Don’t turn your back on European equities, urges Threadneedle’s Nick Davis
Threadneedle manager Nick Davis outlines reasons why equity investors should look to a range of solid European companies for returns.
European politicians do not do bazookas – and investors waiting for a big bang moment to increase their exposure to Europe are unlikely to get one.
Our central scenario remains that the eurozone muddles through – and there are signs of limited progress towards further integration in the last few weeks. Most encouraging has been the discussion about a banking union and an acceptance of Spain slowing its austerity programme – both suggest that politicians will be more flexible than some of us feared. The problem is that every step forward tends to be preceded by a mini-crisis and then followed by some disagreement on what was actually agreed! Things will likely remain volatile – but ultimately European valuations provide sufficient potential reward to justify taking the risk.
The interesting question is how the relative merits of Europe compare to other regions. As the debate shifts to the US “fiscal cliff” and slowing emerging markets growth, we believe that the “European discount” on global companies listed in Europe compared with similar companies elsewhere will look increasingly questionable. We continue to like quality European companies exposed to global growth and structural themes.
Cheap debt: An opportunity for some, a risk for others!
Crisis monetary measures are having interesting implications for European corporates. The collapse in the “risk free” rate has seen bond yields fall below dividend yields for some stocks (even ones that we consider to have good growth prospects). Anheuser-Busch Inbev (ABI) recently bought out a Mexican brewer using debt that cost just 2% – given the growth prospects for this market, we believe that equity investors are getting a great deal. Another example would be Atlas Copco where its corporate bonds yield less than the equities despite delivering high single-digit organic growth. This is also positive for those invested in the targets that are being acquired – we have seen some signs of returning M&A. There is no doubt that there are good businesses in Europe – and we expect M&A to increase going forward (albeit dependent on an improvement in confidence).
Cheap debt also makes it cheaper for companies to buy back their own shares – and, given that some of the companies we invest in even have net cash positions, we expect increasing scrutiny on the use of cash. In an uncertain world, it is right that corporates want to have conservative balance sheets (and it is one of the ways we screen investment ideas), but net cash is not likely to be an optimal medium-term capitalisation structure for many companies.
Beyond raising new debt to pursue attractive opportunities, there is also an opportunity to refinance existing debt at more attractive rates. For some companies that were forced to raise debt at the peak of the crisis, the impact of refinancing can be meaningful. Lower debt servicing costs again represent a good deal for equity investors.
Part of our confidence in investing in ABI is the fact that management own shares and has a track record of disciplined M&A. However, what is an opportunity for companies like ABI that are investing wisely, can be a risk elsewhere. Cheap debt can make even poor deals look attractive on an EPS accretion basis. The implications of cheap debt for capital allocation are a bit worrying – because distorted decisions now could prove expensive over the long run (a horizon that gets little attention today – but is relevant when evaluating M&A and capex). We worry that industries with growth problems may destroy value trying to grow – when they could be great returns and cash distribution stories.