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Magazine Issues » March 2013

EUROPEAN EQUITIES: ‘Don’t turn your back on an elephant’

ElephantHas the worst of the financial crisis in the eurozone passed? Fiona Rintoul looks at whether investing in European equities is a risk worth taking.

“You should always buy when you’re nervous,” says Dean Tenerelli, portfolio manager of European equities at T Rowe Price.

People are certainly nervous about European equities. Outflows from funds in this asset class domiciled in Europe have totalled €83 billion in the past six years, according to statistics from Lipper. Perhaps Tenerelli is right when he says that buying European equities today will look like a huge opportunity five years from now.

There is also a sense – partly born out of hope, perhaps – that the worst is over in Europe.

“Progress has been made,” says Geoffroy Goenen, head of European equities at Dexia Asset Management. “Politicians are no longer behind the curve. There is a will to go for more financial integration, in the eurozone at least.”

On the other hand, there exists in Europe quite a number of what the investment industry euphemistically likes to call headwinds, otherwise known as problems – not least the by-no-means-fully-resolved euro crisis.

Last summer’s announcement by the European Central Bank (ECB) president, Mario Draghi, that the ECB would do “whatever it takes” to preserve the euro succeeded in breaking “negative self-fulfilling sentiment and creating confidence”, says Andrew Parry, chief executive officer at Hermes Sourcecap, an active European equity manager, but there was also a downside.

“It raised the risk that politicians become complacent and their desire to push through difficult policies is reduced,” says Parry.

“The difficulties haven’t gone away, and turning your back on an elephant can be a dangerous thing.”

European equity markets have risen on a fall – or a perceived fall – in risk. Rising on a fall already sounds a little precarious, and Parry notes that the European equity market rise was not what he calls a “positive positive”.

It was more an absence of negativity. In other words, things have not got better; they have just stopped getting worse. And, boringly for those who have been itching to call the end of crisis at the slightest whiff of positivity (even negative positivity), equity market rises must, at some point, be justified by higher economic growth or higher earnings.

That has not happened. The European Commission now concedes that the eurozone economy will probably shrink by 0.3% in 2013. And on the subject of whether European companies can deliver earnings growth in 2013, Parry says, “not uniformly”.

This is not to say that investing in European equities is a mug’s game, or that the opportunity to which Tenerelli refers is a mirage. Rather, it means that Europe today is very much a Darwinian market where the strong will (or at least may) survive, but there will be little succour for the weak from the economy.

You could argue that this makes Europe the perfect environment for a stock picker – a good one, that is. “We’re in a structurally low growth environment, and that shines a bright light on winners and losers,” says Parry. “The difference between them is exaggerated.”

The winners forged in difficult times – assuming you can find them – may even turn out to be better than those who would have emerged had times been good, suggests Parry.

“Low growth will be better for us than high growth from printed money,” he says. “Low growth forces innovation. We evolve, adapt, develop; it’s part of human nature. Many of America’s greatest companies were established in the 1930s during the Depression. In 2002 to 2007, when we had an easy economic environment, the business model we came up with was efficient balance sheet management, which is basically leveraging up.”

Add to this low valuations in Europe and it is easy to see why investors who have largely run away screaming from European equities over the past six years might begin to reconsider.

“We don’t see a big switch, but there’s a bit more interest in European equities from institutional buyers, many of whom have been underweight for a long time,” says Tenerelli. “And rightly so, because they’re very cheap.”

Certainly, outflows from European equities have subsided from a flood to a trickle, falling from €13 billion in 2011 to €200 million in 2012. But most fund managers throw cold water on the idea that this is a sign of the much discussed great rotation out of bonds and into equities. The reduction in outflows is more to do with investors, many of whom had been underweight European equities for a long time, stopping selling rather than aggressively buying, they say. And many investors, especially those within Europe itself, remain cautious.

“What we’ve seen in the past six months is major flow coming from the US and Asia, but into corporate credits, not directly to equities,” says Goenen. “A lot of European institutions were behind the curve. They were traumatised because they’d lost so much. They’re very nervous, especially about the eurozone.”

Nonetheless, the opportunity cost of not investing in equities means that increased allocation to the asset class has a certain inevitability to it.

“With sovereign bonds, you don’t get any reward unless you take exceptional risk,” says Goenen. “On the corporate side, credit spreads are very narrow. The only places to invest is in equities.”

This does not mean that massive inflows are to be expected. Solvency II and certain pension fund regulations could put a drag on equity investment.

The opportunity cost argument only holds good if there is continued political stability. Should there be another sovereign bond crisis in Europe, or should Israel invade Iran, all bets are off.

It is fear of such eventualities that has led many investors to stay frozen, with money held in bonds yielding well below inflation.

In the meantime, the task for active European equity managers is to shut out the white noise and look for good companies to invest in that can do well even in straitened times.

Often, a key consideration is exposure to markets outside low growth Europe.

For this reason, Goenen says that country-by-country analysis is not important.

“If you look at the DAX or the CAC, the biggest weight is global companies. If the French economy is going down, it won’t hurt Pernod.”

Dexia AM has five main criteria when choosing investments. These include having the best management, enjoying a sustainable competitive advantage, being in a niche or growing market and having a level of leverage appropriate to the company’s activity.

“In many sectors, a lot of companies fit these criteria because Europe has companies that are leaders worldwide,” says Goenen.

“There are industries, such as industrials, agrochemicals, beverages, food and luxury goods, where Europe has strengths versus the US and Asia.”

Others feel that by-country analysis has become more important since the crisis. “Before the crisis we never worried about countries, especially within the eurozone,” says Tenerelli. “Now we do pay more attention to countries, though we hope that subsides.”

The T Rowe Price European Stock fund has, for example, increased its holdings in Spain. “We found a lot of good opportunities in the Spanish market because stocks got so beaten up there,” says Tenerelli.

In some of the countries that suffered most in the crisis, there is perhaps the beginning of a restructuring story.

“A record number of foreign companies set up in Ireland last year,” says Tenerelli. “In Spain, four car companies increased production. That’s a direct reflection of restructuring and the competitiveness they’ve gained.”

Euro equities table

Restructuring is also playing a bigger part in Hermes Sourcecap’s strategy. “We have an increased emphasis on companies taking control of their own destiny,” says Parry. “We like the UBS story because it’s about taking difficult decisions and restructuring in a difficult industry.”

With no “Economic Spring” around, European equity investment is all about choosing very carefully.

“You have to pan through a lot of dirt to find a few nuggets,” says Parry.

It is a dirty job, but someone’s got to do it.


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