A number of global equity indices have reached historic highs in recent months and while European equities have not done badly, they have lagged behind markets in other developed regions, notably the US. Today, however, Europe is back in investors’ good books. In this interview, Jeroen Knol, senior fund manager with our European large-cap select equities team, explains why European equities offer attractive investment opportunities as well as less downside in a possible correction.
In recent years, there were already enough reasons to invest in European equities, in our opinion. But over the past few quarters, international investors too have been increasingly waking up to the slow, but notable improvement in European economic indicators, such as lower unemployment and upwardly revised growth forecasts. Crucially, this recovery is now both more synchronised and visible in a larger number of European countries.
But surely European equities have lagged behind other markets, such as the US?
That’s true. In our view, the European market only reflects the economic recovery in part. This gap in index returns is partly explained by index composition – technology stocks, for instance, which have enjoyed a highly profitable year, account for more than 20% of the US index as opposed to only 4.5% in Europe. Moreover, the US index contains fewer, but far more profitable banks. But the most important factor for us is that European listed companies are, on average, more international in scope than their US counterparts (which generate ‘only’ 15% of their revenue in emerging markets versus 30% for European multinationals) – because after several weak years, revenues from emerging markets are finally starting to pick up. It must be said, though, that the strong euro is now holding back revenue recovery at many multinationals.
And that is just one of the constraints on European profits. Nevertheless, this profitability is no longer at a low and looks poised for a further cyclical recovery, the reason being that European corporate margins are, on average, still three percentage points off their June 2007 peak, while for many US companies, margins are already much closer to that high (see Exhibit 1).
Exhibit 1: Corporate operating margins (in %): the recovery in Europe still lags that in the US where margins are now closer to the June 2007 peak
How does this translate into the market valuations of US and European equities?
Valuation is another aspect that makes European companies interesting at the moment. Admittedly, Europe does not look cheap at first sight. In fact, average European price/earnings ratios are actually slightly above the 25-year average. But for the US market, the P/E is not only much further above the historical average, many US companies are also at a later stage in their profit cycle. This, combined with record-high market levels, has stretched US valuations. In Europe, by contrast, P/E ratios still have enough room to benefit from a further recovery in profits. In the not improbable event of a market correction, Europe in our view offers investors relatively more protection in the form of a limited downside.
But valuations are not the basis for your investment choices among European equities?
Not in the first place. We operate more from a fundamental bottom-up perspective. Attractive valuations, which we ourselves still see in Europe, are a bonus and can be a clinching factor. But the starting point of our extensive and in-depth company analysis is always the structure of the market in which each specific company operates and its positioning within that market. Because we are confident that companies with a strong position in a highly concentrated industry – for instance, a market leader with few competitors or a company that operates in a market with high barriers to entry – are better able to a) generate a relatively high level of profits and b) defend this in the long term. The companies that best meet these selection criteria are eligible for our fairly concentrated portfolio and are held for five years on average, provided their valuations do not become excessive.
With this in mind, can you give some examples of your choices?
Given our style, the number of transactions and the flow of new names is clearly limited. The selection process, after all, is time-consuming. In the first place, there is our extensive company and market structure research. Secondly, we follow a peer review process, where each investment proposal must first be assessed by the team. And it very rarely happens that a company is chosen after only one or two proposals.
Be that as it may, we recently had a chance to invest in a virtually pure play Irish bank. This opportunity presented itself when the Irish government began the partial sale of Allied Irish Bank. The Irish banking market is interesting for us because it is so concentrated, almost a duopoly in fact, with relatively high barriers to entry.
In addition, towards the end of last year, we selected Tenaris as this fitted in well with our contrarian ‘straw-hats-in-winter’ principle. Tenaris had fallen out of favour during the period of ultra-low oil prices from 2015 to mid-2016. As well as its strong and often monopolistic positions in various pipeline markets, the cyclically low valuations and a possible bottom in drilling platform capacity made the company attractive from our contrarian perspective.
Can the performance of such a strategy deviate from the market due to this contrarian approach?
First of all, such a deviation from the market performance can stem from the big active share that is the result of our approach: it is currently a fairly high 80%, which points to a limited overlap with the market index.
In addition, it can take a long time before you reap the fruits of a contrarian strategy. Tenaris, for instance, has not yet contributed to the performance. This means that such a strategy’s performance can lag behind that of the market index. But we take this in our stride at the stock level. At the portfolio level, we try to absorb this effect by including as many unique positions as possible in the portfolio, by limiting undesirable risk concentrations and by trusting in diversification. In this way, we can still offer investors a strategy consisting of solid best-positioned companies without paying too much for high and stable returns on equity.
Written on 01/09/2017