Time to gain exposure to the European recovery?

A huge amount of capital aimed at taking advantage of distressed valuations has flown into European markets since the “whatever it takes speech” to save the euro by Mario Draghi, the ECB president, in July 2012.

Over the past couple of years, the drastic reduction of the risk of eurozone breakup has been accompanied by a significant revaluation of European assets. In 2013 the region’s stock indices posted their biggest annual gains in four years, with the German DAX outperforming regional benchmarks with a gain of 26 per cent, although a few percentage points have been lost year to date.

With equity valuations looking stretched today, what is the rationale for investing in Europe? And what are the risks of gaining exposure to the old continent, where an expected GDP growth of 1 per cent this year is celebrated as a big achievement?

“When you think about Europe today, clearly that valuation discount isn’t there anymore, so you need to believe in economic growth which will lead to profit growth,” says Rajesh Tanna, CFA, portfolio manager Emea at JP Morgan Private Bank.

One of the key investment themes today is around the European recovery, part of a more global upturn, which is played mainly through investing in cyclical stocks.

The auto sector, for example, is a clear beneficiary of the recovery, having enjoyed six consecutive months of sales growth in the continent. Investors should not necessarily play this story through the auto companies only, but also through the components’ suppliers, says Mr Tanna, which benefit from the sector’s expansion regardless of which car maker is producing the best new model.

In Europe, many of the attractively valued stocks are cyclically and domestically-focused companies. Those that carried a high debt burden such as some banks, telecoms or construction firms, will particularly benefit from a recovery in Europe, says Frédérique Carrier, director, Portfolio Advisory Group at RBC Wealth Management. On the contrary, corporates with international exposure, with many of them enjoying a solid balance sheet and good management, are today relatively expensive, having performed well over the past three years.

Look further afield

Most value tends to be found in peripheral countries such as Italy and Spain, which have been sold off considerably over the past few years. The remarkable reduction of the yield spread between their government bonds and German bunds compared to a couple of years ago clearly shows how much investors’ attitude has changed towards these markets, although they remain more risky, warns Ms Carrier.

While Portugal and Greece offer a rather limited choice of stocks, the Canadian bank recommends a small number of companies in Spain and Italy, “trading at very attractive valuations, which are undergoing some strong restructuring,” and benefiting from high quality good management expected to be able to drive changes.

“With growth accelerating recently, Spain is probably the poster child of showcasing how structural reforms have been positive and necessary,” says Jean Médecin, a member of the Investment Committee at Paris-based Carmignac Gestion.

Spain’s recovery and its ability to move back to a current account surplus has not been driven entirely by contraction of internal demand but by regaining export competitiveness, he says. Ten years ago, car production in Spain was 25 per cent below that of France, while in 2013 it shot up to become 10 per cent higher.

However, valuations of European stocks have become stretched, states Mr Médecin. “While it is not unusual that a positive market reaction precedes the acceleration of the earnings momentum, our main concern is that the market has become a bit too optimistic on the speed of the recovery.” Investors’ complacency is evident particularly in certain sectors, such as the industrial, and for stocks that are more sensitive to the economic environment.

“We believe the recovery should remain relatively pedestrian, because of various headwinds,” maintains Mr Médecin, suggesting that a GDP growth rate of 2.5-3 per cent, which is usually the level associated with a significant acceleration of earnings growth as operational leverage starts to kick in, may still be far away.

The first headwind is the strength of the euro, which is counterbalancing the efforts made by some countries to regain competitiveness by lowering wages, and this is affecting companies exposed to emerging markets in particular, some of which have also suffered significant currency depreciation during the last year.

Another headwind is the very low inflation level in the eurozone, which means corporations in countries such as Italy and Spain are still facing relatively restrictive financial conditions or have not see any reduction in the interest rate to finance themselves, as the gain from the reduction of sovereign nominal rates has been offset by lower inflation.

Moreover, another hurdle to the European recovery is represented by France, which needs to address some structural issues and problems of competitiveness. Unlike Spain and Italy, the country has not gone through any major programme of structural reforms. If these were carried out to achieve long-term gains, they will have a negative affect on the growth of the economy in the short term. Not implementing any reform will mean France will struggle to realign with the growth of its partners.

Indeed, the gap is shown by the Purchasing Managers Indices (PMI) indicators, which have fallen in France, both on the service and manufacturing side, below the 50 territory, a level which indicates contraction, while for both Spain and Italy they are above 50, signaling expansion.

“France is still very late in the game, which means that at least for the coming 12 or 18 months, it will probably be a drag on the eurozone growth,” says Mr Médecin.

In Europe, selective opportunities are found in global leaders or companies exposed to growth around the world, not overly reliant on Europe for growing their earnings, according to Carmignac. For example, Inditex, owner of Zara, despite being very exposed to the Spanish market, is also growing very fast in China, and is very well positioned in the apparel segment.

In the domestic space, it is important to seek companies with a domestic focus which can grow their earnings despite a relatively low growth environment. These are preferred to consumer discretionary or some industrial names.

In this regard, the banking sector is a “very appealing self help story,” says Mr Médecin, “as the banks’ earnings growth is much more geared towards optimising their cost base than massively expanding their balance sheet and revenue, and as such is not a story contingent on a very high economic growth.”

Banks have significantly reinforced their corporate structure by shrinking their balance sheet over the past few years, and institutions like Société Générale in France, Intesa Sanpaolo in Italy and ING in Holland are particularly well placed, he says.

The main impact of the upcoming EU-wide stress tests, the Asset Quality Review, will give investors greater confidence and clarity on the business models adopted by banks and the quality of their balance sheet, anticipates Mr Médecin.

Financial boost

Indeed, the recovery of the banking sector and a return to earnings growth will be the key driver fuelling stockmarkets in 2014, amid a generally more benign risk landscape, according to John Surplice, European equities fund manager at Invesco.

Based on expectations of 1 per cent GDP growth in the eurozone this year, Mr Surplice expects low double digit earnings growth for the European market.

His focus is on stocks with some earnings upgrades and earnings growth potential rather than yield plays, with most value found in banking and financial stocks. Following several years of downward pressure on profitability, current financial sector earnings are 60 per cent below where they were in 2007, reports Invesco.

“The banking sector has earnings that are more sensitive to economic growth than any other sector. So, as the economy improves, you are going to get this reflected in upside to earnings estimates for the banking sectors,” points out Mr Surplice. Given the current valuations, this should mean that the sector has the potential to perform well as long as the regulatory environment remains benign or not too onerous, he says.

Banks and financial services will see a remarkable increase in profitability, particularly in Greece, Portugal and Spain as their profit margins are today very low, according to Generali Investments. On the other hand, Italian banks will have to recapitalise first to become more appealing.

Greek banks are particularly attractive, believes François Gobron, fund manager of the recently launched European Recovery Equity Fund at Generali Investments Europe, which runs €330bn of assets under management.

The banking sector in Greece has greatly consolidated, from 20 banks to just four, the market has been cleaned up, competition is lower and there is a significant potential for margins to increase, expects Mr Gobron.

Piraeus Bank and Alpha Bank, both holdings of the fund, are today the main banks on the Greek market and have huge potential for cost saving, having consolidated many smaller banks. These were usually subsidiaries of French institutions such as Société Générale or Crédit Agricole, or other European banks, which had been attracted by the very lucrative local market before the crisis.

More generally, with the first signs of recovery some very attractive opportunities across peripheral Southern Europe region are emerging, according to Generali.

The aim of the firm’s dedicated fund is to take advantage of the upside re-rating of the countries in Southern Europe, the recovery of local markets and companies’ restructuring opportunities, as corporates realign their activities for growth.

Southern European countries will represent almost 60 per cent of the portfolio, with the main focus on Spain, Italy, Portugal and Greece.

Greece and Portugal, and to some extent Spain and Italy, are still lagging behind the Eurostoxx 50, but this is not the case for Ireland, according to Generali estimates.

Favoured companies are those with strong exposure to their home markets, particularly in sectors such as early cyclicals, materials or certain industrials, so that even a modest growth rate recovery, expected in the range of 0.5 to 1 per cent for those countries, will drive an increase in margins.

 “I like fixed-cost industries in a recovery perspective, because even a small increase in volumes brings a lot of earnings appreciation,” says Mr Gobron. He gives the example of the cement industry in Greece, which has reduced to 25 per cent of what it was in 2007, is a capital intensive business, with non moveable assets and companies are mainly focused on Greece, or also mines or infrastructure firms.

The Greek and Portuguese stockmarkets may be quite limited, but this also means they are not as efficient as larger countries such as Germany or France and offer interesting opportunities, believes Mr Gobron.

There is no longer the risk that Greece could exit the eurozone, as the European Central Bank is now the biggest owner of Greek debt and “cannot just pull the plug”, while the country has no choice but to implement austerity measures, believes Mr Gobron.

The main risk today is that the recovery will be weaker than expected, he states, and the upside of stocks, which are selected on the base of a high return potential of 50 per cent or more over the next 3 to 5 years, will take longer to display, thus affecting portfolio performance.

Cashing in on dividends

European corporates are attractive in general today for their ability to generate high levels of cash flow, states Yves Maillot, head of Natixis Asset Management’s European equities investment division.

Listed European companies show a consolidated figure of €825bn in cash, a number which has grown by more than 50 per cent over the past five years. Companies have strong balance sheets and huge levels of cash, as their capital expenditure was very limited over the previous years. Even if they boost their capital expenditure, they are likely to be in a position to increase their payout ratio, ie the amount of earnings paid out in dividends to shareholders.

Moreover, more mergers and acquisitions are expected to take place in Europe, as is the case in the US today, generating investment opportunities.

The focus is then on companies with sustainable business models, with good free cash flow, which can generate growing dividend yields, says Mr Maillot.

Today, the 3.5 per cent dividend yield offered on average by European equities is attractive compared to that generated by core government bonds or investment grade. Good quality companies can offer an even higher yield, up to 4 to 5 per cent, in particular in the pharmaceutical and telecoms as well as in the oil sector, where big integrated oil companies are trading at low valuations. Over the past few years, the oil sector has underperformed the market significantly, given its huge capital spend on shale oil and gas, but this year capex will reach an inflection point, enabling companies to increase their dividends, expects Mr Maillot.