European equity markets are a turn-off for UK investors. The longstanding notion that there is nothing on offer on the continent outside of the sclerotic bank, utility and pharmaceutical sectors, garnished with a few luxury goods makers, is hard to budge.
Add in high debt levels and political uncertainty, and it's not hard to see why investors prefer to look to other climes. The consensus has long been that Europe’s lower valuations are fully deserved, and that better opportunities can be found elsewhere.
Data from the major D2C investment platforms confirms that UK private investors’ interest in European equities continues to lag far behind their appetite for UK and US markets. At Hargreaves Lansdown, US shares have risen from 6 to 17 per cent of direct equity assets on the platform between 2017 and 2021. European shares have risen from 2.4 per cent to just 3.7 per cent over the same period.
The relative performance of the two regions' equity markets will have played a major role in these diverging trends. But the healthy performance of European equities last year did not convince UK private investors to take the plunge either. On Interactive investor's platform, a miserable 0.8 per cent of all direct equities trades made in 2021 were in European stocks – the same level as for Asian shares.
After a decade defined by political crises and underperforming markets, the burgeoning transformation of European stock markets has been easy to miss. Some of these shifts are in keeping with trends seen elsewhere: technology's weighting in the Euro Stoxx 50 has more than doubled, to over 14 per cent, over the past four years. But the changes go beyond mere rises in market value.
Europe’s particular standout is its ‘green tech’ sector. Bolstered by support from policymakers amid efforts to transition to net-zero, and helped by the critical role that electrification has to play in reducing emissions, it offers an array of different opportunities for UK investors.
On this front, the continent can very much compete with international peers. In some ways, it has already surpassed them. This is the view of Leon Howard-Spink, a European equities fund manager at Schroders.
“There is a breadth and depth to the European market, in the areas of tech and green tech, that you just don’t get in the UK. That’s undeniable,” he said.
An outdated narrative
The consensus has long been that ‘Europe’ and ‘innovation’ are two words that just don’t go together. The US tech scene, underpinned by Silicon Valley and injections of venture capital, has been dominant; Europe is dismissed as a backwater for new thinking.
But despite the prevailing narrative, Europe is actually a leader in innovation. The World Intellectual Property Organization’s Global Innovation Index 2021 report, which uses 81 indicators to track innovation trends in global economies, ranks Switzerland and Sweden as the two most innovative economies in the world – the US comes in third. European nations take up six of the top 10 spots in the rankings.
For the relatively small number of UK investors who do trade in European equities, it is green stocks that are on their mind. These tend to fall into three distinct categories, as a trio of top five Europe shares traded on Hargreaves Lansdown in 2021 demonstrate. One is an established business shifting to focus on the energy transition: Volkswagen (DE:VOW3); another is a classic tech play, semiconductor component giant ASML (NL:ASML); and the third is a new type of green energy company: hydrogen solutions business Nel (NO:NEL).
ASML and Nel are among the stocks to have been hit hard by investors' latest turn away from growth stocks at the start of 2022. And while professional investors are now taking renewed interest in the continent – a January global fund manager survey from Bank of America found eurozone equities are now comfortably the largest regional overweight in portfolios – much of this interest focuses on 'old economy' sectors such as banks.
There is an argument that says UK private investors are simply too late: they have missed the gains on offer from 'new Europe', and the sectors which will do well in a period of tighter monetary policy, such as financials, are better accessed in their domestic market.
But the rise of sustainable investing is based on a belief in the long-term merits of innovative businesses, and Europe has plenty to offer on this front. Europe boasts market leaders in a range of green tech areas, from semiconductor equipment businesses to wind and solar companies. Many of its big beasts are well established and could grow significantly over the next few decades, helped by a backdrop of major green policies and investment at a European Union (EU)-wide level.
Green framework
The green drives being undertaken by Europe and other regions in response to climate change will fundamentally alter economies and societies. Tough green and environmental targets, if they are to have any chance of being met, require robust frameworks at a governmental level. And the presence of those frameworks puts a greater onus on companies to do their part.
Sam Arie, head of European utilities at UBS, thinks that it is the level of policy support provided by the EU that differentiates Europe from the UK and US, and positions the continent’s green sector ahead of the pack.
“Ambitious green goals don’t matter if you don’t have a defined set of policy instruments,” he said.
The EU is a global frontrunner in the scale and depth of its green investment agenda. The bloc’s response to the Covid-19 pandemic prioritised green stimulus and investment, and is key to its binding target of becoming “climate-neutral” by 2050. The EU’s green investment plan is substantial, to say the least. The European Commission is aiming for €1trn in green stimulus to 2030, and supports significant new annual investment in transforming energy systems and meeting environmental targets.
The EU also has an intermediate aim of cutting emissions by 55 per cent by 2030 through its ‘Fit for 55’ plan. That has immediate and very practical implications for Europe’s green energy sector.
As the plan notes, the electrification of power sources using renewables is key to hitting the 2030 target. This is fundamental to the long-term aim of a net-zero economy. Significant electrification is a major theme in the greening of Europe's economy, and one that stands to aid green power majors in the bloc.
Goldman Sachs analysts, in a research note covering “the urgency of electrification”, argued that Europe will have to mobilise almost €4trn of capital in the green energy space up to 2030 to be able to meet its Fit for 55 goals, with most of the spend going on green infrastructure.
Diving into green tech
Green tech is a broad term. Contained under that umbrella in Europe are a range of different types of companies. It is perhaps more helpful for UK investors to think about some of the key themes at play.
Electrification, given its importance to Europe’s net-zero hopes, is the obvious place to start. Goldman’s analysts forecast “much higher returns than expected, double-digit earnings growth to 2027, twice the level of the market; and significant intrinsic value creation” for Europe’s green majors.
For big European players such as offshore wind developer giant Ørsted (DK:ORSTED) and utilities business EDP (PT:EDP), the consequences of an electrification push could be vast as they help to drive economic change. Power generation more than doubled at Ørsted in its 2021 full-year results, and operating profits are forecast to surge to DK19bn-21bn (£2.1bn-2.4bn) for 2022. EDP is aiming for €5bn Edibta by 2025, as part of its transformative strategic plan that includes €24bn of investment in the green energy transition.
Schroder’s Howard-Spink thinks that companies such as Schneider Electric (FR:SU) are well placed to take advantage of the changing economic and political environment. The company is aiming for a compound annual growth rate of 5 to 8 per cent in organic revenue and a 30 to 70 basis points increase in Ebita margin between 2022 and 2024, and it trades at a consensus 22 times forward earnings.
“As the world pivots towards electrification, or towards a more digital economy and way of life, they are reaping the benefits,” he said.
This pivot has also helped drive the growth of electric vehicles (EVs). Notably, this is a space which, while very much in vogue, is not home to the same kind of elevated valuations as have been afforded to the likes of Ørsted, EDP and Schneider.
That's in part because many of the key players are in the process of transitioning their businesses away from traditional vehicles and towards EV offerings, in line with the European Commission's goal of effectively preventing the sale of diesel and petrol vehicles in the bloc from 2035.
A recent development in the space is the new global EV production plan announced last month by French carmaker Renault (FR:RNO) and its partners Nissan (JP:7201) and Mitsubishi (JP:7211). They will pour €23bn of investment into electric car production over the next five years. The trio called this “the largest global EV offer” and said they will produce 35 new EV car models by 2030. In simple monetary terms, however, it comes in below Volkswagen’s €89bn spending ambitions on EVs and digital progress.
EVs need a lot of semiconductors to power them. In and of themselves, these chips aren't green, as the production process is very energy intensive. But the irony is that they are crucial to climate targets, given that they are needed for many forms of green tech, from EVs to wind turbines.
European markets offer global chip leaders. ASML, which Schroders’ Howard-Spink described as “possibly the most important company in the world”, and Infineon (DE:IFX) are key players. ASML provides the equipment for chipmaker manufacturers, while Infineon makes ‘power semiconductors’ that direct electricity through various devices. The companies are trading on consensus forward price/earnings ratios of 33 and 19 times, respectively.
Goldman analysts cite Infineon, on which they have a buy rating, as a stock that is benefiting from silicon carbide replacing silicon in power semiconductor production. Their research note on the company forecasts that Ebit will almost double between 2021 and 2024, hitting €2.6bn, and the operating margin will rise to 17 per cent over the same period.
Once again, policy initiatives are supportive. The EU is taking action to address Europe's semiconductor sector’s dependence on Chinese supply chains. Proposals for an EU ‘Chips Act’, published on 8 February, announced €43bn of investment in semiconductor development and production.
Similarly, while the industrial gas sector is a lot older than EVs and chips, it looks set for a new lease of life due to the centrality of hydrogen to green policy goals.
The EU wants to hit 40 gigawatts (GWs) of renewable hydrogen electrolysers by 2030. Goldman’s analysts estimate that Europe could need “100-150 GW of gas/hydrogen backup plants” by the same year.
Christian Zimmermann, senior portfolio manager at Amundi, is bullish about the prospects for the sector.
“The hydrogen revolution is developing, with significant growth potential in the future. It’s emission free, its only by-product is water, and it is fundamental for the decarbonisation path of the global economy”, he said.
He pointed to the fact that the biggest global companies by market capitalisation in the industrial gas sector are European. Energy supplier leader Air Liquide (FR:AI) and sustainability favourite Linde (DE:LIN) are trading in the mid-20s against forward earnings, and the latter is aiming for double-digit EPS growth for 2022 after strong 2021 results.
The final theme in Europe's green economy is one of the more familiar to UK investors: renewable energy. The Fit for 55 plan forecasts that around 70 per cent of Europe’s energy could come from renewable sources by 2030, up from a current 40 per cent. Solar, wind, hydroelectric, and biomass energy companies are the key to unlocking this potential.
But as with most sustainable themes, demand is not coming from Europe alone. Companies such as EDP and RWE (DE:RWE) are “building wind and tech developments around the world”, said UBS’s Arie. Europe is ahead of the curve in this respect, being an early entrant into the renewables space and having a longer track record of using global models – this will benefit them as the green transition progresses, he said.
RWE has built nearly 30 wind farms across the US. In a recent trading update for the fourth quarter of its 2021 fiscal year, the company announced that performance “exceeds expectations”. It now expects adjusted Ebit of €2.2bn for the full year, soaring past prior forecasts of €1.5bn-€1.9bn.
This isn’t to say that all is fine and dandy in the European renewables sector. It had a volatile 2021, and with interest rates rising 2022 could prove a challenge. Supply chain issues and earnings and margin warnings have buffeted share prices. Wind tech companies Vestas (DK:VWS) and Nordex (DE:NDX1) look particularly expensive; hedge funds are circling and short interest is on the rise.
For those worried about the shift to reprice cash flows, a halfway house may be in order, particularly at a time when rising energy prices are leading to a reassessment of traditional players' merits. In December JPMorgan's Emea equity research team named RWE as a 'key idea' for 2022 – partly because of its renewables offering, but also because it is "a bigger beneficiary from higher power prices than widely perceived".
The underlying growth story hasn’t changed for renewables, with their tech a key part of the green transition. They are very much a long-term play.
Relative value?
A new identity for the European economy naturally leads to considerations of whether the valuation gap will be closed with more expensive international markets such as the US.
When comparing European and US valuations, the FAANGs and their outsized impact on the performance of the American stock market over the last decade must be taken into account. Albert Bridge Capital has noted that the S&P 500 and MSCI Europe indexes produced more or less the same annualised return for 1980 to 2009 – it is over the last decade that European and US performance and valuations have truly diverged.
Yet as mentioned above, many of the newer opportunities in Europe have been trading on elevated ratings of their own – albeit perhaps not quite as high as some US peers.
Of course, when thinking in geographic terms, there is always a risk of generalisations. Schroders’ Howard-Spink warned that investors shouldn’t just bundle together apparently similar companies and compare valuations across geographies.
“I don’t think there are actually that many great European businesses, in so called ‘tech’ or in ‘green tech’, that are a huge bargain just because they are sort of tainted by virtue of being quoted in Europe,” he said.
All the same, some differences are apparent. Amundi’s Zimmermann pointed to the valuation difference between Infineon – which he thinks will outperform the industry in growth terms – and the US semiconductor index. The company is trading at 20 times 2022 earnings against the index’s 26 times – a significant difference which perhaps can’t be justified when looking at the evidence. As always, investors should make judgements on a case-by-case basis, taking into account companies’ fundamentals.
That can be easier said than done: behavioural biases – be they a 'home bias' or something more nebulous – can be difficult to correct. It would be easy for UK investors to stick to what they know and to play along with the consensus that sees little of note in European markets. But this would be to ignore the fundamental changes that have occurred with the growth of green tech in Europe. Failing to consider the continent's opportunities would mean missing out on some businesses with a very bright future over the coming decades.
