With political risk receding and the economy improving, investing in Europe is no longer the realm of contrarians. Cherry Reynard explains how there is still money to made on the continent.
At the start of this year Europe looked vulnerable: populist parties looked set to gain traction in upcoming elections, potentially destabilising the European project once again. At the same time, inflation remained below target, and it was not yet clear that economic recovery would be sustained.
Today it is increasingly clear that the populists are not as potent a force as they initially appeared to be, having been defeated in both the Netherlands and France. The removal of political risk has allowed investors to focus on the very real merits of the European economy, which is rebounding strongly.
This has been reflected in share prices. Since Emmanuel Macron became France’s president in May, Europe ex UK has been the top-performing Investment Association sector. Over six months, the average fund was up 12.6 per cent at the start of July. Over one year the returns are even more impressive, with the average fund posting gains of 28 per cent.
On the up but still lagging
Returns, however, lag other developed markets over three years. The average fund is up 39.7 per cent, some way behind North America funds (up 60.2 per cent) and Japan (56.2 per cent). This is one reason many people remain excited about Europe.
Share prices have been held back by the region’s political problems and, until recently, its weaker economic growth. They have yet to catch up with the rest of the world, and therefore do not look as expensive.
Tom Stevenson, investment director at Fidelity International, says: ‘Europe has benefited from a helpful combination of events lately. The political uncertainty has evaporated, general economic growth is better and deflation fears have receded.’ At the same time, he says, there is still a reasonable gap between US and European stock market valuations.
The economic backdrop has certainly improved. The most recent Eurostat figures show GDP in the region expanding at 1.9 per cent year on year, the fastest growth since the fourth quarter of 2015. This compares with a relatively lacklustre 1.2 per cent for US GDP.
The European Central Bank remains supportive. Mario Draghi, president of the bank, has hinted that he may taper quantitative easing by the end of the year, although inflation remains below target, at just 1.3 per cent in June, which may temper his enthusiasm for easing.
What does this mean for investment?
In theory, this economic revival should favour more cyclical, economically sensitive investment areas such as banks or resources, and that is true to some extent. Following Donald Trump’s election as US president in November, ‘value’ parts of the market (lowerpriced stocks) rallied significantly. However, more recently quality growth companies have resumed market leadership.
Overall, it has been funds with a more cyclical or smaller company focus that have performed best over the past year. Top over the past year is the Neptune European Opportunities fund. This had an earlier run of weak performance, as manager Rob Burnett had positioned for stronger economic growth ahead, but it is up 62 per cent over the past 12 months.
The Marlborough European Multi-Cap fund has also been a top performer, up 45 per cent over one year. Its smaller company weighting has undoubtedly been a factor in its success – the dedicated European Smaller Companies sector is up an average of 29.7 per cent over the past year alone. That said, manager David Walton is a well-respected stockpicker from a dedicated small-cap group, and companies such as Wizz Air and Italian staffing company Openjob contributed to performance.
The weaker funds have been those with a strong quality focus. Jupiter European, for example, managed by Alexander Darwall, has had a rare difficult patch. However, the weakest performance has come from those funds that have hedged back into sterling – funds such as the Liontrust European Enhanced Income have suffered.
In contrast, the appreciation of the euro against sterling has been a strong tailwind for investors in European assets, and it has helped the performance of most funds in the sector.
In assessing which types of funds are likely to perform well in future, much depends on the economic outlook and whether markets retain confidence. Some asset allocators are becoming more enthusiastic about European equities, but others believe the story may already be drawing to a close.
No longer the contrarian choice
Thomas Becket, chief investment officer at Psigma, points out that many large US asset allocators are now very positive on Europe. The influential Bank of America Merrill Lynch fund manager survey has found considerable enthusiasm for European markets, particularly those in France and Germany – contrarian activity has evaporated.
Becket says: ‘A year ago, Europe was a contrarian trade – everyone hated it. The US asset allocators studiously avoided the region.’
Now, it has become ‘fashionable’, which has taken the shine off it. Equally, he doesn’t believe the political challenges are over. He adds: ‘We see the political challenges in Europe as having a hiatus, and we expect the easing of political problems and the improvement in growth to be cyclical rather than structural.’
There has also been a merger and acquisition boom, which may ring alarm bells for some. Data from Thomson Reuters shows activity in the EU at a 10-year high. Deals included Italy’s Atlantia bid for infrastructure group Abertis and a £2 billion hostile approach on UK laundry firm Berendsen by French rival Elis. The region has also seen the $30 billion (£23 billion) takeover of Swiss biotech group Actelion by US rival Johnson & Johnson.
European fund managers, as is to be expected, say they are still finding value, but refreshingly some acknowledge it is becoming tougher to find new ideas, as some areas are very expensive.
Roland Grender, European fund manager at Crux Asset Management, says: ‘Companies with a 10-year listed track record that have delivered year in year out are difficult to find on attractive valuations.’ He has been looking more closely at recently floated firms and also delved into smaller companies, where there are more undiscovered opportunities.
Burnett believes there are still compelling reasons to target stocks in areas such as banks or resources, even if the market has fallen out of love with ‘value’ in recent months.
He says: ‘There has been a return to quality growth in the past few months, although the trend has been much more marked in the US than Europe. This doesn’t reflect a change in growth outlook, but a change in bond yields.’ Lower bonds yields across Europe, prompted by quantitative easing, have pushed income seekers into the stock market, but they tend to prefer lower-risk bond-like assets.
However, these are now very expensive. He points out that Nestlé is now trading at 24-25 times earnings, having been at 14 times. This is its highest-ever valuation. Instead, Burnett prefers financials and materials. The banking sector is being supported by European Central Bank policy, while he likes materials on valuation grounds.
He adds: ‘These companies are at trough earnings and are very cheap. Balance sheets are strengthening and dividends increasing.’ In theory, if growth remains buoyant, cyclical stocks should be the place to be; if it doesn’t, markets should revert back to more defensive areas. However, the high valuation of some quality-growth companies makes this hypothesis less than solid. They no longer look as safe as they did.
If anything, more economically exposed, lower valuation areas may prove safer if Draghi begins to unwind quantitative easing and interest rates start to rise.
Spotlight: Marlborough European Multi-Cap
The Marlborough European Multi Cap Fund, a Money Observer Rated Fund, has been among the top performers in the IA’s Europe ex UK sector: comfortably in the top five funds over one, three and five years.
Manager David Walton aims to identify undervalued companies with above-average growth potential across Europe. While the fund will invest across the market cap spectrum, it has a marked bias to smaller companies, with around 60 per cent in smaller and micro cap.
This has undoubtedly been a factor in its success, but picking good companies has also been key to the fund’s performance. Walton maintains a focused list of 200 companies he has identified as potentially good investment opportunities. From this list, he constructs a portfolio of around 100 stocks, focusing on the quality of those managing the businesses.
At the moment, his portfolio has a chunky weighting in cash of around 17 per cent, a reflection of Walton’s nervousness on valuations. Nevertheless, he believes the outlook for corporate profits in Europe is strong, with domestic demand improving. Among his top 10 holdings are French reinsurance group Scor, Norwegian technology group Data Respons and Danish industrial group Nordic Waterproofing.
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