Bargain valuations take Europe from zero to hero

The Big Theme

Europe has been a no-go area for many investors because of the financial crisis, and before that a perception that it offered no growth or dividends. However, in recent weeks, increasing numbers of professional investors and advisers have warmed to Europe, with low valuations being a key attraction. Although the troubles are not over, the region is showing signs of steady improvement, according to Tim Stevenson, manager of Henderson EuroTrust. Because of this, he is prepared to increase the trust's debt to top up holdings during market dips.

"Equity valuations across Europe are similar to those three decades ago and yet companies are now far better managed," says Mr Stevenson. "There are plenty of quality companies, led by reliable management, that are financially stronger than most European governments and which are rewarding shareholders. What's more, payout ratios are on the up and those that had not previously issued a dividend are starting to. We have seen a pick up in international investor interest in Europe of late, but more important still has been a noticeable increase in the participation of the domestic investor, a trend we believe will be sustained for years not just months. We cannot wait until Europe returns to a more normal situation; we need to take advantage of its new reality and find companies that can flourish in this low-growth world. We need to start viewing the situation in Europe as an opportunity, not a threat."

Read our interview with Timothy Stevenson

It is not only Europe managers who are enthusiastic. A recent survey by fund research company S&P Capital IQ reported that two-thirds of global funds they surveyed were overweight in European equities (read more on this). Richard Oldfield, who runs the SJP High Octane Trust, a global equities fund, is overweight Europe ex UK, his largest geographic exposure, although he doesn't allocate according to geography, but rather according to companies’ merits. "We are seeing very good companies in Europe at the moment, and they are as cheap as they have been for a long time," he explains.

Peter Hewitt, manager of the F&C Managed Portfolio (FMPI) fund of investment trusts, which invests globally, recently told Investors Chronicle: "I would not be surprised if European markets do quite well in the next year or two. They are the one part of developed markets that is cheap." (read the full comment).

"Stocks look cheap on two key metrics: the equity-risk premium relative to bonds, and also compared with their longer-term price earnings (PE) trends," adds Jason Hollands, managing director at investment adviser. Bestinvest. "The art of equity investing is to buy things when they are cheap and sell when they are high."

While it is good to pick up things cheaply, there are still many problems in the eurozone. European shares were priced for extremely dislocating events such as the break up of the eurozone, according to Ashish Misra, head of investments at Lloyds TSB Private Bank, although he feels that the risk of these has receded significantly. "Strong policy intervention by the European Central Bank has reduced the risk of any extreme events that would negatively affect the European equity markets and raised the probability of a more stable median-case scenario," he says.

Although the price-to-book ratio of European shares has recently risen from around 1.1 times to around 1.5 times, this is still below their average long-term trends. "In terms of their price, European equities are now trading at just over 30 per cent discount in terms of price-to-book value ratios relative to US equities," adds Mr Misra. "This trend of relative underperformance - now nearly two years old - has likely grown a little long in the tooth and does raise the possibility of a period in which European equities outperform their US counterparts."

It's also not just about price - investors are getting excited about European shares because they include some of the world's most successful multinationals.

UK investors have good reason to allocate to Europe because different markets have different industry characteristics. The UK has a very high weighting to financials and oil and gas, whereas in European equity markets you find many luxury brands and pharmaceutical companies. "So investing in Europe is a way of providing industry diversification to a portfolio as much as it provides geographic diversification," says Mr Hollands.

Risk

Although many companies look good, the many problems remaining in the eurozone could create market volatility. A Greek exit or broader meltdown for the euro would have implications for European equity markets, although almost certainly for stock markets outside the eurozone as well.

The fundamental issues behind the crisis remain and some eurozone countries need to bring down their levels of debt, which could take a long time. Austerity measures are likely to affect European growth rates.

However, European companies' earnings are not necessarily related to the countries where they are listed. "For example, Unilever generates 55 per cent of its revenues in emerging markets and recently disclosed it had generated €1bn (£800m) in revenues from selling Magnum ice creams to the Chinese," says Mr Hollands. "Similarly, BMW recently reported sales growth up 14 per cent in September, despite shrinking business in Europe."

But this means some exporters could suffer if there is a slowdown in China and emerging markets. Earnings reports are likely to spark some volatility on the markets if profits come in below forecast and guidance is weaker than expected, according to Cedric de Fonclare, manager of the Jupiter European Special Situations Fund. "When European firms gave out their guidance earlier this year, many of them were factoring in an economic recovery in Asia, particularly in China in the second half," he says.

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