The question of whether the Eurozone is going to hang together or fall apart has dominated markets over the past four months. Europe’s debt crisis has overshadowed everything, with the only investment decision that appears to matter being whether markets are ‘risk on’ or ‘risk off’.
Against this backdrop, it’s not surprising that Europe has been the one of the most unloved sectors for investors this year. Prospects for the sector will undoubtedly hinge on a successful resolution to the euro crisis.
Yet, at the same time, European equities are trading on some of the lowest price/earnings ratios seen in a generation. There are relatively high yields on offer. And, with the unprecedented swings in markets, even positive corporate results have been ignored. If you think one of the keys to successful investing is going where others won’t, perhaps now is the time to consider European fund managers who are able to take advantage of low valuations and indiscriminate sell-offs.
Valuation metrics
Currently European equities are very cheap relative to their own history and compared with other equity markets. The chart below shows the Graham and Dodd Price to Earnings ratio (P/E) ratios for Europe (MSCI Europe), the US (S&P 500) and Asia (MSCI Asia-Pacific ex Japan). Graham and Dodd are the fathers of value investing and their metric uses ten year earnings to smooth out the business cycle. On this basis, Europe is touching the low valuation briefly reached at the nadir of the market in 2009 and is at the lowest level in over 20 years.
Other valuation metrics, including the yield on equities, also support the argument that current valuations are at historic lows.
Industrial Powerhouse
Despite the gloom, we shouldn’t lose sight of the number of high quality companies in Europe. Often these companies are in consolidated industries which gives them pricing power and a competitive advantage over new entrants. For these companies, the political and economic backdrop is important but to some extent many will continue to see demand for their goods and service, almost regardless of the outlook. Many have cash-rich balance sheets and are well placed to take advantage of troubled times by acquiring weaker competitors and taking market share.
Global Companies
The fortunes of many leading European companies are not just tied to the continent. Take Nestle as an example. Representing over 8% of the European equity index, Nestle is certainly not an undiscovered star, but with worldwide supply contacts and great brands it is able to continue expanding even in the current market environment. In its latest trading statement it announced sales growth in the Americas, Europe and Asia, Oceana and Africa of 5.6%, 3.8% and 11.7% over the previous nine months. The company has an excellent track record of growing its earnings consistently.
Global Specialists
Many other European companies, even smaller companies, are global experts in their fields. One example is Hexagon; they are a leading provider of design, measurement and visualisation technologies used in infrastructure projects such as bridges and dams. With few competitors worldwide, growth in China in particular has been impressive. Hexagon will of course carry a greater risk than Nestle, however it does illustrate how many European companies are positioned to benefit from global growth, particularly in Asia and China.
Asia Pacific Growth
Europe is in fact very likely to benefit disproportionally from exposure to Asia. This is one part of the world forecast to grow in any meaningful sense. In addition to technology and global food brands, Europe also has some of the leading consumer discretionary and luxury goods producers. Sales to Asia, in particular China, of high quality goods produced by companies such as BMW, LVMH, Swatch, Richemont, Continental and Daimler – to name just a few – have rocketed in recent years. BMW experienced sales growth of 18% in China in the first nine months of the year – with a 40% increase in luxury car sales.
Not all European companies are in the Eurozone
A number of companies that we have identified have another common characteristic; they come from countries outside the Euro currency area or are from stronger Northern countries. Hexagon is a Swedish company and Nestle as Swiss company, both outside the Euro. Even within the eurozone, German companies also have an element of safety given that, in the event of a Euro breakup, any currency supported by German taxpayers would almost certainly appreciate dramatically and offer something of a safety net to investors in the short term (although for exporters this benefit would be tempered as a stronger currency would hurt their businesses). Only about 13% of European listed companies are in PIGS countries.
Is the time right now to invest?
Of course, we don’t overlook the potential dangers of investing in Europe. Nothing is, of course, ever so cheap that it can’t get cheaper. There are serious issues in the European banking sector and companies more generally may well be affected by government austerity measures. At the very least, the short term is still likely to be dominated by the Euro crisis and macroeconomic events.
But, we believe that there are companies that have attractive valuations and fund managers who have the skill to navigate a path through treacherous times. We still expect that European governments will eventually act to save the monetary union but the point is that Europe is blessed with high quality global companies with tangible competitive advantages and these companies are trading on attractive valuations.
Our top picks
David Dudding focuses on high quality growth stocks where companies have a competitive advantage or a natural barrier to entry. The earnings of these companies tend to be relatively stable and therefore more likely to outperform even in choppy markets. Over the cycle this is the primary way that Dudding generates his outperformance. Dudding has shown clearly that he has the ability to pick growing companies through the excellent performance of his European Smaller Companies fund. We believe that he has demonstrated this on the European Select fund which has a multicap approach.
Leon Howard-Spink has already built up an impressive record over a number of years. He benefits from the considerable resource of Schroders' Pan-European equity team which aids him in monitoring a broad universe of stocks. His focus on the highest quality companies and diversification across sectors means that this fund is typically less volatile than many of its peers. We think the manager's style makes this a good choice for a core European equity holding.
Different funds carry varying levels of risk depending on the geographical region and industry sector in which they invest. You should make yourself aware of these specific risks prior to investing. We aim to provide investors with information to help them make their own investment decisions although this should not be construed as advice or an investment recommendation. If you are unsure about the suitability of an investment or if you need advice on your specific requirements, we strongly suggest that you consider professional financial advice.
The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. Prevailing tax rates and reliefs are dependent on your individual circumstances and are subject to change.