For those investors who ignored the warnings against Europe's stockmarkets, the past few years will have proved both rewarding and lucrative. Cherry Reynard outlines where the best value has been found and if the markets can exhibit sustainable growth in the future
European stockmarkets have belied the unpromising economic outlook. For the best stockpickers, Europe has provided a fertile hunting ground with its choice of top global companies and successful smaller companies. But can the markets retain their momentum?
On the plus side, the macroeconomic outlook is starting to pick up. On the downside, this has not always been a help to stockmarkets and valuations are now comparable with those of the UK. Where are fund managers seeing the best value?
It has certainly been a fruitful few years for those invested in European stock markets. The average Europe ex-UK fund is up 105.2% over the three years to 20 February, compared to 89.9% from the average UK All Companies fund and a mere 50.8% from the average US fund over the same period.
Smaller companies have done particularly well. This is perhaps counter-intuitive, given that smaller companies tend to be more domestically focused and therefore have more exposure to the weak European economies. But many have proved themselves nimble and have sought out profitable niches within those lacklustre economies. The average European smaller companies fund is up 174.3% over three years.
On a regional basis, the star performers have been Norway, Denmark and Greece. The MSCI indices show rises of 48%, 32% and 41% over the past three years respectively. France and Germany put in respectable performances, returning 22% and 29% over the same period. They have also been among the top performers over the past 12 months. The difference between the return from the indices and the returns generated by active managers is telling - it shows the extent to which the region rewards careful stockpicking.
So what is next? In macro terms, things are looking up. It is difficult to make one prediction for such a disparate region, but overall Western European economies appear to be stabilising. If this happens, it is likely to have a knock-on effect on consumer confidence.
Philip Saunders, head of asset allocation at Investec, says: &The fundamentals should be supportive in the region. The dollar has scope to appreciate against the euro, though this is far less clear-cut than in 2004.& If this happened European goods and services would become more competitive.
But stockmarkets have not always been in tune with the macro picture. This is partly because many European companies are deriving a substantial part of their earnings from outside Europe, but also because they have been doing a lot of 'self-help'. Can this be sustained?
Saunders believes it can: &The bottom-up picture remains pretty good. Analysts continue to underestimate the scope for companies in Europe to rationalise. Markets have run up, but this was only to catch up with earnings. Multiples have moved up, but from a straightforward valuation standpoint, they do not look expensive. Its relative attractiveness to the UK has declined, but less so with the UK.&
Roger Guy, manager of the Gartmore Selected Opprtunities, says that M&A activity is likely to be stimulative for the region as well, adding: &M&A activity is slowly but surely gathering pace, with almost every day leading to yet another bid: Linde/BOC, Mittal/Arcelor, BNP/BNL, Ferrovial/BAA, Sonae/Portugal Telecom. We had anticipated a pick-up in activity in 2006, but we are surprised by the hostile nature of some of the deals. Either way, hostile or non-hostile, the prospect of increased M&A volumes bodes well for European equities in 2006.&
And despite recent strong rises in European share prices, valuations still look good. Olly Russ, manager of the Britannic Argonaut European Income fund, says: &European stockmarkets are on about 14x. This is at the bottom of the historic trading range so they still look pretty cheap. There is also nice earnings growth coming through. The improvement in continental European economies can only help.&
Where are the most promising areas? Saunders says: &A lot of European stocks are cyclical. If the pendulum swings back, quality growth stocks such as pharmaceuticals and technology will outperform.&
Russ is backing income stocks and has just launched a European equity income fund. He adds: &The free cash flow for European stocks is the same as in the UK, so there is cash available to distribute as dividends. A few years ago European government bonds were paying 6%, now they pay around 3.3% - about the same as equities.&
Russ says that a few years ago a European equity income fund would have been confined to utilities and tobacco, but now most of the market pays more than the bond yield. He is foraging in three areas:
Value: which is largely made up of financial stocks like Banca Intesa or Fortis.
Growth: made up of companies that don't need to retain capital to grow, like Telecinco, which has a 5% dividend yield and 20% earnings per share growth.
Special situations: companies that are restructuring and have the scope to change.
Italy is a region to watch, according to Russ and Andrew Lynch, manager of the European Smaller Companies fund at Schroders. Both believe the region has been unloved and looks set for a revival of fortunes with many companies restructuring and the stockmarket generally underowned.
The picture for corporate bonds is similar to elsewhere in the world. Spreads over government bonds do not leave much margin for error. Default rates are low, but short-term interest rates could go up in Europe. The biggest fear among commentators seems to be that the ECB will 'do something stupid'. As Lynch puts it: &There is always a risk that the ECB will do something silly. It may decide there is a significant risk of hyper-inflation and raise interest rates substantially. It may make some other policy mistake.& This view would seem to have substance as the ECB's recent rate rise demonstrates.
Eastern Europe has been a popular theme in recent years. Exposure to the region has been very beneficial for some managers. Elena Shafton's Jupiter Emerging Europe fund has been one of the top performers of all European funds. But most observers believe that the party is now over for investors. Lynch says: &The Eastern European story has been pretty well played-out. There was a lot of value around five or six years ago. The cleverer corporations went and bought up local assets and have benefited. These days we tend to play the region indirectly through companies with operations out there.&
Europe has everything going for it, except the fact it has everything going for it. Usually when everyone is upbeat about a region, all the good news is in the price. But with valuations still cheap, it appears continental Europe markets may have plenty of growth left.
It is simply the source of that growth that has changed.
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