Scouring Europe for overlooked value in equities
08 May 2014
Michael Clements
For the past year and a half, Europe’s economic fundamentals have been recovering from one of the worst financial crises since the Great Depression. To achieve the notable progress Europe has seen since then, significant structural reforms have been introduced in a number of countries. At the same time, the European Central Bank (ECB) has adopted a monetary policy that has featured historically low interest rates and numerous extraordinary measures designed to support investment and growth. So it’s not surprising to my team and me that as economies have recovered, equities have recovered as well. Even so, we don’t believe it’s too late to invest in European equities. As long-term investors, we take a five-year or even longer view on European equities. That being the case, we think this is still very much a good time to invest.
Looking at the equity valuations, the European market overall was trading on roughly 14 times forward earnings compared to well over 15 times earnings on the US markets (31 March 2014).1 But investors have received a better dividend yield in the UK and the European markets, where there has been roughly a 3.5% dividend yield, compared with about 2% in the United States. 2 On this basis, the European market looks attractive to us compared to other markets around the world.
We also think those European dividend yields compare favourably with what’s available in the bond market. Bond yields in Europe are extremely low because the ECB has maintained very loose monetary policy. Certainly, European companies aren’t without some problems, but if you take a long-term view, I think their fundamental value is generally compelling.
Restructuring Economies
We think European politicians have done a pretty good job of restructuring economies. In Spain, for example, there have been a number of structural reforms that have improved the competitiveness of the labour force versus other economies around the world, and that’s feeding through to the overall recovery. Spain is now also running a positive trade balance.
We’re also seeing a lot of economic indicators in Portugal, Ireland and France move in the right direction, and that’s starting to feed into a better environment for companies based in these countries.
For some time, we have been attracted to the consumer and industrial sectors in Europe because it is in these areas that we find companies that have a strong competitive advantage, a strong balance sheet, good cash flow and attractive prices. More recently, we’ve become interested in the oil services industry and the mining equipment-related industries.
UK Housing Gets Help from Government Policy
The UK is further along in its recovery than most of Europe, and its equity market reflects this. The UK housing market is a big driver of the economy, and government policy has done a good job of helping to stimulate this sector. The housing market has also been helped by the very loose monetary policy, including historically low interest rates.
We have been seeking out exposure to the UK housing market in general through housing-related stocks, but also through companies exposed to the retail consumer, where we think conditions in the UK are also improving. The challenges in the UK, I think, are really over the longer term, such as what happens when interest rates rise and how will that impact the consumer, and what impact will that have on companies’ abilities to generate cash.
Recovery in Europe
In mainland Europe, the economy is still recovering as a whole, but because we are bottom-up stockpickers, we tend not to focus on macroeconomic factors. Nor do we spend a lot of time considering whether we should be invested in Germany versus France because of the different economic recoveries we see. For us, what is critical is to look at the individual companies to see what’s priced in, and where anomalies exist that involve looking at parts of the market that are out of favour. We tend to do this by focusing more on stock-level, rather than on country- or sector-level analysis.
For example, we are seeing a lot of anxiety and unrest in sectors that are exposed to the emerging markets, such as stocks in the mining space and the oil service space. These are areas of the market that are out of favour with shorter-term investors. We are also finding ideas in parts of the markets that directly invest in emerging markets.
A Focused Play
The best way to think about our investment style is to view it as a focused play on a fraction of what we consider to be the best individual stock ideas within the broader market universe. We look across the whole of the European market for what we believe to be the best companies with the most attractive valuations that we can find, quality businesses that we believe have some sort of competitive advantage but where the valuation today looks attractive because they are out of favour for some reason.
Mergers and acquisitions (M&A) is another area of interest, though not an active part of our stock selection process. Trying to understand the many factors that play into these kinds of decisions is difficult to begin with, while outcomes are similarly very hard to predict. Clearly, M&A activity has been picking up in Europe. At the corporate level, European companies have been deleveraging their balance sheets for several years, putting many in a very strong financial position. This is also true on the private equity side.
As markets have begun to improve, companies have regained the confidence to do M&A, and they have the cash to pursue it. While we do not actively look for M&A candidates, the kind of companies we look for are attractive acquisition targets because we buy businesses that have competitive advantages and strong balance sheets and that generate lots of free cash flow. These are attractive features for us, but they are also attractive attributes for any potential buyer.
Mike Clements’ comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
What Are the Risks?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
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