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European income at attractive valuations

Investors have been cautious on continental Europe but market experts believe that this area offers compelling income opportunities and attractive valuations
August 7, 2013

Europe has been a no-go area for investors because of its sovereign debt problems, and before that because of the perception that it did not offer good returns. But recently a number of market participants have highlighted the opportunities the region offers investors, in particular for equity income.

"Taking a global view, at the moment, Europe is one area that is also quite compelling," says Ben Lofthouse, fund manager of Henderson International Income Trust (HINT). "The economic picture is stabilising and with the significant de-rating that has occurred over the past five years, numerous companies seem cheap with low expectations for growth. In many cases fundamentals are attractive; management have de-levered their balance sheets, built up cash reserves and are beginning to invest in projects, and mergers and acquisitions are driving future growth again. The public sector may have some way to go, but the private sector is looking healthy. We have increased our allocation in Europe from circa 25 per cent last year to where it stands today at around 40 per cent."

Will James, manager of Standard Life Investments European Equity Income Fund (GB00B3L7S735), adds that if you take a selective stock picking approach to European equities you can identify a range of businesses offering not only attractive dividend yields but, "just as importantly the potential for future dividend growth. The survivors from the European crisis commonly have good technical indicators of dividend sustainability, such as sustainable business models and robust balance sheets."

Examples include Norwegian oil rig operator Seadrill which yields around 8.5 per cent and Danish medical devices maker Coloplast, whose managers are committed to returning excess cash to shareholders.

Meanwhile, Merrill Lynch Wealth Management sets out seven reasons to revisit eurozone equities in a recent report. These include attractive valuations. "In both absolute and relative terms, equity valuations for the region are attractive," they say. "Focusing on the MSCI Europe Index, the current 12-month forward price-to-earnings ratio (PE) is 11.6 times, a more than 20 per cent discount from its 20-year average and a 20 per cent discount to the US. Relative to bond markets, the current 12 month trailing dividend yield of 3.6 per cent is nearly a full per cent higher than the current yield on the 10 year US Treasury note. These attractive valuations, combined with a better earnings outlook, make it a good time to begin reconsidering eurozone equity exposure on a tactical basis."

Graham Duce, co-head of multi-manager funds at Aberdeen Asset Management, points out that European income stocks are cheaper than US income stocks and produce a more attractive yield. "Europe is home to world leading businesses which due to the debt crisis traded at discounts to their global peers, even though many of their end markets were outside the eurozone. Even though the European market has recovered significantly from the low point, many companies continue to offer attractive yields, and in some cases offer dividend yields in excess of corporate debt."

Companies listed in the eurozone also do not necessarily make substantial amounts of their revenues there.

Stephen Macklow-Smith, manager of the JPMorgan European Income Investment Trust (JETI), says that key factors supportive to the valuation case include:

1. European company exposure to fast growing markets is the highest of any developed region. Because these companies seek to compete on quality rather than price, this pushes them towards higher return businesses;

2. Europe is especially strong in high-end aspirational consumer goods, benefiting disproportionately from the growth globally in the middle class;

3. Healthy European balance sheets and strong cash generation means increasing buy-backs should support stock prices; and

4. Dividends have scope to grow.

 

Risks remain in Europe

However, not everyone is convinced that European equity income is a good opportunity.

"European equities as a whole are not cheap from a cyclically adjusted PE (CAPE) valuation basis, rather they are more middling or fair priced," argues Damien Fahy, head of research at FundExpert. "The US is expensive by comparison and if investors are looking for cheap then there are better opportunities elsewhere, though that's not to say there are not pockets of value among European equities."

"Arguably Asia has the stronger growth potential than Europe and therefore companies can grow their dividends," adds Adrian Lowcock, senior investment manager at Hargreaves Lansdown. "There is also a big culture shift in the US as investors start to recognise the appeal of dividends and large companies return cash to shareholders."

Risks remain, for example, eurozone growth could slow. "For European stock markets to begin outperforming those of the US and UK there has to be positive news flow on the economy or else meaningful reform," adds Rob Pemberton, investment director at HFM Columbus Asset Management. "Eurozone equity markets will likely only outperform other global markets sporadically in a risk-on environment but aren’t yet deserving of long-term investor support as a macro play."

Growth in emerging markets could prove to be weaker than forecast hitting corporate earnings of exporting companies in Europe, for example, German engineering companies and luxury goods. Mr Duce points out that for sterling investors there is the risk a weaker euro will erode sterling investors' positions. Even though the shares or units in your fund may be denominated in sterling, the underlying shares are quoted in euros and have to be translated back into sterling.

Even if these shares are doing well, if the euro is weak against sterling, you will lose some of those gains. For this reason, analysts at Merrill Lynch Wealth Management prefer to hedge the euro when investing in eurozone equities. However, Mr Gilligan says that currency risk is a short-term issue from month to month so not as much of a concern for investors taking a three- to five-year view. Also, as some of European-listed companies make their revenues globally this is less of a problem.

Mr Gilligan recommends that you do not have more than 5 to 10 per cent of your portfolio in European shares, and this is if you have a medium to high risk appetite. If you want income from your portfolio, some of this allocation could include some European equity income funds.

 

Best funds for European income

If you have a lower risk appetite consider a diversified global income fund such as Artemis Global Income (GB00B5VLFH80) which has nearly a quarter of its assets in the eurozone, and a good record of growing its payouts according to Mr Fahy.

Veritas Global Equity Income (IE00B0WFLH68) has more than a quarter of its assets in Europe ex UK. "This fund's standout characteristic is the extent to which the managers aim to deliver real returns to investors," says Jeffrey Schumacher, fund analyst at Morningstar. "It invests in companies with durable competitive advantages and strong, sustainable cash flows that can lead to dividend payments. Yield is one of the considerations, but the managers are not prepared to invest in high yielding companies that are unlikely to contribute to capital growth."

Mr Gilligan says that investment trusts also offer an attractive way to play a potential recovery in Europe, as a number of European trusts trade at discount to net asset value (NAV) and he expects that to narrow as sentiment in the region improves. His suggestions include European Assets Trust (EAT), which we tipped in June (read the tip). We tipped it because of its strong yield of 5.1 per cent and reasonable costs - plus it trades at a discount, now 1.71 per cent, which is not the case with many investment trusts that offer a good yield.

JPMorgan European Investment Trust - Income (JETI) yields 4 per cent but can still be picked up on a discount of 13.83 per cent. Its share price returns are not as good as its peer average but they are growth mandates and it offers a much higher yield than most of them.

Investment trusts offering exposure to European income

Investment trust

Yield (%)

1 year cumulative share price return (%)

3 year cumulative share price return (%)

5 year cumulative share price return (%)

Discount/premium to NAV (%)

*Ongoing charge (%)

Henderson International Income Ord

3.37

22.96

NA

NA

+3.38

1.46

JPMorgan European Income Pool Ord

4.03

39.80

41.12

58.03

-13.83

1.48

European Assets Ord

5.11

56.64

85.80

62.22

-1.18

1.71

MSCI Europe Ex UK GR USD

40.34

32.85

37.80

Source: Morningstar, *Association of Investment Companies

Performance data as at 2 August 2013

For those preferring an open ended fund Mr Gilligan and a number of advisers favour IM Argonaut European Income Fund (GB00B7K73D30) which has a current predicted yield of 4.88 per cent, although Morningstar's current 12 month yield is only 1.93 per cent. The fund aims to provide an income in excess of the yield of MSCI Europe ex UK Index while preserving capital.

IM Argonaut European Enhanced Income Fund (GB00B734ZP78), meanwhile, follows Argonaut European Income's investment process but hedges returns into sterling to remove currency risk and boosts the income generated by the underlying portfolio using covered call options. It currently yields 2.33 per cent but is targeting a 6 per cent yield of in the year from 15/04/13 to 15/01/14.

Mr Duce suggests BlackRock Continental European Equity Income Fund (GB00B43MZ612) which yields 4.6 per cent. The fund only launched two years ago but over one year is among the top 25 per cent of performers in the Europe ex UK fund sector.

"We invested in this last year when the valuation argument became attractive due to the debt crisis," he says. "The BlackRock fund was attractive given the strength of their European team and because the fund had a solid balance between high yielding opportunities and higher quality dividend growth companies."

Open-ended funds offering exposure to European income

Fund

Yield (%)

1 year cumulative total return (%)

3 year cumulative total return (%)

5 year cumulative total return (%)

Total expense ratio (%)

Artemis Global Income R Inc

4.46

34.82

65.97

NA

1.64*

IM Argonaut European Income R GBP Inc

1.93

34.79

NANA

1.54**

IM Argonaut European Enhanced Income R GBP Inc

2.33

22.33

NANA

1.53**

Standard Life European Equity Income Retl

4.7

31.62

54.13

NA

1.61

Veritas Global Equity Income Retail GBP

4.27

10.60

37.61

69.73

1.61

MSCI Europe Ex UK GR USD

40.34

32.85

69.73

IMA Europe Excluding UK

37.36

40.72

69.73

Source: Morningstar, *Artemis, **Argonaut

Performance data as at 2 August 2013

There are some passive tracking exchange traded funds (ETFs) which follow European high yields indices, for example, iShares EURO Dividend UCITS ETF (IDVY) which yields 5.96 per cent and has a total expense ratio (TER) of 0.4 per cent, and SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDV) which yields 3.17 per cent and has a TER of 0.3 per cent.

However, Mr Gilligan says an active manager can also take advantage of some of the mid- and small-cap opportunities, which may not be present in these indices.

And in areas with trouble spots such as Europe, active management is relevant in that there is not only a need to pick good companies, but also to avoid bad companies, and troubled countries and sectors. "Investing in index funds will also include high yield names that may have little dividend growth and therefore includes less desirable companies with little or no growth to underpin the dividend," says Mr Duce. "Being selective in Europe will continue to remain very important over the coming years."