The market's best buying opportunities normally appear at times of high anxiety and uncertainty, so Europe should make fertile hunting ground for value investors in 2012. The region has spent much of the past year wallowing in a quagmire of economic and political turmoil as it attempts to pull several overly indebted eurozone countries off the perilous paths they've been walking. Coercing 17 nations to throw their economic lot together and act in the interest of the entire bloc is proving tortuous, which is unsurprising given the massive loss of sovereignty such action entails.
The good news for investors is that the uncertainty is creating signs of value. "What counts in terms of investment returns is valuation," says John Pennink, the respected manager of British Empire Securities & General investment trust. "And right now valuations in Europe are attractive. The weighted average discount on our portfolio is above 35 per cent and this is as wide as it has ever been."
Reasons to be uncertain
Treaty changes aimed at taking rogue eurozone nations in hand are on the table, but such rules have proved hard to enforce in the past and 2012 may show us that the people of Europe are not prepared to swallow the medicine. Successive governments have been overturned in the eurozone's most debt-ravished countries at a pace that is reminiscent of the Arab Spring - but the mood is very different. There are mounting concerns that democratic legitimacy is being sacrificed for financial stability, which does little to promote the cause of monetary and fiscal union.
Eurozone sovereign defaults, which were once deemed unthinkable, are now a stark reality, with Greece leading the way. The extent of possible defaults is hard to guess and increased unity could allow the European Central Bank to fill the breach in 2012, which could have a very positive effect on markets. Even so, the ramifications of a significant default would be extremely far-reaching, with the knock-on effects having the potential to cause a second phase of the credit crunch.
With the contradictions behind the currency union laid bare, the project is creaking at the seams and the constraints it places on national economic policy make recession look more likely.
While some argue that re-adopting national currencies followed by default and devaluation would be the best way for overly indebted eurozone nations to kick-start their economies, the fallout from such events still looks very scary, especially for the banking system.
Where to hunt for value
For investors, it is hard to know what to plan for in 2012: a collapse of the euro, a depression, a credit crunch, a quantitative easing-induced explosion in inflation, or all of the above? Consequently, hunting for value won't be easy as there are many potential traps investors could fall into.
"It is important to consider how buying cheap assets will translate into shareholder returns," says Mr Pennink. "It is not enough to simply buy cheap companies and hope that the market or another investor will recognise that value and take you out at a higher valuation. Thus cash flow and dividends have become more important to returns and are an important discipline in avoiding 'value traps'. We are tilting our portfolio towards more defensive companies - those with strong balance sheets, relatively high dividends and sustainable cash flows. Examples would include Vivendi on a dividend yield of over 9 per cent, and Orkla in Norway, which has a yield of over 5 per cent and is returning cash to shareholders by disposing of non-core businesses in an attempt to eliminate the discount."
Growth opportunities still exist in Europe as many European listed companies are world leaders and can be expected to continue to prosper despite the economic disruption in the countries where their shares are listed. What's more, there are global structural growth opportunities that should continue to benefit many businesses. "We aim to avoid companies whose success depends on a specific GDP growth rate, currency rate or commodity price," says Alexander Darwall, manager of Jupiter European Opportunities investment trust. "No matter how strong the business model and the management, we want companies that can benefit from a multi-year structural trend to support their growth. These trends range from the growth of the diabetes pandemic, online education, e-commerce, ever tighter vehicle emissions regulations and governments' drive to ensure energy security."
Traps to avoid
It looks like this is make-or-break time for the euro. The disbandment of the currency would have huge consequences, especially for weaker nations where substantial capital flight and devaluations are both likely outcomes. To avoid being hit by this risk, the most prudent strategy would seem to be investing in non-euro countries or avoiding companies that are listed on the exchanges of countries that can be regarded as non-core eurozone players and fiscally weak. The flipside to this is that companies listed in stronger countries could benefit from currency appreciation should the euro collapse.
Truly international companies should be better positioned to ride out the problems due to their ability to generate earnings and access capital in a range of currencies. "While companies may be listed in a particular jurisdiction it does not necessarily mean that their businesses operate exclusively in that country," says Mr Pennink. "While Ferrovial, for example, is listed in Spain, the two assets that make up the vast majority of its value are BAA in the UK and the ETR407 highway in Canada."
Sovereign defaults are also a risk, with events in Greece proving the necessity of such action for certain eurozone members. The financing problems that this will cause for companies in those countries that are reliant on domestic markets could be acute and credit in general could become scarce, too. While the effect of defaults would be widely destabilising, the impact is likely to be deepest in the financial sector, where balance sheets could be shredded. Financial companies are already looking very cheap based on their recent trading, but investors only need to cast their minds back to 2008 for a reminder of how quickly emergency fund-raisings with discounted rights issues can destroy illusions of value. For this reason it looks prudent to avoid the financial sector as well as companies carrying noteworthy amounts of debt.
There are also risks associated with potential policy responses to the economic strife, especially as governments try to boost tax revenues. "We look for companies with cost flexibility, favouring those that can relocate to countries that benefit from lower production costs or more favourable regulatory or corporate tax regimes," says Mr Darwall. "For example, governments have been targeting captive, capital-intensive companies that cannot escape their clutches, such as utilities, banks and telecommunications, so we avoid these. We prefer business models with an abundance of intellectual property that sell a large number of small-ticket items and have a cost-effective route to market."
With austerity, uncertainty and falling confidence comes the prospect of recession. This means cyclical stocks look precariously placed, although these are also the type of companies that will lead any recovery. At the moment we remain of the view that prospects look best for defensive sectors, such as consumer staples, and any company that appears to offer credible structural growth potential.
In the face of mounting disquiet among the people of Europe, politicians will be under pressure to go down the populist route of printing money, which normally results in rapid inflation (default by the back door). History suggests this is ultimately the most likely road developed nations will take and, under such circumstances, investors will need to look for companies with pricing power and an ability to control costs.
Funds to watch
One way to get exposure to Europe is through investment funds. In the case of investment trusts, the discounts to net asset value (NAV) at which the shares tend to trade provide an extra potential source of outperformance if they can be bought close to the bottom of the market. Here's our pick of some of the best unit and investment trusts for European equity exposure.
British Empire Securities & General
British Empire Securities & General investment trust is a global fund but with a big European focus. At the end of November, nearly half of the fund was invested in continental Europe, although much of this was in non-euro countries such as Sweden and Norway. What's more, the fund is thoroughly focused on value investing though a strategy that identifies companies that are valued at discounts to the sum of their parts. In its full-year results to the end of September, the trust estimated that the average discount on its underlying holdings had increased over the year from 23 to 39 per cent. Meanwhile, at the time of writing, the trust's own shares trade at a 4 per cent discount to NAV. While the trust's long-term record is strong, short-term performance has not been impressive; nevertheless, the trust looks like a great way of targeting the value theme and diversifies exposure beyond just Europe.
Top 10 equity holdings
| Vivendi | 10.82% |
| Orkla | 6.92% |
| Jardine Strategic | 5.86% |
| Investor AB | 4.88% |
| Sofina | 4.13% |
| Aker | 3.91% |
| GBL | 3.69% |
| Jardine Matheson | 3.64% |
| Deutsche Wohnen | 2.95% |
| Yamana Gold | 2.33% |
| Total | 49.13% |
As at 30 November 2011 | |
Neptune European Opportunities
The flair that Neptune's fund management team has for capturing major global themes and feeding that into stock-picking looks particularly well suited to the current environment, where so much of the action is dictated by 'top-down' macro factors. The Neptune European Opportunities unit trust moved to a defensive stance in July and has completely shunned the financial sector over fears of a meltdown. Its major bets are now with defensively placed consumer staple companies and high-yielding telecom stocks. As of the end of September its principle geographic bet, at 24 per cent of the portfolio, was Switzerland, a non-euro country. Other non-euro countries that feature in the top 10 country holdings include 10.3 per cent in Norway, 6.2 per cent in the UK and 4.5 per cent in Sweden; 18.8 per cent of the portfolio is in cash.
Top 10 equity holdings
| Daimler | 4.10% |
| ABB | 3.39% |
| Alstom | 3.09% |
| Syngenta | 3.08% |
| Eads | 2.92% |
| LVMH Moet Hennessy Louis | 2.85% |
| Reckitt Benckiser | 2.58% |
| Deutsche Lufthansa | 2.56% |
| Siemens | 2.50% |
| Cie Financiere Richemont | 2.29% |
As at 30 June 2011 | |
Jupiter European Opportunities
Jupiter European Opportunities investment trust manager Alexander Darwall pays as little attention as he can to both investment timing and the macroeconomic outlook. His approach is based on holding a concentrated portfolio of high-quality growth stocks that will weather whatever the economy has to throw at them. That's not to say Mr Darwall lives in a bubble. Where there are obvious pitfalls and dangers, he avoids them and builds this into his stock-picking strategy; he avoids companies that are "captive to government", for example. As Jupiter European Opportunities' portfolio includes companies that would make excellent long-term holdings, the shares could prove a real bargain if they get badly knocked by the current crisis and move to a big discount.
Top 10 equity holdings
| Novozymes | 7.50% |
| Experian | 7.20% |
| Croda International | 6.40% |
| Syngenta | 5.40% |
| Novo Nordisk | 5.40% |
| Johnson Matthey | 5.20% |
| Intertek | 4.70% |
| Reed Elsevier | 4.20% |
| Vopak | 4.10% |
| Provident Financial | 4.10% |
| Total | 54.20% |
As at 30 November 2011 | |
