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Does Europe still offer value?

Investors have been piling back into Europe funds as economic fundamentals improve, with some arguing that the market and recovery has further to go.
November 26, 2013

Over the past few months investors have increasingly poured money back into European equity markets after avoiding the region due to concerns about sovereign debt. Performance of European equities has improved with the Russell Developed Europe Index returning 19.8 per cent year to date (as of 19 November).

Europe has started to show signs of economic recovery, which - while risks remain - is sustainable, according to Martin Skanberg, European equities fund manager at Schroders. The region has emerged from recession, posting growth of 0.3 per cent in the second quarter.

"Europe's austerity headwinds are now easing and the region has returned to positive gross domestic product (GDP) growth," he says. "This could set the stage for significant growth in earnings per share in 2014, led by the banks and cyclical stocks whose earnings were most depressed in the downturn."

Consensus earnings estimates for MSCI Europe Index are 12.5 per cent for 2014, up from -0.7 per cent for 2013.

Consensus earnings expectations for MSCI Europe

201320142015
MSCI Europe-0.712.510.6
Consumer discretionary-12.913.311.7
Consumer staples1.19.49.4
Energy-9.711.64.9
Financials15.914.713.3
Health care-0.28.89.1
Industrials517.812.5
Information technology20.629.118.7
Materials-6.720.116
Telecoms -12.64.96.1
Utilities-10.9-0.44.1
Europe ex financials-5.211.89.7

Source: Schroders, JPMorgan

Stephen Cohen, head of investment strategy at iShares, believes the recovery is not about a major shift in growth, but a case of a sentiment reversal and reallocation into a previously unloved region, and for many, a long-term underweight. "While we remain cautious in the long term on structural challenges, particularly in the eurozone, short-term momentum is strong - inflows into total European equity funds have broken multi-year records in recent weeks, with investors also starting to broaden into high-beta segments, such as Italian equities as well as broad European small and mid-caps," he says.

Stuart Mitchell, manager of the SJP Greater European Progressive and SJP Continental European funds argues that there are quality businesses in the eurozone and that their value relative to other equities such as the US continues. He also says there is an opportunity offered when the eurozone's economic recovery strengthens in line with the US. "We are still in the early stages of a European upswing - with the UK slightly further along the rebound than the continent," he says. "The case for European stocks remains that they offer better growth prospects - even if this looks later rather than sooner - and promising returns in sectors such as industrials, financials and technology."

Azad Zangana, European economist at Schroders, notes that: "Leading indicators suggest that not only has core Europe continued to expand activity at a steady pace, but that peripheral Europe may be on the verge of resuming growth. Greece is making great progress in fixing its public balance sheet, and if growth does resume in the near future, then there will be a tailwind to boot. The remaining periphery is also improving."

Russell Developed Europe Index returns

Index Year to date return as at 19 November (%)
Europe 19.8
Austria13.1
Finland34.2
France22.5
Germany22.6
Ireland38.4
Italy21.3
Luxembourg6.5
Netherlands16.5
Norway10.5
Portugal19.9
Spain23
Sweden17.5
Switzerland21.6
United Kingdom16.5

 Source: Russell Investments.  Returns are euro-denominated and are total returns reflecting reinvestment of dividends and distributions

Risks

However, a number of risks remain to the European outlook.

"We see a risk that retail investors will be encouraged by the argument that European stocks are cheap, only to find that growth in returns from European companies will be choked off by further reductions in government spending and increased taxation, as overburdened states struggle to service the rising cost of debt," warns Paul Taylor, chief executive officer at wealth manager McCarthy Taylor. "We are astounded by the extent to which other investment professionals are so relaxed about this. It seems to us very unwise to increase exposure to a market so over borrowed."

He says unwary investors in Europe may be missing the increasing risks from extensive government debt. "We remain of the view that a low level of exposure is desirable until the Europeans demonstrate that they truly have resolved their debt issues and can sustain the risk of increased interest rates being forced upon them as quantitative easing comes to an end," he adds.

Read more on this

Unemployment is still high in southern Europe while there are concerns about the health of European banks.

"The question remains as to whether the European economic recovery is sustainable," says Mr Skanberg. "It will be difficult to have sustainable GDP growth in Europe without companies having easier access to credit. In particular, companies operating in the periphery continue to be charged much higher rates of interest than their core Europe counterparts, making them quite hesitant to hire new workers and expand capacity. The timing of the upturn in the credit cycle remains the biggest risk facing Europe."

For these reasons, advisers generally suggest that if you invest in Europe you should have a long-term time horizon, and medium to high risk tolerance. How much you allocate will depend on your risk appetite, though Adrian Lowcock, senior investment manager at Hargreaves Lansdown, suggests investors could have around 10 per cent of their assets in European equities.

 

Value?

In addition to these risks the rise in European shares since last summer means some analysts argue that they are over valued.

"Looking at Europe's price-earnings (PE) multiple in absolute terms and in respect of historical levels suggests that we may be pretty close to peak multiples," say analysts at broker Charles Stanley. "The 12-month forward PE for the MSCI Europe Index has risen by 55 per cent over the past two years to levels only marginally (and briefly) exceeded in early 2010 and 1998."

European equities are no longer so cheap in aggregate and partly because many of the better companies are now trading on expensive valuations, according to Mr Pemberton. "The bull case on European valuations is that even though the PE is not especially cheap (at around 13x) there is potentially a lot of operational gearing in the earnings: if the European economy does manage to reach escape velocity then there could be some very strong earnings coming through, which would make the valuation fall considerably. The potential for upward earnings surprise is greater in Europe than it is in the US and the UK."

Proponents of the value case include Mr Skanberg. He says: "It remains the case that European equities are still cheap compared with both their own history and when compared to US or Asian equities. Europe is the last of the value equity trades. We have seen strong performance from European equities over the summer, but would argue that there is more to come."

 

Best Europe funds

Because of the problems in certain parts of Europe advisers generally favour active funds, as there is not only a need to pick good companies but also to avoid bad ones, and troubled countries and sectors. Active managers can take advantage of mid and small-cap opportunities, which may not be present in the indices that exchange traded funds track.

Read more on whether to go active or passive

Mr Pemberton says that while deep seated problems remain and Europe is a high risk/reward market for equity investors, there are several stock picking funds which take advantage of the many individual company opportunities. In view of the argument for an upward earnings surprise he suggests a recovery fund. "The one we have been recommending all year is Cazenove European Income Fund (GB00B7CM2R31)," he says. "Its name may imply that it is full of traditional secure growth or expensive defensive companies, but this is anything but the case and instead is full of economically sensitive industrial and financial stocks."

Read more on the case for European equity income

"Two safe-pair-of-hands funds we recommend for the long term are Jupiter European Special Situations (GB0004911540) and Blackrock Continental European (GB0005804728)," he adds.

Manager Vincent Devlin took over Blackrock Continental European in March 2008 and had previously amassed solid results at four continental European funds.

Ben Gutteridge, fund analyst at Brewin Dolphin, suggests Neptune European Opportunities (GB0032308594) because of the stage in the cycle. "The fund is investing in more economically sensitive parts of the market, and is well place to benefit from the improving outlook," he says.

Threadneedle European Select (GB0001529345) has done well over three and five years, though has not been so good in the past year.

Read our tip

Read our interview with the fund's manager

 

Performance of recommended Europe funds

Fund1-year cumulative total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)
BlackRock Continental European 26.5531.91129.851.67
Cazenove European Income 42.59NANA1.64
Jupiter European24.6735.11161.991.78
Jupiter European Special Situations28.4331.65103.461.79
Neptune European Opportunities 24.5421.3887.171.81
Threadneedle European Select21.9843.07141.411.73
FTSE World Europe Ex UK TR GBP29.3128.49102.52
Average IMA Europe ex UK fund29.1328.6698.78

Source: Morningstar

Performance as at 22 November 2013

 

There are eight Europe investment trusts but the discounts on most of these have tightened. However, in a rising market trusts can do better because of their ability to take on debt, while they can benefit from a double rerating - both of their holdings and share price.

"There is not a huge amount of value in the sector now as discounts have narrowed significantly," says Charles Cade, head of investment companies research at Numis Securities. "For large cap focused funds, the average discount is 4.9 per cent versus a 12-month low of 11.2 per cent. However, there are some strong, experienced management teams running funds such as BlackRock Greater Europe (BRGE) and Henderson Eurotrust (HNE): both have good long-term track records achieved by investing in quality growth companies."

Read our interview with Henderson Eurotrust's manager

Mr Cade also likes Henderson European Focus (HEFT) as it has a focused all cap portfolio and has performed well since its investment approach changed in November 2011.

We have three Europe investment trusts in our IC Top 100 Funds including Jupiter European Opportunities (JEO). Its performance is miles ahead of its peers and the FTSE Europe index over three and five years, but as a result trades at a premium to NAV of 3.65 per cent. Investors who don't want to buy at a premium could try its manager Alex Darwall's open-ended fund, Jupiter European (GB0006664683), which has also done well over three and five years, though it has a much higher ongoing charge.

"Jupiter European has many of the features we like to see: a talented long-standing manager who is part of a highly experienced European equities team, a diligent investment process that has been proven through time, and a consistency of approach that investors can rely on," says Muna Abu-Habsa, analyst at Morningstar.

Meanwhile, following a change in manager the performance of European Investment Trust (EUT) has improved, and we tipped the trust as a buy last week (IC 22-28 November 2013, read it here).

 

Performance of Europe investment trusts

TrustDiscount/premium to NAV (%)1-year cumulative share price return (%)3-year cumulative share price return (%)5-year cumulative share price return (%)Ongoing charge (%)
BlackRock Greater Europe -333.6136.65148.221.4
European Investment -9.5848.7748.00109.180.63
Fidelity European Values -9.2327.7351.24108.541.38
Henderson European Focus Trust -3.8146.9862.24148.092.28
Henderson EuroTrust -1.845.9262.79144.691.09
JPMorgan European Growth Pool -8.1340.7142.41146.401.48
JPMorgan European Income Pool -8.6642.2446.31146.611.48
Jupiter European Opportunities +3.6527.2776.26340.521.13
FTSE World Europe Ex UK TR GBP29.3128.49102.52
Average AIC Europe trust39.1553.24161.53

Source: Morningstar

Performance data as at 22 November 2013