July 2017- European Value strategy: outlook & positioning

240717 Market Commentary

July 2017- European Value strategy: outlook & positioning

Market environment & outlook

  As stock pickers, our investment decisions are not dictated by macroeconomic and/or political events. However, these factors are an important part of the operating environment the companies we invest in are facing. Therefore, we look at these events through the perspective of the Board rooms of these companies and incorporate them into our analysis when determining the earning power of the business we analyse. So, we are certainly not ignoring the environment in which we, and the companies we are investing, evolve. European stock markets have now more than doubled since the through seen in March 2009 while the earnings of European corporates have hardly grown. At the same time international investors were, over the recent years, largely disinterested in the European equities asset class. Based on these observations, one can wonder if the asset class still has some upside potential. In our view, there are no objective elements in favour of a trend reversal. On the contrary, after a gradual upturn in the European economy, the European stock markets continue to gain attractiveness.  
Earnings growth is back
  The main element that underpins our optimistic view of the European stock markets lies in the now-confirmed return of earnings growth for European companies. We have repeatedly mentioned that the last decade has been a period of earnings stagnation for European companies arguing that a solid recovery of profits would act as a powerful catalyst for the European stock markets. While the European stock markets continued to rise, investors were still waiting for a new phase of earnings growth. As markets become more pricey, the moment of truth where companies should meet investors’ expectations by demonstrating their ability to generate earnings to justify higher valuations is approaching. And this recovery seems finally to materialize. Indeed, while the Q1 reporting season is now behind us; we can conclude it was positive with solid earnings growth across the board and a vast majority of companies beating the consensus estimates, which had already been revised upwards. Another striking feature is the desynchronization, since the emergence of the Eurozone crisis, of the US and European earnings cycles. As a result, US EPS are currently 12% higher than the peak of the previous cycle in 2007 while European ones are currently 45% below 2007 levels[1]. It would therefore be reasonable to believe that, in the absence of a major shift in monetary policy, a seismic political event or an unexpected external choc, European companies are only at the beginning of the catch-up phase in terms of earnings.  
Still compelling valuations
  Another support factor, specific to the equity markets is that despite the rise of the European stock markets, the valuations of European companies remain attractive, both in an absolute and relative terms.  Indeed, while they are currently in line with their historical average, European companies are still trading at a discount (about 46% in terms of P/BV) compared to their US peers and compared to the levels reached just before the Eurozone crisis in 2010 (approx. 50% in terms of PB/V)[1]. It is also worth to note that this valuation gap is not limited to a specific set of sectors but is noticeable for all individual sectors as shown in the below chart.  
Europe is “En Marche”!!
  In recent years, Europe has suffered repeated crisis, both at the economic (2008 crisis, Greek crisis, debt crisis) and at the political levels (terrorism, Brexit, immigration, political instability) that largely contributed to fuel the mistrust of international investors. Did the 2008 financial crisis and the Eurozone crisis that occurred just after, make us losing sight of Europe’s secular ability to recover even after the darkest pages of its history? Historically Europe has shown a surprising resilience and ability to grow stronger out of its biggest challenges.   Thus, we should not misjudge the efforts made at a European but also local level to get Europe out of its lethargy. We can highlight the following actions:
  • Monetary policy: the ECB continues to inject billions of liquidity into the European economy. And even if a gradual tightening is probably to expect, the ECB remains highly committed to support European growth.
  • Willingness of European authorities and local governments to restore the health of the Banking sector with rigorous government’s actions. This was recently the case in Italy (acquisition by Intesa San Paolo of regional banks) and Spain (Banco Popular acquired by Santander) without creating any tensions on the financial markets.
  • Strengthening of the Franco-German alliance with the election of Emmanuel Macron in France.
  • Willingness of Germany to increase its infrastructure spending that should indirectly benefit to other European countries.
  • European defence project which is now becoming more concrete.
  However, any trend reversal takes time and does not happen in a linear way but gradually things are coming back into place.   From a macroeconomic point of view, this improvement can be seen at several levels: rising household consumption and strong business confidence index (manufacturing PMI), easing of deflationary fears and a still accommodative ECB’s policy. As for the job market, although the unemployment rate is still very high compared to its historical average and compared to the situation in other regions (Japan, US and UK), it is also true that the momentum is now clearly improving in virtually all the countries of the euro area.   On the political front, if all the risks are not yet removed, the situation should progressively calm down. Thus in France, the outcome of the presidential and legislative elections has removed the spectre of an inward-looking attitudes from France and even restoring a certain hope in the future of the European construction thanks to Macron pro-EU agenda. The situation in the UK remains more contrasted: the recent elections have indeed weakened Teresa May’s position tipping the balance of power in favour of the EU in the Brexit negotiations. This new situation pleads for the stability of continental Europe but could prove to be more challenging for the British economy. However, we are not overly concerned and believe that the British entrepreneurial spirit and wish to succeed remain unchanged. We are continuing to identify interesting investment opportunities across the Channel, as demonstrated by the recent addition to our portfolio of the retailing company Next. However, there are still some electoral deadlines to come that might bring some noise, mainly the German federal elections at the end of September and the Italian general elections expected to take place before the end of May 2018.   At a microeconomic level, European companies did not sit idly by and many of them took, during this difficult period, initiatives to create a positive environment for their development. Unfortunately, this dynamism of European corporates has often been overshadowed by the persistent political tensions. Here are some concrete examples of active policies conducted by some companies that are included in our portfolio to protect or even enhance their earning power:
  • Confronted to consumers with a weakening buying power and a rapidly changing sector, Europcar has adopted a two-fold strategy; first increase its positioning in the low cost car renting business by acquiring market leaders in this market segment and secondly purchasing companies active in digital business to compete with new players like Uber.
  • Through the acquisition of BPI, CaixaBank is aiming to reduce its costs and bring the profitability of the activities of BPI at the same levels of the other Group’s activities.
  • FLSmidth took advantage of the crisis to acquire some mining activities of Atlas Copco.
  • Elekta innovates by launching a new product that combines radiation with medical imagery and thereby improves its competitive positioning.
 
 Investor sentiment is turning more positive
  European equities have been largely shunned by international investors in recent years. Fears about the solidity of the European Monetary Union and political instability (Brexit, Greek crisis, etc.) were the main underlying reasons of this distrust; but the disparities of GDP growth between the different European countries, the lack of dynamics in earnings growth also probably played a role. 2016 was thus a year marked by a massive exodus of investors resulting in approximately USD 100bn outflows from European funds. Just as for earnings growth, 2017 seems to mark a trend reversal with about USD 15bn flows in European equities investment funds and ETFs. And this is probably only the beginning knowing that most international investors are still currently underexposed to the European stock markets.   [1] Source: SG report “The Big Picture”, Société Générale Cross Asset Research published on 1 June 2017.