European equities: the next Cinderella story?

European shares have crashed out of favour with investors, yet companies wearing tattered rags will eventually see their fortunes change, suggests Pras Jeyanandhan.

European equities are trading at five-year valuation lows owing to growth fears and record fund outflows.

However, lost among the headlines is the fact that Europe is home to many of the world’s leading businesses. Although growth has slowed, it has not fallen off a cliff.

Market uncertainty and unease represent a window of opportunity to purchase companies still wearing tattered rags, whose fortunes are set to change like the fairy-tale princess.

European equities have crashed out of favour with investors over the past year, which experienced the longest run of persistent outflows in a decade. For 2018, net outflows from active European equities funds totalled €44 billion (£37.9 billion), with another €14 billion in the first two months of 2019.

European market participants were battered by disappointing economic news and a deteriorating macro picture. In addition to being plagued with worries about a global slowdown and the US-China trade war, they faced region-specific problems, such as the “yellow vest” protests in France and political uncertainty in the UK and Italy.

However, we believe that domestic demand-drivers remain supportive of a 2019 GDP growth of about 1.5% for the euro area. Declining unemployment at six-year lows, rising real income, positive consumer confidence, and very accommodative financing conditions all point to growth stabilisation. The latest Purchasing Managers Index (PMI) and consumer confidence numbers also indicate a rebound from 2018 year-end lows.

Across our European equity strategies, portfolio P/Es have significantly de-rated, but the earnings power of the companies in the portfolios has either grown more than - or is at least in line with - the Stoxx Europe 600 Index.

Despite worries that profit margins and other company fundamentals would come under pressure, the estimates for next year’s earnings, which incorporate Q4 and full-year 2018 results, are back on an upward trend. After a tough 2018, the OYSTER European Opportunities fund P/E has advanced more than the market year-to-date.

Identifying unsung opportunities

We have confidence in the long-term health of the companies in our portfolios and believe that they will be rewarded by the market eventually. Europe is still home to many leading companies. While they may not generate as much fervour as Amazon or Apple, companies in our portfolios, such as Louis Vuitton, Moët Hennessey, ASML and Prudential, are world-class.

We view the negative international sentiment surrounding European equities as an excellent contrarian buying opportunity. The growth scare has led to an unwarranted discount – even after the year-to-date rally, investors can access European equities at five-year valuation lows. These are especially attractive compared with US equities on measures such as price to book, with US stocks trading currently at a P/B of 1.3x more than European stocks.

Although currently unloved sectors and stocks are more economically sensitive, when chosen correctly, they have the ability to outperform the most in an eventual rebound.

We are therefore investigating areas of the market such as the energy, auto, and tech hardware sectors, where valuations imply that we are in a mild recession.

Our expertise lies in identifying high-quality companies and purchasing them at attractive valuations to deliver strong returns in the medium to long term.

While we are bottom-up stockpickers, we use fear and negative sentiment to our advantage, as entry points into the market.

Where everyone else sees rags, we know that the best companies will eventually be donning their rightful ballgowns.

Pras Jeyanandhan is co-portfolio manager of the OYSTER European Opportunities fund at SYZ Asset Management.

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