Why should we still look at Europe?

F&C’s Paras Anand looks at why European equities are currently an attractive option for investors.

Continental Europe is diverse in terms of its geographic, cultural and economic make-up, which helps to create an exceptionally wide range of investment opportunities. In addition to a number of global leaders, Europe’s stock market also contains many winners of tomorrow, making European equities a potentially lucrative yet overlooked asset class. In addition, due to years of lacklustre macroeconomic performance, valuations in the region are far from demanding.

When considering investment in any asset class, it is of course best to start with a
broader perspective and compare each option with the wider available opportunity set, rather than simply starting with a very narrow focus. One of the principles upon which investors can construct a genuine and solid investment strategy should not be simply where they can make the most money, but rather the preservation of purchasing power over time. Good quality European equities may satisfy that criteria.

From a global perspective, it could be argued there are currently four broad categories
available to investors: government-backed fixed income securities, corporate debt, developed market equities and emerging market equities.

It goes without saying one starting point for any investment should be the historical performance versus the alternatives available. When considering low-risk, government-backed fixed income securities, it is worth taking into account the robust long-scale market backdrop for this asset class, despite the short-term positive developments in newer areas of the market. To put this into some context, while emerging market equities have enjoyed meteoric growth over the past three to five years, the returns versus German government bonds are comparable to March 2009 over 15 years.

We are now entering an environment where clearly many international governments are burdened with a high degree of borrowings, which will undoubtedly force them to issue a considerable amount of paper in the coming years to purge themselves of such debt. There is also the potential for inflation to creep back into the system, given the extent of monetary stimulus that has taken place since the first bite of the crunch.

It could therefore be argued government-backed fixed interest securities may not actually be the best place to guarantee the purchasing power of capital going forward. Were inflation to reappear, the return could even be negative in real terms.
Corporate bonds

Turning to corporate bonds, this asset class offered a solid risk/reward trade as the global economy hit the depths of the financial crisis in the early part of 2009, with the debt of many high-quality businesses being priced at levels that would suggest a risk to cashflow materially different from anything evidenced in history. While this obviously represented a good risk/reward opportunity, fast-forward one year and global borrowing spreads have contracted quite sharply.

One potential incremental positive from here could be that the world view alters to the point where investors are more comfortable with the solvency of individual companies versus the solvency of individual governments. Looking at certain parts of the debt market in Europe, it could be argued this is already starting to take place. The important consideration here is again the risk of inflation as, like most fixed interest securities, returns are nominal rather than real, so the existence of any inflationary pressure will immediately degrade the returns. The target achievement of trying to retain the purchasing power of the capital in corporate bonds could subsequently be difficult over the medium to long term.

When considering fixed income versus equities, the relative returns for the former has
undoubtedly been strong following last year’s rally. Fund flows traditionally follow the most successful asset classes, and throughout 2009 these were tepid in equity mutual funds but strong in bond funds. The conclusion drawn from this is investors still believe bonds carry more return opportunity and more potential to preserve capital than equities over the medium to long term, which is a position we challenge.

Within equities, investors may be divided on whether to select from the developed markets or emerging markets. There is little debate the stronger underlying growth from a macro-economic perspective is likely to be found in the developing market economies due to favourable demographics, whereas many of the richer economies in the world now have poor government and personal balance sheet positions in addition to challenging demographics.

However, the opportunity set and therefore potential return prospects are significantly
greater within developed than in emerging markets. because over the long term share prices reflect not earnings growth but the value creation of individual companies. While underlying growth rates may be slower in Europe, there is a good representation of businesses that have sustainably superior economics than in emerging markets.

In addition, the reason why Europe remains attractive relative to other developed market regions is two-fold. First, despite concerns over headline economic growth, the region is more out of favour than most, which historically can be a good starting point from a valuation perspective. Second, the evolution of companies being managed in the interest of shareholders is still in its relative infancy, meaning the latent potential for future value creation is significant.
Dividends

Dividends within European equities undergoing radical change, and payout ratios are low in comparison to global peers. Investors need to consider both a company’s ability to grow dividends as a result of underlying operational performance, together with a level of payout that is sustainable. While dividends in Europe remain on average lower than they are elsewhere, the scope for them to rise is much greater.

Potential areas of opportunity in European equities are high-quality businesses with strong, long-standing exposure to evolving consumption patterns in the emerging market countries, as well as technology or intellectual property-rich businesses that can aid the productivity in mature markets where underlying demand growth is less evident. This offers investors exposure to the success of the emerging markets story, while mitigating some of the risks inherent in the region.

European equities offer the opportunity to invest in businesses that are able to combine good long-term growth prospects with the ability to generate an attractive total return in terms of both income and capital growth over time.