The fact is that there is probably no geography with as large and diverse a range of companies as Europe for active managers to capitalize on irrational investors, macro turmoil and rapidly changing political dynamics. Within Europe we have the resource rich Norwegians and the Swiss with their strong currencies, the dynamism of a young developing east including Turkey and Poland, the profligate, uncompetitive PIIGS and the bickering core countries of Germany and France calling the political shots.
By extension of this diverse opportunity set, there is no other market where stock picking can thrive to the same extent. Ruffer European has outperformed by 220% over the last eight years, Blackrock European by 40% in 5 years and Odey European has outperformed by 343% in the 14 years since inception! With countries possessing different currencies, differing growth rates, different demographics and different debt dynamics, there is likely always some company, industry, currency or country which is doing well relative to its neighbors.
Sentiment – EuroBulls, Where Are You?
At the moment there is a race on the part of fund managers to emphasize how little euro exposure they have. Like the financials in 2008 or U.S.-listed Chinese stocks this year, it has become a badge of honor to say you are avoiding Europe, pitching it to investors as a benefit of your “flexible” mandates.
The chart below form Montanaro Fund Managers shows that investor sentiment on euro equities is back at crisis levels.
The institution that I work for currently has a large overweight U.S. equities, a near-zero weight in euro equities and a neutral on Swiss Equities. It is my impression that this is fairly representative of where most market participants are right now. The U.S. is a safe haven in comparison — earnings yields are way higher than the U.S. 10 year, there is some serious momentum in the relative outperformance of the trade — it’s the easiest call to make.
But the shunning of euro equities has been going on for a few years. Look at the chart below. Since the financial crisis, there have been basically no net fund flows to Europe! Even Japan is getting more love!
Let us not forget that so many European companies, as the part of the longest-standing economic region on the planet, possess revenues that are global in origin and a weaker euro provides a boost to their comparative pricing as they become cheaper than their USD or JPY denominated peers. To use a simplified example, say the euro weakens 10%, then ceteris paribus, the 28-year-old Chinese social networking millionaire will be able to buy Pirelli, Continental or Michelin Tires for his Ferrari relatively cheaper than he would be able to buy Bridgestone (Japanese) or Goodyear (American) tires. Not to mention that the Ferrari itself will be cheaper in yuan than a Corvette or an Aston Martin. This is why the Germans love the euro, because it allows them to have a much weaker currency than if they were trading in the mark.
One of the most attractive sectors of the market is still the large-cap, high-quality, defensive, global franchises. After a decade of de-rating they have had only a few months of outperformance relative to the cyclicals, the “rubbish” and the small caps. I believe this might be the beginning of a secular relative appreciation for high-quality franchises — even better that we can buy them now at low valuations which afford us attractive dividends and a margin of safety. The power of their cash generation and their commitment to capital allocation through buybacks and dividends means that names like Imperial Tobacco (ITY), Astra Zeneca (AZN), Roche (RHHBY) or Total (TOT) will or could effectively take themselves private within 15 years. High-quality franchises currently offer revenue/earnings predictability without paying up for it, reliable and growing dividend streams, and lastly, the opportunity for multiple expansion. (See GMO’s forecasts on high quality outperformance.)
ECB is now moving from being the most hawkish bank in the world to a stance more in keeping with the world’s other central banks — extremely accommodating. Two rate cuts in successive months won’t hurt equities, but they are probably more indicative of a truly poisonous macro environment rather than anything to get too excited about. The danger, of course, is the fiscal austerity that the politicians have now decided is the best way to align the economies of Europe. There is a not insignificant chance that this forces a periphery depression rather than a recession and that this might cause the earnings of many eurozone companies to disappear.
To me it seems that when they are finally forced to choose, in a great denouement, the politicians will opt to print to save their great currency experiment rather than to break it up and have their lives' work derided as a failure. This generation of politicians are just far too committed/invested in the idea of a euro currency. However, the monetization that would be an at least temporary elixir for equities seems some way off on the back of Draghi’s comments that there will be no “grand bargain” and that the ECB articles “embody the best traditions of the Bundesbank.”
Crispin Odey, who is rather bullish, has an interesting take on the macro perspective: He seems to believe that it’s the uncertainty that’s killing the market, not the bad news. He intimated that a crisis will “bring resolution” and perhaps substantially higher equity valuations. Not sure I believe it, but an interesting thought.
In 90% of occasions, valuation is all that matters. On average, good things happen to cheap stocks and bad things happen to expensive stocks. Today, there is an attractive valuation discrepancy across geographies. The reality is that most companies listed on the major bourses are global in nature and derive most of their revenue from trade with partners in a range of continents. We live in a global economy, not a parochial one.
Why then, I ask, playing devil’s advocate, does the U.S. market deserve to trade on a CAPE of 19x, compared to the MSCI Europe trading on a CAPE of 12x? I accept that there are macro reasons for a valuation differential. In fact, I’m about as bearish on the euro situation as anyone, but I suspect that investors are failing to make sufficient distinctions between the prospects of multi-national businesses and the prospects of “the man on the street” in much of southern Europe.
The difference in the multiple of 7x, or a valuation discount between Europe and the U.S. of 37% if you prefer, is as wide as it has ever been. The chart demonstrates that Europe does traditionally trade at a discount to the U.S., probably rightly so given the inflexibility of labor, less economic dynamism and less favorable tax regimes. However, at some point the discount is so great that it presents compelling value and the spread will tighten, as it has always done before.
From a valuation perspective we can see below some indicative long-term returns that the two indexes are offering equity owners currently. A CAPE of 19x, which is historically about 20% above average, offers equity holders a small to slightly negative real return over the long term. Contrastingly, a CAPE of 12x offers very attractive long term equity returns — in fact, as the chart shows, they have only presented as negative on the rarest of occasions, often compounding at 10-15% annualized.
In summary, if we were to use history as our guide, then European indexes are priced to provide long-term attractive returns even if we enter a global recession in the next 12 months. If we were to muddle through or better, then I think those returns would come much larger and much faster. It’s also worth emphasizing that these are index returns, and we have already mentioned that Europe is an area where alpha is easier to come by than most.
See below the GMO Seven-Year Asset Class Forecasts which provide further evidence to this effect:
The difference in prospective long-term returns between the two large economic blocs is so great that euro bears could even go as far as to hedge the currency without too great a detriment to their expected outperformance. This is the approach which I am taking in my portfolio as it helps me sleep at night!
1) Avoid the financials. Do not touch the banks. If Italy takes a haircut they all blow up.
2) It would be easy enough to build a diversified basket of the global franchises I talked about with an average yield well in excess of 4% which are all trading on sub-12x this year's earnings. That would include names like Total S.A, ENI, France Telecom, KPN Telecom, Tesco, Deutsche Telekom, Novartis, Roche, Groupe Bruxelles Lambert, Imperial Tobacco, Deutsche Post. This strategy is boring, but the revenues and earnings lack cyclicality, and the dividends are relatively secure.
3) If one has the inclination they could go digging amongst the smaller companies for unique bargains or special situations. For example, the Greek market is down 90% top to bottom; that’s as bad as anything in the Great Depression. I’m sure there are some bargains in there! I have one or two smaller eurozone companies that I am monitoring, but again perhaps you’ll want to hedge the currency. I’ll add these at appropriate prices on top of the next idea which is already in the portfolio.
4) A fund – the easiest option. Personally, I have opted to add an initial small position in Ruffer European. The fund is the best performing in the eurozone over the last five years, yet despite this only has £220 million under management. My guess is that this is because they dare to “asset allocate” rather than just staying fully invested in equities the whole time. The fund currently sits about 30% in cash and index linkers with a further 3% in put option protection and almost all exposure hedged back to sterling. They have the size and flexibility to play in the small caps where true bargains may emerge, and they maintain the flexibility that has allowed Timothy Youngman to build the best track record in the sector.
5) Other ideas would be Senhouse European, a very disciplined, small fund which I think will provide excellent returns to investors who get on board at current levels and/or Cazenove European where I think Chris Rice has one of the best grasps on the euromacro environment. If you can get his commentary, read it!