The list of criticisms levelled against the eurozone economy seems almost endless. To be fair, it is...
The list of criticisms levelled against the eurozone economy seems almost endless. To be fair, it is difficult to get enthusiastic about the macro-economic environment and outlook - sluggish GDP growth, high unemployment rate, flagging exports... But are commentators and investors caught in a half-empty glass approach, blind to the positive factors and focusing only on negative news? More importantly, the strong negative consensus view on the core economies could hide a more complex state of affairs for investors.
Ultimately, challenging the consensus thinking could generate rewarding investment themes.
When a macro-economist looks at the eurozone, what does he see? GDP growth is decelerating to the point of stalling. In 2005, GDP growth is expected to slow to 1.5% when world economic growth is expected to reach 3% in 2005. Economic growth in the eurozone does not compare well with the UK (2.5% expected in 2005) or the US (3.7%), China or India.
Does it really matter for investors? Bluntly put, not really. In 2004, China was the most dynamic economy but its stock market returned a disappointing -7.5% in sterling terms. At the other end of the spectrum, Italy was one of the slowest economies in 2004, with GDP growth reaching 1%. Despite this, the Italian equity market returned a strong 19.9% over the year. This counterintuitive example shows the merits of challenging the consensus and going beyond the macro-economic analysis.
Looking at market conditions within the eurozone, the picture does not, at first glance, look much rosier. Since the start of the year, the MSCI Euro has fallen by 2.3% in sterling, as the performance of the region was dragged down by the German stock market (-5.2%). Investor sentiment has deteriorated and investors have become more risk-averse.
Not everything is wrong with market conditions in Europe. Valuations are appealing and are a central argument in favour of the region. P/Es are attractive on a historical, geographic and relative basis. On an historical basis, equities are trading close to October 2001's low. On a geographic comparison, while European equities have always traded at a discount to US equities, this is now at its widest since June 2002. Finally, the relative valuation shows equity valuations are extremely attractive.
The consensus is that eurozone equities are attractively valued for good reason: companies in the region simply cannot grow their earnings. It is widely held that, in an environment of lacklustre consumer spending, firms will not be able to increase their sales volume. The overall lack of pricing power in the eurozone means they cannot raise prices without losing market share, so will find it difficult to increase their turnover. Added to this, the rise in commodity prices means that companies' production costs increase, so earnings are likely to come under pressure - hence the current theme of decelerating earnings growth. But could there be more to it than this?
Companies' earnings may be under pressure but levels of free cash flow generated in the region are very high compared not only with other regions but also with historical standards. They are a key driver behind the revival of the M&A activity in Europe and the recent increase in dividend payments and share buybacks. Unlike the M&A activity of the late 1990s, firms are tending to consolidate within the same sector. On a case-by-case basis, the benefits of well-planned M&A could include market share gain, improved pricing power, and reductions in production costs as synergies are developed.
The dividend theme also calls for a selective approach: the sustainability of the dividend payment policy should be closely examined. What proportion of earnings is paid out as a dividend? Companies presently use 41% of their earnings to reward their shareholders with dividends - this is actually the lowest payout ratio since July 2001. But while it looks low, high-yielding companies with low payout ratios should be able to sustain their dividend policies and continue to reward their shareholders.
When consensus opinion is too strong to truly reflect the reality, adopting an unconstrained approach can help generate promising investment ideas. This leaves those investors free to enjoy the half-full glass of wine.
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