From a cyclical point of view, companies in Europe are likely to face a tougher time in the future t...
From a cyclical point of view, companies in Europe are likely to face a tougher time in the future than they have during the past year. This is for two main reasons. The first is a tightening in the region's extremely lax monetary conditions, caused by a decline of more than 20% in the value of the euro against the US dollar since the euro's inception in January 1999.
The second reason is the fact that global growth rates appear to have peaked after recovering strongly in the aftermath of the Asian crisis. The likely result is that fewer companies in Europe will remain as profitable and the emphasis of investment will shift away from cyclical and value issues to defensive and outright growth stocks.
From a structural point of view, however, Europe's corporations are set to embark on a prolonged period of profitable expansion. This growth is being made easier by the fact that the region's capital markets are finally coming of age: eurobond issuance has risen to similar levels to the US corporate bond market; and for the first time buybacks of equity have matched share issuance.
The most important development, has been the level and nature of corporate activity undertaken by European companies. During 1999, mergers and acquisitions (M&A) rose by 44% to $727bn - equivalent to 33% of all M & A in the world last year. Even more telling is the fact that $240bn-worth of these deals were financed by cash, not by shares. Put another way, Europe's CEOs are becoming increasingly willing to leverage their balance sheets in order to enhance returns for shareholders.
Properly deployed, higher gearing is good, for two reasons. First, it allows companies to grow faster than they would if they relied solely on internal cash streams. Second, the tax benefits associated with debt financing mean that value is created at a much lower hurdle rate than with equity financing.
Europe's base of quoted corporate assets rose by 15% in 1999 and gearing levels have doubled during the past decade to stand at 44%. That is only the beginning. Gearing in Europe remains low by comparison with the US and debt still represents only 15% of the "enterprise value" of listed European companies.
We expect an increase in capital employed of at least 40% during the coming three years. Much of this will be spent outside Europe, as was the case last year when over 70% of the $236bn growth in the assets of quoted European companies was spent in the US.
Furthermore, the new world is manifesting itself in Europe in a different way from the US.
Operating returns should edge higher, partly because of the attractive investment opportunities that lie ahead and partly because companies' balance sheets will become more efficient. This will lead to double digit real returns annually in European equity markets for the next three years.
Mark Pignatelli is a director of Schroder Investment Management
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