Turning a crisis into an opportunity

The sovereign debt crisis is blinding investors to the fundamental value to be found in Europe’s top companies.

European and UK equities are presently the cheapest in the world.

Not too much of a surprise given the fears that the sovereign debt crisis could lead to the break-up of the eurozone, even if Germany is booming right now.

But the aversion to European stocks is providing us with the opportunity to invest in undervalued companies that are exposed to long-term global structural growth trends and which will see demand for their goods and services increase for generations to come.

The risk of a Greek default is real, as its government is struggling to find the political support necessary to implement the harsh €28bn of cuts that the Germans and other eurozone finance ministers are demanding as a condition of any further bailout.

But the sovereign debt crisis is blinding investors to the fundamental value in Europe’s top companies.

Despite record levels of business confidence in core Europe, equities are generationally cheap compared with other assets.

Great franchises such as Rolls Royce or Schneider Electric are at low-teens multiples.

This makes us think that the market is discounting much of the risk of sovereign contagion.

London’s FTSE 100, for example, is trading at a 12-month forward P/E of only 11  far below what one might expect given that Europe’s top companies now have strong balance sheets and are expected to produce double-digit profit growth.

Indeed, with the EU sovereign debt crisis seen as the number one tail risk by global investors, regional allocation has turned the eurozone into a possible contrarian buy.

As in the US, European investors are presently being paid more to own equities than to take on risky credit with risky upside.

In Europe, the earnings yield is 9% for the FTSE World Europe Index, compared to 6.6% on a trailing 12-month basis on the S&P 500.

The yield on junk bonds is about 7% in the US and 7.7% in Europe.

The fact that truly global European companies are trading as if they were purely domestic ones is of particular interest to stock pickers.

Unilever, which derives 60% of its revenue from emerging markets, trades on 13-14 times earnings in Europe, while its subsidiary Hindustan Unilever trades on 20 times earnings.

Even if you believe the domestic boom in Europe’s core can not be sustained,it is worth remembering many of Europe’s world-class companies largely trade outside the continent.

By force-feeding strong growth in a number of key emerging markets, QE2 undoubtedly helped core Europe by generating strong demand for exports from a number of developed economies. This is particularly true of Germany, which exports only a little to the periphery.

But it is Germany’s deserved reputation for quality and servicing its goods that lies behind the $1.35trn it exported in 2010, compared to China’s $1.5trn.

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