European economies favoured over the US

The perception of continental European equities has not been helped by false dawns of recovery in stock markets in the past. This has been compounded by suspected fraud at the Italian dairy company Parmalat and Dutch retailer Ahold. But confidence in European equities appears to be spreading. Some fund managers argue that, based on valuations, potential profit growth and restructuring, European stock markets are at their cheapest levels for 30 years.

This view follows a 57 per cent increase in the DJ Euro Stoxx index since March 2003.

Rally leaders

As Stan Pearson, manager of the Luxembourg-based Pioneer Core Europe Equity fund, says, the rally over the past year has been led by small and mid cap stocks, particularly financially leveraged companies.

“At the start of 2003, we believed the euro was too low and European equities were cheap,” says Mr Pearson. “We missed out on some performance because we did not get involved in companies where we were not confident about the balance sheet or the competence of the management. But this also meant we missed out on Parmalat.”

‘European equities not cheap but better value than bonds’

Stan Pearson, Pioneer

He is confident such problems will not be discovered at other European companies, at least not on the same scale, especially with new global accounting standards.

Where Mr Pearson has more concerns is the outlook for technology stocks, after their meteoric rise over the past year. Pioneer prefers capital goods, whose stocks are more likely to gain earnings upgrades, and pharmaceutical stocks. “Most pharmaceutical companies have clean accounts,” says Mr Pearson. “The last three to four years have been a poor period for new drugs but there are signs of improvement.”

He admits European equities are not particularly cheap but argues they offer better value than bonds. “Investors need to adapt to more modest return expectations of 7 per cent rather than 20 per cent. There needs to be earnings growth to provide value at these share prices,” says Mr Pearson, while playing down the threat to European companies of the falling dollar.

More important positive influences on stock market performance, according to Mr Pearson, are a high appetite for risk among investors, corporate spending, cash flow and mergers and acquisitions activities. Pioneer’s core European equity fund has lagged well behind the index over one, three and five years.

Chris Taylor, product manager at Schroders, agrees that European equities are cheap compared to US stock markets despite a 57 per cent rally since March 2003.

Chris Taylor

“This price differential may tell us different things,” says Mr Taylor. “One is that earning expectations in the US will be upgraded quicker than in Europe. There is also uncertainty over the impact on European exports and economies of a further fall in the dollar.

Mr Taylor says it is harder to make predictions about future movements in stock markets now than it has been over the past few years. Over the past two or three years, he believes, fund managers have been able to make clear top down calls from the technology bubble to the subsequent downturn and then on to the out-performance of small and mid caps since March 2003.

He argues it was easy to add value if a manager got these big calls right. His flagship equity fund is in strong positive territory over five years, unlike most competitiors. “Now it is much harder to make top down calls. We are in a real stock-picking market which will play to the skills of some fund managers.”

An example of the need for stock-picking, says Mr Taylor, is illustrated in trying to predict the effect of a depreciating dollar against the euro. “Investors need to analyse how much a company is exposed to exports to the US and how much their positioned is hedged.”

The Schroder ISF Euro Equity fund has maintained a significant overweight position in small and mid caps, as Schroders believes there is still some valuation to come through. While the fund is also overweight financials, it is underweight technology as it feels valuations are too stretched.

Volker Koester, head of equity portfolio management at UBS Global Asset Management in Zurich, points to a positive environment for European equities this year. “The global relaxation of fiscal and monetary policy appears to be working. Europe will benefit from global economic growth as well as the continued low interest rate environment. We expect economic growth in Europe to be close to its long-term target of 2 to 2.5 per cent by the end of 2004. The major question facing investors is how much of this growth is priced into equities.”

Even though European stock markets have increased by 57 per cent since March 2003, Mr Koester believes equities still have some room for price rises. “On a top down valuation measure, Europe ex the UK is undervalued by about 7 per cent. The UK is even better as it is 27 per cent undervalued whereas the US looks fairly priced.”

While stressing that UBS takes a stock-picking approach to managing money rather than a top down view, Mr Koester says its European equity funds have significant overweight positions in the telecoms sector at the moment. The European equities team is also over-weight financials. Their performance has been disappointing, however.

Another manager who believes there is a positive environment for equities is Graham Clapp, who runs the Fidelity European Growth Fund. This is the best performing of the 10 largest funds, gaining 53.61 per cent over five years, when the S&P Europe 350 index lost 12.39 per cent.

Graham Clapp

He argues companies are generating a lot of cash compared to their valuations; earnings forecasts are improving with upgrades outnumbering downgrades for the first time in three years. “I would expect markets to make further progress in 2004,” says Mr Clapp.