When investing in European equities, the analysis should start at a company level. This will tell you more about a stock's prospects than examining its sector or even the country in which it is based
In selecting European stocks, it is good to start on the ground with company rather than macroeconomic analysis to produce recommended weightings in each country or market sector.
That is not to suggest completely ignoring country and sector analysis. Country effects do still exist in Europe. For example, there is not tax harmonisation within the EU and tax changes can affect competitiveness. Elsewhere, many industries such as electricity producers are also still regulated at the national level rather than Europe-wide. However, specific country effects are less significant as means of generating performance for investors in Europe than they were, say, 20 years ago.
What is now considered more important than country allocation for investors is sector bets. For example, companies operating in the same sector across Europe are generally influenced by at least some of the same factors. They tend to have the same supply issues, experience the same pattern of demand and often face the same obstacles. There is arguably more in common between car makers in Germany and France than there is between, say, UK pharmaceuticals companies and UK oil producers, and investors tend to make comparisons with other companies in the same sector to determine a fair share price.
For these reasons, it is important to pay attention to both the country and sector weightings in portfolios. This should be a cross-check within the portfolio construction process, to ensure the country and sector weightings from a bottom-up stock selection approach look sensible.
look beyond the Nationality
The most effective way to manage reasonably concentrated portfolios in the European equity markets is to work on an empirical basis or on a company-by-company approach. To group companies together simply on the basis that they operate in the same country or are in the same industry sector is too much of a broad-brush approach.
For example, if a company has a competitive advantage against peers in the same sector the returns could be better for one business than the other. A better product or more attractive price point, or a motivated, skilled and shareholder-friendly management can result in vastly different share price performance between similar companies. This could provide the opportunity for active equity managers to deliver better performance to investors.
Just as market capitalisation is not a bar to being able to deliver growth in profits, so too companies should not be ruled out from being candidates for portfolios simply because of a negative view on a particular country or sector. Companies should be considered on a case-by-case basis, as well as the evidence to produce a return for each.
When looking at individual companies, what fund managers should be trying to do is form a view on whether they think the management will be able to deliver better earnings results than anticipated by the broader market.
This involves fundamental research. One method is looking at growth at a reasonable price (Garp), meaning combining an analysis of the prospects for earnings growth going forward in each company with an acute awareness of the price paid for that growth. Companies with these characteristics make the most attractive investments over the long term.
One of the effects of this approach is to direct managers towards stocks, which are not necessarily as efficiently covered by the broking community as the very largest companies in the market, and towards markets on the periphery of Europe, which might have been overlooked by others.
The first step when considering whether to invest in a company is to try to understand the industry in which it operates. If an investor does not understand the forces at work in the industry, and the likely winners and losers going forward, it is best not to invest. It is a simple as that. It is important to read widely around the subject, talk to experts in the area, and, importantly, meet the management of the companies operating in that industry.
Once an investor have a good sense of the competitive environment, it becomes necessary to break out the calculator and spreadsheets to analyse the balance sheet and cashflow for the company they are examining. It is necessary to understand the business model for each company before considering investment and, most particularly, the likely future sources, magnitude and duration of earnings growth - and how these are likely to differ from what the market is expecting. Key things to look at here include the annual report, the profit and loss accounts of the company, and any filings with the stock exchange that might have an impact on the valuation of the company.
Having completed this analysis, it is time to put a price on the prospects for the company. This is a useful sanity check. There are many different measures of valuation to look at. The price/earnings ratio is the classic measure, and most valuable when used with a forecast of likely future earnings rather than historic reported earnings, but others give greater insight for particular industries. In the European financial sector, for example, the price/book ratio is more useful, while the ratio of price/earnings to growth is commonly used when analysing the European technology sector.
In each case, it is important to compare projected earnings growth with the consensus view and the valuation measures, which are most appropriate for that company, to the levels equivalent peers and the broader market are trading at to form a view on whether shares in a given company are likely to prove an attractive investment. From this, it is possible to start to identify the candidates for European investment portfolios and construct portfolios from the ideas that have the highest level of conviction.
It is also important to review the investment case for each of the stocks held on a regular basis. If the investment thesis made when purchasing the company has changed or been superseded by events, it is important to review the holding. At the same time, it is also a mistake to trade too heavily in investment portfolios, as this can be expensive for investors. Maybe take a 12 to 18 month time horizon when investing and try to be disciplined to avoid incurring unnecessary turnover.
Right now, investors should be positive on the outlook for the European equity markets. The gradual economic recovery across Europe should continue this year and next, helped by a pick-up in the pace of consumer spending and a rise in the level of economic activity across Europe. The European Central Bank (ECB) will undoubtedly raise short-term interest rates to keep inflation from becoming a threat, but the ECB is not likely to raise interest rates to the point where it would be a significant impact on the rate of growth. With valuations reasonable and consensus earnings expectations for European companies still too conservative, prospects for the European equity markets look attractive, although careful stock selection will be necessary if returns are to be satisfactory.
Company analysis first step to investment
Do not ignore country and sector analysis
Prospects for European markets attractive
Putting the tech into protection
Square Mile’s series of informal interviews
Fallout from Haywood suspension
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£80bn funds under calculation