Old Mutual AM’s Kevin Lilley sees a ‘beta’ year ahead

Kevin Lilley, manager of the Old Mutual European Equity Fund, believes that as the macro events of 2012 subside, the New Year should accentuate the positive.

2012 has been one of the most eventful of the 20 years or so that I have been managing European equities. There is also a strong chance that it will have been a transitional period, setting up 2013 to be another positive year for equity returns.

Europe has been at the heart of negative economic headlines, yet it looks like the worst may be behind us, with economic data beginning to stabilise. Austerity measures being imposed on southern European nations have clearly impacted their economies in the short term, but the associated reforms are beginning to achieve their desired objective in making those countries more competitive again. Recent announcements that both Volkswagen and Renault are increasing production in Spain highlight this.

It is not just austerity but the associated labour reforms that will allow the economies of peripheral Europe to regain the international competitiveness that they lost during their profligate decade following the formation of the euro. European quoted companies however are typically international in structure and will benefit from the recovery in the rest of the world that is forecast for 2013. Fiscal cliff worries and Chinese regime-change should be worked through in the first quarter, giving companies greater confidence to invest for growth once again, utilising the strong balance sheets they have built up in recent years. This will in turn create jobs, stimulating further growth and bringing the global economy back to a classic business cycle, though the pace of increase is likely to remain relatively slow.

2013 will not be without headlines, with upcoming elections in both Italy and Germany bound to create pockets of volatility. Peripheral Europe will continue with its painful adjustment process, but with the backing of the European Central Bank’s OMT (outright monetary transactions) programme in place, it is unlikely that we will see once again a destabilising surge in their sovereign bond yields. As we enter the second half of 2013 the year-on-year comparison of austerity laden economic growth will start to abate. Central banks are also likely to continue with their accommodative monetary policy until it is abundantly clear that the growth environment has normalised.

European equity market valuations currently look attractive compared to historic levels, while dividend yields are high. The big question will be what type of stocks and sectors will outperform in 2013? For some time now, during this period of high political volatility, fund managers have crowded into those stocks perceived as high quality, generally characterised as having strong balance sheets and secure growth, but with little growth potential. This is understandable given the levels of uncertainty, but it has driven the relative valuation of these stocks to exceptionally high levels.

The question is, during 2013, will this stance continue? I believe not. My view is that value stocks will close the gap relative to quality that has emerged as the events that have dominated 2012 subside. That is the way my portfolio is positioned. It is overweight banks, consumer cyclicals (cars) and materials, whilst underweight expensive defensive sectors such as consumer staples. It has a portfolio beta around 1.1, which should give a disproportionate benefit from a rising market.

Five undervalued European names to play for 2013

Volkswagen – This global car company has made large market share gains during the crisis, has a breadth of brands from VW through Audi to Bentley and has the scale necessary to absorb the costs associated with increasingly tough environmental standards.

Electrolux – The Swedish international electrical goods manufacturer has rationalised its production and is now gaining market share in the US. This stock should benefit from an improving economy and the recovering US housing market.

Sanofi – Whilst not economically sensitive, this stock has a low valuation, a good dividend yield, a strong international presence and has returned to growth following major patent expiries.

SES – This Luxembourg based satellite operator provides capacity for the likes of Sky and other TV operators globally. It has good visibility on its profit growth through long-term contracts. It is a good growth company with a good dividend yield.

BBVA – The Spanish bank that derives most of its profits from outside Spain. Benefits from strong positions in the Americas, particularly Mexico, and will benefit from the rationalisation of the Spanish banking system currently underway.

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