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Magazine Issues » December 2010

EUROPEAN EQUITIES: the cheapest place in the world

gavelIs it time for a fresh look at the most hated asset class of the moment: European equities? By Angele Spiteri Paris

Being trendy is not always all it is cracked up to be and in the world of investment, going against the grain can sometimes pay dividends.

European equities have been touted as the “most hated asset class of the moment”, but this can actually be a good thing for anyone with an eye for a good investment.

From a top-down perspective, Europe is definitely not the place to be. The trouble in the peripheral countries and the depths into which the euro has been plunged have all made for exciting but deterring headlines.

Yet many fund managers will tell you that by taking a bottom-up view, that is, going through the corporate names and taking a long hard look at the financial shape they’re in, will show that Europe is not such a bad place and could be a portfolio’s diamond in the rough.

2010 has been the year of emerging markets and fixed income. Equities, particularly those in Europe, have been left by the wayside and fund sales figures weren’t impressive. According to data from Lipper, European equity funds were down €12.9bn as at September 2010.

Jeffrey Taylor, head of European equities at Invesco Perpetual, says: “There is very little appetite for equities full stop and the desire for European equities is even more dire. I think European equities have taken over from Japanese equities to be the most hated asset class around.”

And none of the other experts Funds Europe spoke to disagreed.

Lee Freeman-Shor, portfolio manager with multi-manager Skandia Investment Group (Sig), says: “Europe and the US are vying for the title of most unloved asset class on a regional basis and no one can dispute that.”

James Barber, portfolio manager at Russell Investments, says: “European equities have attracted a lot of bad press and negative headline-grabbing attention. Interestingly, the further away the investors are from the asset class, the stronger the negative perception. So you saw people in the US and Asia selling European equities, more so than the investors in Europe itself.”

But European equities may not be so hated for much longer.

Rory Bateman, head of European equities at Schroders, says: “We’ve seen an increase in the number of consultants, asset allocators and pension funds expressing an interest in Europe equities. They’re still hesitant but at least questions are being asked … twelve months ago anything around European equities was completely dead. This does not necessarily mean we’ll see more inflows but more interest is always a positive thing.”

Taylor, at Invesco Perpetual, says: “Time will see investors coming back. It’s about people getting their heads around the fact that even in this low-growth environment, earnings can grow and equities can still be attractive. Over time people will realise that buying government bonds at very low yields are not the risk-free trade they thought them to be.”

And according to Bateman and several of his contemporaries, investors should not remain hesitant for much longer and wily investors who know their way around a cycle may want to jump on the European train before it takes off again.

Taylor says: “The contrarian in me thinks this [the lack of appetite for European equities] is a good thing rather than something to be worried about, in that demand for equities can only improve from here.”

Attractive valuations that are seen in the European equities space means it’s a good time to invest before the good assets are more fairly valued. Freeman-Shor, at Sig, says: “Europe is the cheapest region in the world at the moment. It’s cheap relative to its own history and also compared to other markets.”

Good opportunity

Taylor says: “We should see investor appetite for Europe come back when people concentrate more on valuation and less on momentum. The equity market is cheap on an absolute basis and relative to bonds, which provides an attractive investment opportunity.”

Neil Dwane, CIO, Europe, at RCM, says: “The rolling price-to-earnings ratio in Europe looks very cheap and the yields available are of above 4%, which is very attractive compared to bond yields of over 2%, which is what investors are currently getting.”

And the experts say there are a number of reasons for European equities to be a good investment option – it’s not just that they’re cheap.
Bateman, at Schroders, says: “We’re bullish on European equities for a number of reasons. The economic fundamentals around core Europe are improving so there is a positive economic background. Furthermore, there are strong corporates to be found in Europe, such as exporters in Germany and Scandinavia. These are good, profitable companies.”

Paras Anand, head of European equities at F&C Asset Management, says: “Given that it has visible problems, the equity valuations within the European market are very attractive. The dividend yield to be had within Europe is also the highest one can get, which is surprising as Europe was generally associated with a low-yielding environment.

“You should find interesting businesses with a good European business and a low valuation. Exporters are still a big part of the corporate sector in Europe and therefore the forecast continued strength of the dollar against the euro will be a good thing for these firms.”

Freeman-Shor, at Sig, says: “Over the long term, the contrarian approach to investing is hard to beat. According to data from AllianceBernstein, on a ten-year horizon European equities represent the best investment over the next ten years.”

The problem is that despite this seemingly sparkling opportunity, the message still needs to get through to the investors themselves.

Trendy allocators
Taylor, at Invesco Perpetual, says: “The problem is that pension funds often sell an asset class low and come back in at the top. Just as this happened in other cycles, it might happen again this time. As can be seen from the fund flow data.”

Fabio Di Giansante, senior portfolio manager at Pioneer Investments, says: “Normally asset allocators follow the trend and get carried by the momentum. As a result, they consistently buy what has just delivered good performance. Historical data has shown this.”

But difficult as it may be, investors may have to be pushed to do what hasn’t, historically, come naturally to them – especially considering that by piling into emerging markets, they may be taking on more risk than they need to.

As mentioned, emerging market equities have been wildly popular over the last year and this popularity may be a good hook for European equities managers to hang their hats on.

It’s no secret that the growth story in the emerging world is providing a significant boost to companies in the developed markets like Europe. This aspect of European equities may take on increased importance as securities in the emerging world look like they’re getting expensive.

Taylor, at Invesco Perpetual, says: “On a price-to-book basis, investors are paying a substantial premium for emerging markets, when compared to developed markets including Europe.”

Freeman-Shor, at Sig, says: “Some prices in Asia are extreme but people are willing to pay up because that’s the hot story right now.”

However, from someone on the outside, looking in, it may seem silly for investors to pay the premium for owning emerging market equities considering they can get exposure to some of those high-growth emerging regions through European companies, which are a lot cheaper and potentially less risky.

Di Giansante, at Pioneer, says: “Through European equities you not only get exposure to emerging market growth through companies with strong balance sheets and good cashflows, but furthermore, the corporate governance within those companies is very reliable and transparent.”

Emerging exposure
Freeman-Shor says: “It’s bizarre investor behaviour that leads people to view investment in European companies as a play on Europe. The fact is most European large-cap companies, even many of the smaller ones, are all exposed to the global economy and a significant proportion of their revenue is generated overseas.”

Di Giansante says: “When you buy European equities, you’re not only buying European GDP. The top-line GDP for Europe was around 1%, but company growth came in at 5-6%, on the back of global growth.”

Barber, at Russell, says: “Earnings growth for European companies has been strong. They definitely benefited from the growth in emerging markets.”

Dwane, at RCM, agrees: “Europe remains well placed to offer exposure to the emerging markets like Asia and Latin America. The emerging markets are currently the only source of economic growth in the world and therefore exposure to these regions is very good for European companies.”

He gives examples of European companies looking to benefit from overseas growth. Brand names like Zara, owned by Spanish company Inditex, and Nestle, can make the most of the fact that people in the emerging markets are looking to improve their lifestyle.

Freeman-Shor says: “From a bottom-up perspective, Europe has the most market leaders with exposure to the emerging world – companies like Diageo and Richemont are typical examples.”

Diageo is a wine and spirits producer, among other things, representative of brands like Tanqueray, Smirnoff and Johnnie Walker. Richemont is the luxury goods giant that owns brands like Cartier, Dunhill, Montblanc and Chloé.

Barber, at Russell, says: “Richemont’s growth has come from the emerging markets and the company’s profitability and operating leverage remains in good shape. BMW is another company that is riding the wave of emerging growth. It can no longer be considered as just a German car manufacturer. It has been benefiting from people in the emerging world switching to high-end vehicles. Therefore it’s not just about selling more cars in these regions but also about selling more expensive cars as the lifestyle improves.”

Macro concerns
One major factor working against the positive perception of European equities is the shaky macro-economic environment. All of the bad news emanating from Europe certainly is not encouraging to the standard investor.

Bateman, at Schroders, says: “In peripheral European countries the macro issues are more of a problem for domestically focused companies, so they’re not looking attractive at the moment. Those companies that export their expertise are in a much better position than those solely reliant on their domestic markets. So, for example, banks like Santander and BBVA are in much better shape that the local Spanish banks.”

Di Giansante, at Pioneer, says: “Top-down worries create the opportunity to invest in crisis companies. For example, this year, I bought positions in some of the Spanish listed companies. At the end of the day, if you’re a long-term, bottom-up investor you just buy what you know to be a strong name and are not too worried about the short-term noise.”

Anand adds: “Macro growth is not the be all and end all; it is not the pilot light people assume it is. For example, Brazil has not seen the biggest GDP growth among the emerging markets but it has generated the best returns, historically.”

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