A rose among thorns

Lynn Strongin Dodds discovers that there are some stocks worth backing in an otherwise questionable European equities space

Against the broad investment picture, European equities do not look that enticing. Performance has been weak and the economic outlook is murky thanks to the global malaise. As with any downturn, though, opportunities are lurking but pension funds are advised to be more discerning than they once were as they navigate their way through the continental landscape.

Not surprisingly, the subprime crisis is the main culprit. Although the Eurozone has not been as badly affected as the US, the fallout of the credit crunch, coupled with a strong Euro and soaring commodity prices is taking its toll. There are also concerns over how European corporate earnings, already downgraded, will weather rising inflation, a weak US dollar and patchy consumer confidence across the region.

As recently as November 2007, the European Commission was forecasting a relatively healthy growth rate of 2.2 per cent but now it is more likely to be an anaemic 1.7 per cent, a sharp drop from the 2.6 per cent hike in 2006.
By contrast, economists expect the US to eke out an annualised growth rate of just 0.2 per cent this year. Ironically the country’s stock markets, albeit depressed, have fared better than their European counterparts. The first quarter
of 2008 was dire for equities, but Europe distinguished itself as being one of the poorest performers. The MSCI Europe index was down 14.5 per cent in the first three months followed by the FTSE 100 which was off 12 per
cent. The S&P 500, along with the MSCI emerging market index, shed almost ten per cent.

One reason for the dismal showing is that the main European indices have their fair share of financial stocks. Banks represent 20 per cent of the market and they have taken a beating in the post credit crunch environment. The other factor is that historically Europe tends to overreact in terms of price movements, according to Rajesh Shant, manager of Newton Investment Management’s European higher income funds. “Unlike in other countries, European companies are still dominated by large family holdings and there is a smaller percentage of free float held by pension funds. As a result, the market experiences bigger swings so, for example, in the period between 2004 and 2007, the MSCI Europe outperformed the UK, US and Japan benchmark indices. It is the same type of behaviour when the market is falling.”
In addition, Patrick Seth, head of institutional sales at JO Hambro, notes that the US is still seen as a safe haven. “Despite being at the epicentre of the credit crunch, many investors are attracted by the depth and breadth of the market. Also the government has been actively addressing the problems there.”

This is not the perception on the continent where the European Central Bank (ECB), unlike the US Federal Reserve, is much more focused on dampening inflation. The ECB held rates at four per cent whereas the Fed has consistently whittled down rates to their current two per cent from 5.25 per cent last summer. Both central banks, however, have joined forces to inject massive doses of liquidity into the monetary system to ease the continuing credit drought. In April, bi-weekly auctions by the Fed and ECB raised $75bn and $25bn, respectively.

Despite the volatility, European pension funds have not lost their appetite for equities both on their home ground and overseas. In fact, a recent Mercer Investment Consulting survey showed that the average allocation was 50 per cent in 2008, up from 42 per cent at the start of 2007. By contrast, UK funds reduced their exposure to 58 per cent this year compared with 61 per cent in 2007 and 68 per cent in 2003. Overall, European institutions view equities as better value than bonds, and in this increasingly liability driven world, pension funds are looking at higher return investments.
Richard Lacaille, head of global active equity at State Street Global Advisers, says: “There has been a new wave of thinking in Europe with liabilities as the starting point for asset allocation. This has meant a shift away from equities to alternative asset classes such as real estate, private equity and hedge funds. Equities, though, play an important role in a diversified portfolio and they offer good long term returns on a risk adjusted basis. European equities are attractive but investors need to be careful about how much financial risk they are willing to take.”

Newton’s Shant also stresses the diversification benefits of including European equities in a portfolio. Overall, he believes that Europe’s blue caps, which have been lagging behind, will be one of the main benefactors of the credit crunch. Companies with strong balance sheets, cash flows and earnings are well positioned to exploit the weaknesses of their smaller colleagues. Favourite sectors include oil services, pharmaceuticals and medical technology sectors.

“Europe is not one homogeneous market but upwards of 16 heterogeneous stock markets with their own cultures and investment opportunities. There are also unique stories that do not exist in other countries. Take Nokia. It is the only company that has consistently made money out of mobile handsets,” he adds.

Juliet Cohn, fund manager of Principal Global Investment Funds’ European Equity Fund, also stresses that pension funds should not tar an entire sector with the same brush. “In some cases, we have seen investors throwing the baby out with the bathwater. For example, the disappointing results from Michelin, the tyre manufacturer, brought the entire sector down, but the Finnish company, Nokian Renkaat, has a good fundamental story to tell. It is aggressively expanding in Russia and benefiting from strong demand for winter tyres and low production costs. When it announced its results, its share price rose but investors might have missed out if they had been underweight the sector.”

James Buckley, who manages the Baring European Growth Fund, is keen on materials and agro-chemicals. “The first quarter was the worst since records began and I do not think the next quarter will be as bad. That does not mean that we have reached the bottom but there are decent values in terms of price/earnings ratios and dividend yields which would suit a pension fund with a longer term horizon. We like sectors which benefit from the emerging market economic growth story and are not dependent on consumer spending.”

Mark Lovett, co-chief investment officer Europe at RCM, the asset-management unit of German insurance giant Allianz, is keen on the brand name, luxury good, companies which have a high concentration in Europe. The domestic consumers may be watching their purses, but the fast growing middle classes in developing countries in emerging Europe, Asia and the Middle East cannot buy these designer products fast enough. Their tastes, though, are just as discerning and it is likely that those high-end brands with that certain cache such as Chanel, Gucci, Prada, LVMH, and Richemont will do better than the more accessible names.

“What we are looking for are long term structural stories which are hard to replicate on a global basis.
If you wind the clock back to the 1950s and 1960s, Japan and Korea experienced similar infrastructure growth which was then followed by increased consumption including spending on luxury and branded goods. We are now seeing the same type of cyclical growth in countries such as China and India which should be a powerful positive for luxury goods companies in Europe.”

Other themes that fund managers are capitalising on are renewable energy such as solar and wind turbine companies as well as mining companies which are benefiting from the large infrastructure spend in China and India. Commodity
plays are also popular due to rising prices while views are mixed on financials. One of the big questions in the marketplace now is whether the floor has been reached for financial stocks.

Karen Olney, chief European equities strategist at Merrill Lynch, notes: “We are neutral on financial stocks even though it is the fourth cheapest sector. The shock factor is gone but I think there could be more bad news out there. Now the banks have to face up to everyday issues of a downturn and their ability to generate earnings growth.

We do like insurance companies, though, because they have fallen to 2003-like valuation levels (a period of desperate rights issues), yet they have stronger balance sheets than in 2003 versus the banks and tend to do better in an inflationary environment.”

Written by Lynn Strongin Dodds, a freelance journalist