Little more than a year ago Europe was on the verge of tearing itself apart. The financial crisis had pushed peripheral eurozone nations to the point of bankruptcy, and politicians struggled to agree on the depths of austerity measures that would be required in return for crucial bailout cash.
This turbulent political and economic backdrop has raised risk aversion across European bourses - who in their right mind, after all, would take the chance of another flare-up that could rock European markets. Indeed, in the five years since the collapse of Lehman's, most European bourses have significantly lagged the QE-driven recovery seen in London and New York. The Cypriot banking crisis earlier this year further highlighted the fact that the continent wasn't immune to further shocks, and its politicians did not always sing from the same hymn sheet. The disagreements between Germany's Angela Merkel and France's Francois Hollande over austerity perfectly encapsulated the division over how to react to Europe's problems.
But the resulting indiscriminate sell-off has proved manna for value investors prepared to take a contrarian call. Since June, European shares have staged a rebound, while remaining relatively cheap compared with other major indices. So, with signs that an economic recovery is in progress, it is time to consider whether it's a good time to increase exposure to the troubled continent.
Plan comes together
The key turning point in the seemingly perpetual eurozone crisis was the intervention of European Central Bank chief Mario Draghi, and his promise that he would do "whatever it takes" to save the euro. His successful plan was a scheme known as the long-term refinancing operation (LTRO), which hoovered up bonds issued by debt-laden banks to improve liquidity.
A year later, and his words appear to be having the desired effect. This summer saw the European trading bloc exit a downturn that lasted six consecutive quarters, with economic output climbing by an average of 0.5 per cent across the continent. Inevitably this was led by Germany, which posted third-quarter growth of 0.7 per cent, but even laggards such as France managed 0.5 per cent growth. Important confidence indicators have started to swing upwards, too, including Germany's Ifo business survey and its ZEW investor confidence survey, which hit its highest level in over three years in September.
The outlook from the bond markets also seems to be positive on the prospects for Europe - ratings agency Fitch highlighted how the number of ratings downgrades has fallen over the past three months as the continent emerged slowly from recession.
The context to the Fitch report is that there is an accumulation of evidence that Europe is over the worst of the economic downturn. Manufacturing PMIs across the eurozone's members are now nearly all reading at 50 or above, a level that signifies expansion. Even recent data from recession-hit Italy, which has experienced a long and tough contraction, showed a pick-up in manufacturing orders that tends to come before a rebound in capital goods production, with most economists now expecting a fourth-quarter rally in the country's economic performance.
Only sclerotic, over-taxed France and - unsurprisingly - Greece did not register expansion, according to the latest manufacturing PMI figures from Markit economics, although France's overall effort shows that it is at least heading towards equilibrium. The Iberian peninsula remains a toxic brew, meanwhile, but Spain's more enterprising companies have been expanding abroad in search of new markets and its economy came close to stabilising in the third quarter - its export volumes have risen faster than even those of Germany over the past three years, rising 6 per cent in Q2 due to falling unit labour costs. With its export PMI hitting an impressive 57.4 in August - above the eurozone average of 53.6 - Capital Economics, for one, believes that growth should continue. Portugal, too, is on an improving trajectory, exiting a 10-quarter recession with 1.1 per cent growth in Q2.
Overall, that's expected to lift eurozone GDP to 0.8 per cent next year - from an overall contraction of 0.3 per cent in 2013 - which means that, along with the US, mature economies will account for perhaps two-thirds of global growth next year.
Another false dawn?
However, there is still plenty of evidence to support the more pessimistic view that suggests Europe’s recovery will remain a protracted affair at best. July’s industrial production figures from Eurostat served up a reminder of the recovery's fragility: factory output fell 1.5 per cent month on month, with a surprisingly large fall in Germany where output shrank 2.3 per cent over the month. "The European Central Bank's warning that the recovery will be only gradual and slow, with plenty of potholes on the way, looks right," said economists at RBS.
Germany's prospects still loom over any economic debate in the European Union, particularly now that the country is in the middle of an election. Some analysts speculate that the election could see a change in emphasis towards infrastructure spending, particularly if Chancellor Angela Merkel is drawn into a new "grand alliance" with the Social Democratic Party. That's a worry, as the Dax market has been a powerhouse all year for equity returns and the prospect of an improvement in Germany's key export markets has kept investors coming back for more.
Bank deleveraging continues, meanwhile, which could hold back growth - indeed €146bn of the €489bn borrowed from the ECB under LTRO has already been repaid this year. Fitch reckons that ongoing bank deleveraging is behind the 28 per cent fall in overall bond issuance in the year to the end of August compared with the same period last year. The rise in non-financial bonds wasn't enough to offset the 44 per cent fall in banks raising debt. Part of that fall is structural as the peak debt-raising period was in the first half of the year, but Fitch reckons the high allocation towards cash in Europe shows investor sentiment is still cautious.
There is much economic data to suggest caution should remain a watchword, not least unemployment, which remains structurally high at 12.1 per cent, having fallen by just 0.1 per cent in Q2. That could hold back the nascent recovery in consumer finances, subduing rises in wages and consumption. The Netherlands, meanwhile, a small but strong part of the eurozone, is enduring one of its worst housing busts in 20 years.
And it should never be assumed that EU politics will remain harmonious - especially with European government debt levels still at elevated levels. Fiscal policy in the form of deep austerity is still seen as a likely drag on growth, and its unlikely that the Troika will relent on these policies as they strive towards fiscal union. At least that means the prospect of interest rate rises in Europe remain distant, which, given the rising prospect of tightening in the UK and US, suggests a low rate environment could remain a fillip for European markets.
Are European shares cheap?
So while investors are no longer faced with the prospect of imminent continental-sized collapse, they are nevertheless still faced with the dilemma of whether to take advantage of lowly valuations across the continent's bourses, lest the economic improvement prove a mere blip in a continuing downward slide. Whether a slight upturn in several of Europe's more troublesome economies will automatically lead to share prices increasing is a moot point - although given that economic weakness has depressed eurozone share prices, it follows that they will receive a boost from economic recovery.
Certainly compared with the US stock market, European companies, in aggregate, are cheaper and trading at an average price-to-book value (PBV) of 1.7, compared with 2.8 for the S&P 500. This is also noticeable for the valuations of the continent's biggest companies. For instance, the Euro Stoxx50 comes out better against the FTSE with a forecast PE this year of 12.79 and a price/book value of 1.26, compared with the FTSE 100's PE ratio 12.91 and price/book value of 1.76, despite FTSE companies being included in the index.
The lower aggregate valuation seems to be partly down to rock-bottom prices for large sectors such as European utilities companies, where worries over whether Spanish, Portuguese, French and Italian consumers would be able to pay their bills - and the huge upheaval to Germany's nuclear generating capacity - weighed on confidence so much that the Euro Stoxx 600 Utilities index is trading at a forecast PE ratio of only 11, a clear discount to the rest of the market, dragging the rest of Europe's companies with it.
It's not just Europe's problems that have depressed valuations. Fears over China's slowdown and a subsequent fall in its demand for new equipment has consequently weighed down on those shares reliant on healthy exports. German companies have been particularly exposed to this: Siemens has notably underperformed, returning 2.5 per cent in the year to date, compared with 5.5 per cent for the Dax. However, this means that the possibility of a cyclical recovery in Western markets, along with signs that China's slowdown will not be as bad as feared, could leave Siemens, along with other cyclical companies, ripe for a recovery.
Nevertheless, it will still take some time for capital goods suppliers like Siemens to rebuild their margins, but eurozone utilities already appear to be making a comeback. Lombard Street Research shows that basic earnings for utilities companies have been stable for the past two years after suffering a peak fall of 20 per cent in 2009. In essence, the worst of the earnings trough is behind this sector, with the benefits of cost-cutting only just starting to flow through, which suggests that current European valuations are not going to get cheaper.
Therefore, it is possible to define a company's profitability and the relationship between share prices. If the recovery slows through next year, then other sectors will follow utilities in the slow improvement in their basic earnings. The most effective strategy is to follow the trend and to switch profits made in small-cap companies into the mega-cap shares that will see the benefits of an economic upturn later in the cycle.
UK investors looking for diversification opportunities will note the effect that the UK's surprisingly strong economic figures have had on the value of sterling against the euro; a rise that has left good-quality European large-cap shares looking even better value compared with equivalents available on the FTSE 100.
Certainly we are keen on a number of large European companies for which the continent's economic prospects are not make or break. The main characteristics of the shares we've picked is that they are all large and established companies, with geographically diversified businesses. All are also easy to trade through online platforms and they can benefit from different stages of the economic recovery over the long term.
The key turning point in the eurozone crisis was the intervention of European Central Bank chief Mario Draghi, and his promise that he would do "whatever it takes" to save the euro.
SIX OF EUROPE’S BEST
EADS (Fr: EAD), the European aerospace and defence contractor, had a strong first half, mainly due to record orders for commercial passenger jets made by its Airbus subsidiary. The division is on track to beat margin targets for 2015, and there’s speculation that China will place more aircraft orders, too. In fact, the business is doing so well the company will be renamed Airbus next year. Strong underlying demand and an ongoing share buyback programme reinforce our positive view.
Airbus is doing so well that EADS will be renamed Airbus next year.
Volkswagen (Ger:VOW3) sells more cars than almost any other manufacturer and, despite the slump in European car sales, sales for the first eight months of 2013 hit a record 6.2m. VW and Audi did well, especially in China, which now accounts for one-third of group sales. A groundbreaking new production line using standardised parts across a range of models will eventually deliver more than €2bn (£1.7bn) of annual savings, too. Up 26 per cent on our buy tip (€146.10, 18 October 2012) and with a US economic recovery under way, VW has mileage.
French car maker Renault's (Fr:RNO) home market has been abysmal in recent years. Overseas profits, however, have risen fast and its budget brands have also done well. Yet the current share price reflects nothing more than the company's 43 per cent stake in Japan's Nissan and small interest in Daimler. With sales growing and a wave of cost cuts to come, Renault's share price should finally begin to reflect that stronger automotive performance.
Dutch grocer Royal Ahold (AEX:AH) runs the Albert Heijn chain of supermarkets in Holland, grocery stores across Belgium, Germany, the Czech Republic and Slovakia, and the Stop & Shop and Giant supermarkets in the US. But while supermarkets are its core business, Ahold has its fingers in various other pots too, including drugstores, liquor stores and an online non-food retailer similar to Amazon. So far this year, trading has been solid, with a 2.6 per cent rise in underlying operating profit and 3.8 per cent increase in sales in the first half. The company is managed conservatively and is cash-rich, allowing it to both invest in growth and reward shareholders. The dividend yield is forecast at 3.4 per cent this year, rising to 4.2 per cent in 2014.
Syngenta AG (SW:SYNN) was created following the merger of the agri-business divisions of Novartis and AstraZeneca at the tail-end of 2000. In the intervening period it more than doubled its annual sales to SFr13.3bn (£9bn), with the bulk generated from its integrated range of crop-protection technologies (herbicides and insecticides), in which Syngenta is a market leader. However, the group is also one of the largest global suppliers of seeds to agricultural markets. The growth of the group is being predicated on the expansion of biotechnology throughout the global agricultural sector, as farmers the world over are struggling to grow (or simply maintain) yields with depleted water resources, increased soil degradation and a rise in climate-linked infestation.
Bayer (Ger:BAYN) has performed consistently well, thanks, in part, to its conglomerate structure of pharmaceuticals, chemicals and crop science offsetting the worst vagaries of each of those sectors. The pharmaceutical division might have been a source of anxiety, but Bayer seems to have overcome the possibility of a patent-cliff with a series of drug approvals over the past 12 months. The next approval decision is expected for Riociguat, a treatment for pulmonary hypertension in cancer patients, in October this year. The share price has retreated from highs of €99 this year on the back of an anti-trust investigation in China. The Chinese investigation seems to be part of a broader investigation, but it is too early to tell if it will have a material impact - although the recent experiences of GSK suggests it will not.
Bayer has performed consistently well.
