European equities draw favourable US comparisons
Wahid Chammas, portfolio manager at the Janus Europe Fund argues that from a US perspective, European equities remain attractive.
With valuations still low and profit margins improving off trough levels, European companies should be able to grow earnings more significantly in 2014 and 2015. Relative to their US peers, the region’s companies have been under-earning.
Due to austerity efforts, which have given European companies a rare chance to boost productivity, they should be able to regain profitability back to their average 20-year discount to US margins. Currently, the gap between European and US margins remains too wide, in our view.
As such, despite recent gains, European stocks remain attractive. However, we think the momentum-based trading that we saw in the fourth quarter of 2013 and early in the first quarter of 2014 is over, making for a better environment for stock picking.
Companies whose margins are likely to improve have exposure to global growth, as well as having significant opportunities to improve margins and productivity. Examples include Volkswagen, which is among auto manufacturers reducing costs, and Royal Dutch Shell, an energy company under new management that is better managing its capital expenditures in order to improve returns on invested capital. We also see this trend in pharmaceutical companies, which have become better focused on efficiencies in their research and development expenses.
There are three reasons to be bullish on Europe. The first is growth. With global economies improving, including in Europe, companies enjoy revenue growth opportunities globally. The majority of revenues for European companies come from outside Europe, with growth in China and the US, in particular, helping European firms. While perhaps decreasing in importance, local European economies also are improving slowly, offering further revenue support.
At the earnings level, European companies have the ability to increase efficiency, rationalize operations and drive margin expansion. While operating margins in the US are at 10-year high and are fully recovered from the global financial crisis (GFC), in Europe they are below past levels and lower than pre-GFC levels. Earnings growth should exceed revenue growth in aggregate.
Second is the aspect of valuations. European companies trade at lower price-to-earnings ratios and with higher dividend yields than their US counterparts. On 2015 earnings, MSCI Europe trades at 12.8x multiples and 3.9% yield versus the S&P 500, which is trading at 14.3x multiples and 2.2% yield. While we do not think the US is overvalued, if European companies meet our growth expectations and regional risk tolerance increases, we think multiples could expand more in Europe, providing stock returns that exceed earnings growth.
Third is the micro story. In general, companies are healthy in Europe, with flush balance sheets. With greater confidence and facing less macro risk, managements can spend the money either in capacity expansion or strategic acquisitions. More efficient balance sheets will increase returns on capital and ultimately enhance earnings growth. Average corporate returns on equity remain well below levels pre-GFC. Paired with the opportunity to raise margins through efficiency gains, many well run European companies can delink their futures from the economic forces that roiled markets and instead tie them to their own operational skills.