Raj Tanna, European equity strategist and César Pérez, EMEA chief investment strategist at JP Morgan Private Bank have looked at the case for investing in European equities.
We want to focus on companies where those dividends can be sustained through low leverage and global diversification. Of course there are risks to owning equities, but we believe the prospect of owning stakes in those companies with multinational profits, strong balance sheets, along with high dividends yields are persuasive.
Given all the concerns at the macro level it is understandable that on most conventional measures, European equities appear attractively valued. On a price to earnings basis, for example, European equities trade on 10x forward earnings versus their 20- year history of 13x – well below their US counterparts.
On a price to book basis, European stocks’ discount to their own history is just as marked: 1.1x versus 1.5x. What is more striking is the comparison between multinational companies in Europe and those in the US. We looked at the average valuation of the largest companies by sector in the US versus their direct peers in Europe. In most cases, the European companies were at a clear discount – often despite better fundamentals.
Of course, avoiding the losers is just as important in successful investing, and demands skilled stock-picking. Utility companies, for example, were traditionally thought of as solid income stocks until the 2008 recession. Demand subsequently collapsed, leading to very depressed power prices. The sector now faces falling demand, excess supply and large amounts of debt on its balance sheet.
As a result, a number of companies have cut their dividends over the last 12 months. Europe’s banks, too, face multiple challenges. Their traditional business has been hit by Europe’s weak economic growth in a moment where they were highly leveraged and too dependent on wholesale funding which has now disappeared. The ECB had to intervene giving them close to €1 trillion through the three year LTRO window to help their funding problems.
Sovereign debt issues also affect Europe’s banks more directly than any other sector. Spanish and Italian banks, for example, have a combined market capitalization of €120bn, alongside total sovereign debt exposure of €500bn – so investors in those banks are essentially taking on leveraged exposure to sovereign debt.
As political leaders grapple with the crisis under huge uncertainty, now is clearly not the time to take on this exposure, in our view – so we remain significantly underweight the banking sector. There are, of course, exceptions to this: those banks with emerging markets exposure, will benefit from much higher growth potential.
While no one doubts the substantial difficulties facing the Eurozone, investors are overlooking some of Europe’s positives. One of these is Germany, which continues to be the region’s bright spot.
Of course, for all of Europe’s internal problems, the region’s growth is also dependent on growth in the rest of the world. We believe that global demand, especially from Asia, will continue to benefit European multinationals from a trend, rather than cyclical perspective.
So, while Emerging Markets growth will be very weak in Q2 and Q3, monetary policies in EM countries will likely be supportive this year given slightly less concerns on inflation fears. Also, given the strictly weaker global composite PMI data year to date, the Emerging Markets slowdown is already in the price. With regards to the speed of the global recovery, the PMI surveys suggest that the expansion will stay on track this year and global growth will likely equate to around 2.0%-2.5%.