European equities: reasons to be cheerful

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Major European sectors such as banking should do well in 2014 as company profitability recovers. Investors should look for large-cap companies offering longer-term growth and sustainable earnings, which together with attractive valuations can result in opportunities to take or expand positions.

European recovery = European opportunities
Now that revenue sources outside developed Europe, in particular emerging markets, are sputtering, investors should turn to European large-cap companies that are much more domestic in nature. As Europe starts to recover, it is these companies that you would logically expect to start to perform better.
We see potential for companies that can grow their earnings sustainably over three to five years, especially those in concentrated industries or in industries where there is a clear trend towards consolidation. Those are characteristics that have historically supported share price performance.
In terms of when to buy, investors would do well to focus on market areas that are out of favour for transitory reasons – and thus valued attractively – as this can be a good time to pick up quality stocks.

Still broadly valued attractively in 2014
European equities look attractively valued now, while companies’ profit margins appear to offer considerable scope for improvement. These can be seen as buy signals. We believe European large-cap equities should be able to earn double-digit returns in 2014 as earnings normalise.

Being stock pickers, it is our view that earnings should be the focus when selecting stocks for a portfolio. Factors such as big-picture macro trends, short-term market direction, sector overweights or underweights and style rotation are very hard to fathom. Forecasting these tend to produce binary choices, where a thorough analysis of a company – and its place in an industry – can lead to insightful views adding value in the run-up to stock selection decisions.

Going for financials rather than telecommunications and utility stocks
Admittedly, earnings in these three sectors have been poor over the last five years, resulting in stock market valuations that may look attractive. But we believe that telecoms and utilities face structural issues and that it is much easier to see the profitability of the financial sector recover. In that respect, financial stocks have more scope for price gains.

This should be the case for high-quality retail banks in particular. Their earnings have been depressed by the high sums they had to set aside for bad loans during the financial crisis. As the eurozone economy recovers, they should be able to scale back the set-asides, which should improve their earnings. Another effect of the financial crisis has been greater concentration, reducing the number of players and boosting the market power of those remaining. This combination of earnings potential and greater market power, as well as attractive valuations, supports the outlook for banks in this segment.

The lustre of luxury
Consumer discretionary goods companies also look attractive, in particular luxury goods companies. Their margins are typically high. Since demand for their products as a rule reflects international consumer trends, rather than local appetite, it tends to be recession-proof. We believe another niche area – industrial gases – should be resilient too and offer earnings stability. Finally, construction should be able to recover now that the bottom of the economic cycle is in sight.

European equities ahead of the US and Japan
Given the outlook for further modest growth in Europe, many European companies focused on mainly domestic markets should be able to lift their earnings and recover from the setbacks of the financial crisis. Improving profitability and attractive stock market valuations should be the ingredients for future outperformance, allowing European large caps to catch up versus US and Japanese equities.

Further information about European Equities on Parvest website.

Daniel Hemmant

Senior portfolio manager, global equities, CFA Charterholder

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