europe. Those European companies with a global footprint mean that even if the local economy is not firing on all cylinders, it is likely that the economies of other countries in which it operates may pick up the slack. For example, Swatch Group, the watch and jewellery company that counts Omega and Longines amongst its many brands, has less than 37% of its sales in Europe, with the fast-growing Asian region accounting for just over half its sales. With brands straddling different price brackets as well as countries, the company benefits from a diversified customer base.

Other European companies are operating in industries that are enjoying secular growth that is largely independent of the economic cycle. A good example is the fragrance and flavourings business, which is consolidated into the hands of a few players. Two European companies, Symrise of Germany and Givaudan of Switzerland, are at the forefront of this industry, creating the ingredients that improve the taste of food and providing the fragrance in cosmetics, perfumes and humbler personal care products. With consumers becoming increasingly demanding in terms of quality and developing markets wanting the same products as those used in rich nations, the only real constraint on this market is the size of the world’s population, which is expected to grow by two billion over the next three decades.

One of the advantages of European companies is that they can provide exposure to fast-growing areas of the world but with the reassurance that comes from being listed on a well-regulated, established stock exchange and the good corporate governance that entails. In fact, companies such as Bureau Veritas, the French testing and inspection group, make a virtue of their European roots and the quality and trust it engenders.

Similarly, Kone, the Finnish lift manufacturer, receives orders because customers trust the quality of its product: it is simply not worth the risk of installing an inferior lift in a building when reliability and safety are paramount. Through maintenance and service contracts Kone is able to enjoy recurrent earnings from an installed base of more than 850,000 lifts and escalators that help reduce the cyclicality from its original equipment manufacturing business.

There is no denying that the last few years have been challenging for European companies but, in many cases, this backdrop has hastened reforms and efficiencies meaning that those European companies that remain are generally in strong financial shape.  At the aggregate level, therefore, European equities look attractive, although, in our view, a selective approach can help isolate those companies with even stronger prospects.

¹Source: Datastream, at 31.12.12