European markets have prospered over the last few years. Although they are marginally below the head...
European markets have prospered over the last few years. Although they are marginally below the heady days of 2000, the MSCI Europe (Ex UK) Index has risen almost 150% since its nadir in March 2003 - a healthy return by any standards.
So are European markets expensive again? Curiously, this market rally has been entirely under-pinned by earnings growth. Markets are not more expensive in PE terms - indeed, at 13.1x next year's earnings, they are trading below their recent average.
As Morgan Stanley pointed out, typically 50% of a bull market's returns come from an upwards re-rating of markets, and the rest from earnings growth - investors have not been willing to pay higher multiples during this bull market.
How then has corporate Europe increased its earnings at such an impressive rate? The secret lies in expanding margins and an all-time high rate of return on equity. RoE now stands at more than 17%, comfortably above 1999's peak of 15.5%.
Lacking major reform and restructuring from European governments, European companies have cut costs, relocated manufacturing further east, and paid far more attention to capital discipline than ever before.
If the politicians haven't helped, neither has the European economy, with fairly lacklustre growth over the last few years in the core eurozone economies, especially Germany. This should change in 2007, however, with growth revving up in Europe's largest economy.
Hence, in addition to the good growth seen in Europe's peripheral countries, the main 'cylinders' may finally contribute their fair share.
The prevailing economic climate therefore looks very favourable, and should prove a tailwind to corporate earnings. And to complete the Goldilocks story, inflat-ion (CPI) is back below 2.5% in the eurozone.
However, as Bertie Wooster noted, it is when everything is going swimmingly that fate has a habit of creeping up behind you with the sock full of sand.
Markets have risen almost 30% since last June in a largely straight line. This encourages us to short-term caution, and we are positioned defensively.
Nevertheless, we are finding significant value in the telecom sector. Technology has regained some notional glamour since 2000 but Telcos were unloved for much of 2006, even as utilities soared.
These companies are moving into the ex-growth phase but unlike some estimates they are not threatened with complete annihilation by Voice over IP. Their fixed-line revenues will decrease but the broadband that carries VOIP is a significant new earnings driver.
The sector yield has overtaken Bunds for the first time in a decade, and many, such as Teliasonera in Sweden, have significant potential to enhance yields further by increasing, or introducing, gearing.
This re-gearing exercise will enable strong rates of RoE to be maintained, as equity is retired and balance sheets optimised.
This is what private equity aspires to do - and investors do not really have to trade prime equity for junk bonds, which is the effective trade in current private equity deals. Shareholders should ask managements to make these efficiencies before selling cheaply to buyout firms.
Nevertheless, we expect 2007 to be the year of the mega private equity deal. Merger and acquisi-tion activity is increasing, and increasingly funded with cash - the predators clearly believe equities are cheap.
Of course, for such strategies to work a low interest rate must be sustained - and prudent investors will carefully monitor credit defaults and inflation, especially in the US, which might indicate that the bears are returning.
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