With valuations at such low levels, the region appears to be bottoming out and there should be plenty of opportunities for selective share purchases
The European markets have seen such substantial falls, particularly when compared to the US, that they now offer interesting value.
However, sentiment in Europe is still driven by what happens across the Atlantic. With the scope for decoupling limited, we will probably need positive US markets to deliver a significant and sustained rally. Once again, it will remain crucial to pick the right areas in which to invest during the course of 2003.
Regardless of the outlook for 2003, one of the best ways to invest is to seek out quality. There are some high quality companies that have performed well. Let us not forget that companies such as Unilever, the Anglo-Dutch food and household products group, has succeeded in driving profits and margins forward during the last year. This has come about through careful management delivering on the promised business strategy of concentrating on core brands.
Elsewhere, companies have continued to deliver, albeit at a more modest level, despite the difficult economic environment. Many have achieved little recognition for this and have been pulled down by an indiscriminate market. On today's depressed valuations, assuming no unforeseen surprises, these valuations would not be demanding were they to rise considerably from current levels.
There are also a number of quality stocks that are offering a generous dividend yield. This ought to limit much in the way of further downside, since these stocks are attractive to income seekers. Moreover, interest rates are expected to remain low while the economy is under pressure and with bond yields at around 4% the mathematics clearly justify higher P/E multiples. Under these circumstances, we now see the risks as more on the upside.
Within Europe, there has also been growing corporate activity of late. We have been encouraged by the increasing number of management buyouts (MBOs) among the mid caps and acqu-isitions/stake building amongst large caps at significant premiums to the market price. Recently, we have seen ENI purchase 50% of Union Fenosa Gas, and the Benetton family increase their stake in Autostrade, the Italian motorway toll company. This is an encouraging sign, as managers do not risk their own capital unless the shares are offering extreme value ' suggestive that the lows of this year touched some critical valuation support.
The French banking system seems to be adopting a more aggressive stance. Following from its takeover of Paribas, BNP made an audacious move on Credit Lyonnais, which initially caught Credit Agricole off guard. This should wake up the French business establishment and show them the merits of a competitive takeover bid.
A typically French solution will be found to this situation and rest assured that if a foreign bank were the predator, the French authorities would be unlikely to be so enthusiastic about this capitalist bravado. On the same front, within Germany, Munich Re has given its approval to consolidation in the banking sector, which removes one of the stumbling blocks for HVB should it choose to bid for Commerzbank.
The European telecom sector can be seen as a caricature of the global economy ' over-enthusiasm led to expensive investment, causing excessive debt levels, that are now forcing through business restructuring.
It began with KPN, which chose to follow BT's restructuring and admit it overpaid in a dash for growth. KPN booked a near E9bn impairment charge in its second quarter results and the company has been able to face the future with a cleaner slate.
Even the embattled France Telecom is finally acknowledging its own hubris. Unfortunately, the rescue plan, although welcome, has all the hallmarks of a French bailout at taxpayer's expense. Similarly, Vivendi Universal, although requiring a push from Vodafone's bid, is embarking on a more focused business plan to offload non-core assets and reduce debt. Debt has focused the minds of many of these continental businesses and during 2003 we may see emerge several European companies with a business practice that is more akin to the Anglo-Saxon model.
Although there has not been a full-blown recession from a negative GDP growth perspective, over expansion in the boom has depressed earnings to a similar extent. Return on invested capital is at the lows of the early 1990s, without a demand recession.
Any company that has managed to keep its head above water in the last two years, must have survived for good reason. The calibre of remaining companies should therefore be higher than when we began this bear market. Thus, many stocks deserve to be on higher multiples than the modest or depressed valuations that this emotional market is according them. If the uncertainty can be relieved, some of the stocks will look exceptionally cheap.
If the market does drift lower, then expect the number of MBOs and corporate bids to accelerate. This should provide a floor for the market, although with the hedge fund industry having become more powerful, the volatility of the last couple of years is likely to stay, underlining the importance of considering company fundamentals before investing.
On a more positive note, there is plenty of cash to drive the markets higher. Money supply in the US and Europe has been substantially increased. Credit is being generated within the economy, which is in sharp contrast to the Japan of the 1990s. The rally after the falls of September and October shows just how nervous investors are that they may miss out on a run up in shares. This is welcoming news, suggesting that panic is not one-sided. In addition, the structural selling of equities by insurance companies that have been buying bonds to better match their liabilities is also slowing.
This should be a positive, since it will reduce the supply of secondary stock on the market. More importantly it may lead to institutions returning to equities, particularly as the yield on many quasi-government bonds is now quite low, with little room for further outperformance from this asset class.
On the downside, there are still a lot of European companies that want to tap the markets for cash. This supply of paper may dampen some of the upside and is compounded by European governments' privatisation plans to help them stay within the agreed budget deficit limits of the Stability Pact.
Politics is rarely a positive for European equities and 2003 looks to be no exception. The European Central Bank's reluctance to act as decisively and swiftly as the Fed has hampered the Continent's growth rate. However, there does seem to be renewed thinking as the ECB demonstrated on 5 December when it cut base rates to 2.75%. This was a bold step from a bank that had been so slow to move and recognise the very real structural problems in the German economy.
However, there seems to be no great rush to reform the labour regulations in Europe, despite most commentators agreeing that they are an impediment to employment and Europe's competitiveness.
The enlargement of the European Union over the next 12-18 months will also consume precious time and money. It is also questionable what benefits either side will generate from this expansion.
The source of cheap labour is nothing compared to globalisation where a worker in China still makes a cheap, skilled worker in Poland look expensive. The European Union may have to face up to some uncomfortable truths and allow a softening of the Stability Pact or larger countries such as Germany and France will be forced to break the rules. Expect some fudge along Gordon Brown's over the lifetime of an economic cycle argument.
In summary, the European markets have probably already seen the lows of this bear phase. With most major European indices having fallen by over 50% by autumn from their highs in 2000, opportunities for selective share purchases present themselves. The really interesting period will probably be around March. Most of the companies will be reporting final quarter and annual figures for 2002.
It will be an opportunity for companies to sum up their performance and give an outlook for the remainder of 2003. Moreover, it is the accountants and directors last chance to come clean over any issues lurking in the accounts.
This should finally draw a line under this unhappy episode and lead to greater confidence in earnings going forward. If the results are good, then this may herald the start of a positive market for 2003.
Many companies that have continued to deliver despite the environment have been pulled down by an indiscriminate market.
Return on invested capital is at the lows of the early 1990s, without a demand recession.
The ECB's reluctance to act as decisively as the Fed has hampered the Continent's growth rate.
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