Two main concerns forge the consensus view of Europe as being unattractive relative to other regions...
Two main concerns forge the consensus view of Europe as being unattractive relative to other regions: the lack of economic growth, and long term structural issues determining that continental Europe has too high and rigid a cost base. Are we seeing any evidence to challenge these long-held views and can the perception of Europe change?
On the first concern, while the European economy has lagged its developed country peers, more recent economic data has been more positive. In France, the economy grew faster than expected to June 2004, and was largely driven by consumer spending. Also, the French business confidence indicator hit the highest level for three years. Meanwhile, Germany's GDP growth rate exceeded expectations in Q2 - although driven almost entirely by exports. The widely watched IFO business climate index in Germany improved and the forward-looking portion of the survey suggests further German economic recovery in the second half of 2004.
On the second concern, there are early - but significant - signs that structural improvements are occurring in Germany. The recent working hours agreement struck with Siemens employees could set a crucial precedent as employees realise that a more flexible approach to working practices are better than losing jobs to their new EU neighbours. This in itself will not stop the flow of commodity type employment to lower cost countries, but it could be a small step towards allowing higher value-added jobs to stay in Germany and western Europe.
While the above developments are positive, Europe still lags far behind on these issues. However, there are other significant differences with the US and UK which may begin to tell in Europe's favour as the global economic cycle unfolds.
The European consumer has not amassed debt to the levels that those in the US and UK have and is therefore unlikely to be a drag on the economy as interest rates increase globally. Furthermore, equity valuations in continental Europe remain reasonable. Concern is increasingly focused on the damage a declining US can do to the European recovery, than on whether that recovery can happen at all. Stock selection, therefore, is focused on companies that can take advantage of the latter (but do not depend on it) and insulate themselves, to some degree, against the former.
At the stock level, these investment opportunities include Bouygues, ABB, Hypo Real Estate and Numico. Bouygues, the French conglomerate, have shown their commitment to shareholder value; having avoided the '3G' licence debacle, but having invested heavily in their core businesses, the company is reaping the rewards from these investments. Crucially, so are the shareholders - as seen in the recent announcement of a special dividend.
ABB, the Swiss engineering company, displays the holy trinity of internal restructuring allied with cyclical and secular improvement. The latter follows from a sustained period of under investment in power infrastructure in most parts of the world - especially in Asia and China. This potential ramp-up in demand must benefit ABB, who are the world leaders in power infrastructure equipment with a 45% market share.
Hypo Real Estate (HRE), a German commercial property financier, is another strong internal restructuring story and long-term recovery play. Spun-off from HypoVereinsBank in October 2003, HRE is well capitalised, and the majority of its lending is to German government regions and commercial property owners at near break-even levels. Through aggressive restructuring it is reinvesting capital in more profitable markets where its core (rather than legacy) businesses lie. This will drive a significant improvement in returns that the shares are not discounting.
The recent second quarter results from Numico, the Dutch food producer that specialises in infant and clinical nutrition products, provided further evidence of the company's metamorphosis. Following the sale of GNC, the US vitamin retail chain, we remain convinced that this is a high quality business in a secular growth market - in a sector where all the major players are under pressure.
At the sector level, our biggest conviction is an underweight position in the IT sector, where valuations remain stretched and earnings momentum is slowing. Managers prefer the oils, construction and telecoms sectors. Oil companies are benefiting from record high oil prices, while construction companies continue to benefit from an improvement in both volumes and the pricing environment. Within the telecoms sector, our preference is for those companies that are committed to returning cash to shareholders, such as the Dutch company KPN.
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