Ignore all the buzz about US markets surging away and businesses enjoying a boost from lower tax rates. We think Continental Europe is a better opportunity and one that is still underappreciated by many investors.

Why do we like Europe? Economic conditions are good, companies are finally enjoying decent earnings growth, politics aren’t getting in the way and equity valuations aren’t overly expensive.

In contrast, there are growing concerns about strong inflation in the US and a lack of faith in President Donald Trump which could cause US markets to wobble. US equity valuations are also very high in many sectors, plus we feel there is too much excitement in general about US markets.

Bank of America Merrill Lynch says there is ‘little evidence of euphoria on EU equities despite froth elsewhere’. It says booming macro data and improving profit margins underpin a recovery in earnings per share growth for European-listed companies.

IT CAN’T ALL BE GOOD, CAN IT?

It is important to stress this article and its comments are only about Continental Europe and do not include the UK.

Before we explain in more detail why European equities are a great place for your money at present, it is important to note one negative to the story.

The euro has become much stronger versus the US dollar since December 2017 which presents a headwind for European companies which export goods.

However, many observers comment that global growth is more important to European equities. You also have to consider that many European manufacturers incur costs and revenue abroad, providing a hedge for the currency impact.

‘Yes, the euro strength has some minor implications for some exporters at the edge. But far more important is the improving global outlook. The bigger picture is so strong that a higher euro is not a concern at the moment,’ says Jake Robbins, fund manager at Premier Global Alpha Growth Fund (GB00B6740K61).

‘Businesses in Europe were previously hit by excess capacity and no pricing power. They’re now seeing better demand. Old economy industries like manufacturers are seeing margin improvement and higher sales,’ he comments.

‘We’re entering into a new phase for European markets in 2018,’ adds Old Mutual fund manager Ian Ormiston. ‘It looks like we will see faster GDP growth than 2017 which leads us to be more optimistic about European equities.

‘Higher GDP growth equals higher earnings growth which should be the driver of the markets.’

FIVE REASONS TO BE BULLISH

1. Economic strength

The International Monetary Fund last week upgraded its forecasts for global economic activity in 2018 and 2019, lifting both years by 0.2 percentage point to 3.9%. It also raised expectations for 2017 by 0.1 percentage point to 3.7%, noting particular strength from Europe and Asia.

The key message is that the global recovery has strengthened. The euro area will grow by 2.2% in 2018, according to IMF forecasts. That’s quite impressive when compared against expectations for growth in Japan (1.2%), UK (1.5%) and Russia (1.7%).

Eurozone consumer confidence climbed to a near-record high in January. A flash estimate from the European Commission showed the index rose from 0.8 in December to 1.3 in January.

Businesses are also in a chirpy mood. IHS Markit’s flash composite purchasing managers’ index (PMI) for the eurozone stood at 58.6 in January, its highest level since June 2006. Anything above 50 indicates growth.

2. Earnings growth

Last year was a major turning point for corporate earnings among companies in Continental Europe. Growth started to come through – and the trend is continuing as 2018 gets underway.

‘For six years to 2016, markets started each year optimistic for 10% to 12% earnings growth for European stocks. As each year progressed, growth was revised down to zero or even negative,’ says Tim Stevenson, director of pan-European equities at asset manager Janus Henderson Investors.

‘Last year started with expectations for 10% growth and it got better as the year went on. Estimates suggest we actually got 12% for 2017. Projections for 2018 are still holding up at 10% to 12% earnings growth,’ he adds.

Ian Ormiston at Old Mutual says he wouldn’t be surprised to see low to mid-teens growth for both small and large cap stocks in Europe this year.

Equity ratings should, in theory, move in tandem with earnings per share movements – so you could deduce that investing in a Europe (ex-UK) fund could deliver a return in the region of 10% or more in 2018.

Just before Christmas investment bank Jefferies analysed 2018 market forecasts for an index of stocks across the main eurozone countries and says financial sector earnings were expected to grow by just under 12%; industrials by 13.5%; and telecoms by just over 23%, among others.

Dylan Ball, a portfolio manager at Templeton Global Equity, says earnings at European companies as at 30 September 2017 were just over half of their prior peak, ‘providing ample room for catch-up’.

‘Unlike the United States, where corporate profits have already surpassed their pre-financial crisis peaks, European corporate earnings have lagged,’ he comments. ‘A decade of extraordinary central bank policy support will begin to end in 2018, but a favourable economic environment and improving corporate fundamentals could allow European stocks to play further catch-up with US equities.’

3. Inexpensive equity valuations

European equities are trading on 15 times forward earnings versus a long-run average of 13 times. In comparison, US markets are trading
on approximately 19 times forward earnings.

The long-run average for the S&P 500 index is around 15 times – illustrating how US equities are trading on a bigger premium versus Europe.

European markets can’t be called cheap but they certainly cannot be called expensive when you consider the earnings growth story is in
full swing.

4. Political concerns have eased considerably

A year ago the market was concerned about the potential outcome of various elections in Europe, principally ones in France, Germany and the Netherlands.

The French election result was deemed positive with the centrist party of Emmanuel Macron beating the Marine Le Pen-led far-right party.

‘Macron is definitely a positive for France,’ says Olly Russ, manager of Liontrust European Income Fund (GB00BD2WZ105). ‘Basic tax reforms are a step in the right direction. You can make the case for France to enjoy a better time over the next decade than over the last one.’

There was relief as the mainstream triumphed in the Netherlands election as Mark Rutte’s centre-right party beat the anti-immigration party of Geert Wilders.

German Chancellor Angela Merkel won a fourth term in September 2017 but had still to form a collation government at the time of writing this article.

Going into 2018, the only major election in Europe is Italy and observers don’t believe that event will have a major impact on the direction of European stock markets.

Catalonia is perhaps the one issue that still presents itself as a potential risk to Europe in 2018. Catalonia’s drive for independence has plunged Spain into its biggest political crisis for 50 years. It is being watched nervously by other European states with strong nationalist movements.

5. Monetary policy

The European Central Bank (ECB) will begin a moderate withdrawal of monetary stimulus in September 2018. It has previously said it would extend quantitative easing (QE) beyond this date, or even raise the level of monthly purchases from €30bn, should conditions worsen again. It also said it would keep interest rates low until well past the end of QE.

Some analysts believe the ECB will revise up its economic forecasts at a meeting on 8 March and then use that to justify a change to its forward guidance around QE.

‘The overall monetary policy stance is likely to stay accommodative for the foreseeable future, as the ECB balance sheet is going to stay very large for another decade; extensive amounts of excess liquidity imply that the deposit rate is likely to stay the de-facto policy rate for years to come,’ says investment bank UBS.

It forecasts the first deposit rate hike will happen in July 2019, moving from -0.4% to -0.2%. It sees another hike from -0.2% to zero in September 2019.

‘Eurozone banks should benefit if the ECB’s emergency measures start to come off. Deposit rates moving from negative to zero would have a big positive effect on banks,’ says Old Mutual’s Ian Ormiston.

FOLLOWING A SIMILAR PATTERN?

Stevenson at Janus Henderson believes the ECB is following a pattern that resembles the actions taken by the US approximately 18 to 24 months ago.

‘As the economy grows, you have to start scaling back QE,’ he says. ‘There is still significant bond buying from the ECB. But 2018 could see less bond buying than issuance. This will be the first time there is net supply in 10 years. There was a negative yield on the 10-year German bond in 2016; now there is a positive rate at 0.6%.

‘Do you sell equities now the bond market has turned? We expect the 10-year bond to go to 0.8% by the end of 2018.’

Stevenson doesn’t see rising bond yields as a headwind for equities. He believes a company is a far better investment in a low inflation world than a bond. ‘Leading companies will have pricing power; whereas you can’t say “I want a higher yield” with a bond,’ he comments.

SEVEN FUNDS AND INVESTMENT TRUSTS TO PLAY EUROPE

1. MID AND LARGE CAPS: HENDERSON EUROTRUST (HNE)

Henderson EuroTrust has achieved 14% compound annual growth over the last 25 years. ‘Today in a lower growth, lower inflation world, it is misleading to think you can compound 14% over another 25 years. It is more realistic to drive for 10%,’ says fund manager Tim Stevenson.

‘If we can find a company that grows sales by 5% a year; if it is cash generative then there is a good chance it can add 2% a year through acquisitions. SGS and Sodexo are doing this. That gives you 7% annual sales growth.

‘You can lift this to 8% through small operational improvements,’ adds Stevenson. ‘It isn’t radical to suggest you can get 2% yield from these companies. If you make an unrealistic assumption that markets are valued the same in 12 months as they are now, then you’d make 10% total return.’

The investment trust’s holdings include industrial conglomerate Siemens as the fund manager thinks Germany will spend more money on infrastructure and Siemens will be one of the beneficiaries. Elsewhere, it has a position in Legrand which is an efficient lighting systems business with very good growth, according to Stevenson.

It has also a long-held stake in Deutsche Post which the fund manager describes as one of the world’s foremost logistics companies. He adds: ‘German parcel growth is phenomenal and Deutsche Post-owned DHL has a 45%+ market share in Asia.’

2. MID AND LARGE CAPS: SCHRODER EUROPEAN (GB00B76V8C37)

Healthcare, technology, consumer goods, industrials and financials are key focal points for the Schroder fund which is predominantly weighted towards large cap stocks. Main holdings include pharma-to-agricultural expert Bayer, automotive giant Porsche and private banking group Julius Baer.

Financial data and research group Morningstar says it likes fund manager Martin Skanberg’s measured approach to investing. ‘We believe that under his management, investors seeking core continental European equity exposure are in safe hands with Schroder European.’

The fund manager is style-agnostic, ‘assessing each investment opportunity in terms of an inflection-point thesis (with a focus on a company’s growth, margins, and returns), implied market valuation, and share price behaviour,’ says Morningstar.

‘Performance has generally been steady on a calendar-year basis, which is in line with our expectations of a manager who is style-agnostic but willing to take risks,’ it adds.

3. MID AND LARGE CAPS: FIDELITY EUROPEAN VALUES (FEV)

This investment trust markets itself as the ‘cornerstone long-term investment of choice’ for investors seeking European exposure across market cycles. It has a fairly concentrated portfolio of between 50 to 60 stocks with no bias to a particular sector or company size – however its current portfolio is dominated by mid and large caps.

Holdings include food group Nestle, drugs company Roche and oil and gas producer Total. The investment style is to seek growth at a reasonable price.

4. SMALL CAPS: OLD MUTUAL EUROPE (EX UK) SMALLER COMPANIES FUND (IE00BRTNQ884)

This fund seeks to achieve long term capital growth through investing in European (ex UK) small cap stocks. Its portfolio includes stakes in brick maker Wienerberger, semiconductor foundries group X-Fab Silicon Foundries and education provider Academedia.

‘We recently bought Barco, the Belgian world leader in cinema projectors,’ says fund manager Ian Ormiston. ‘There is massive growth coming from China in projector demand. And in Europe, it’s about making the customers’ life easier. Barco can replace old fashioned light bulbs with laser lights which are brighter and save customers money.’

On the global growth theme, the fund has a stake in Cargotec. It owns Hiab which is the global market leader in on-road load handling. Cargotec also owns Kalmar which is a play on ports automation where the industry is seeking to replace expensive workers with robotic systems. ‘Cargotec is a self-help story with restructuring and a business on verge of taking off in the field of automation,’ says Ormiston.

5. SMALL CAPS: JPMORGAN EUROPEAN SMALLER COMPANIES TRUST (JESC)

This investment trust focuses on smaller European companies. It aims to invest in both undervalued companies and growth companies in a bid to achieve strong returns.

Healthcare, tech and financial sectors feature heavily in its portfolio. The top holding is Amplifon, an Italian hearing services group. The investment trust’s other holdings include Netherlands-based chemicals provider IMCD, French IT consultant Sopra Steria and Italian financial services group FinecoBank.

6. OTHER FUNDS: ARTEMIS EUROPEAN OPPORTUNITIES FUND (GB00B6WFCR53)

‘We like to pick resilient quality franchises which have been (in our view) unfairly de-rated by a sometimes myopic market,’ says co-fund manager Laurent Millet. ‘Investors seem to be obsessed by short-term earnings growth and are prompted to sell stocks without “momentum”.’

Millet says two stocks currently fit this description in the Artemis fund; it has either bought or added to them both in 2017.

The first is Intrum, a European leader in collecting non-performing loans (both for its own purchased debt as well as for third parties); with sales almost double its nearest competitor. Investors have been worried about the costs of integration for a recent large acquisition. Millet is convinced the company will continue to grow its earnings per share by nearly 15% a year in the foreseeable future.

The second is life sciences group Bayer. ‘Its price is still 15% below its peak in the summer of 2017, when it announced its takeover of Monsanto. We purchased our holding after the share price fell. A final decision on the merger is expected in the first quarter and should provide investors with visibility,’ says Millet.

‘If the merger is rejected, we see no reason for the decline from the summer peak. If the merger is accepted, then the company will be able to end the uncertainty around the financing of the deal. Moreover, the combination makes strategic sense: Bayer would benefit from the historically low cost of debt and the synergies should be substantial. If the merger goes through, Bayer should be a more balanced and focused company than in the past.’

7. OTHER FUNDS: FP CRUX EUROPEAN SPECIAL SITUATIONS (GB00BTJRQ064)

Crux’s fund is run by veteran European manager Richard Pease who has been successfully investing in the region for over 30 years. He focuses on companies that have exceptional management
and a market leading position combined with a strong financial position.

These companies should be in a position to generate excess cash which can be reinvested to accelerate growth or returned to shareholders through dividends.

Current holdings include real estate group Aroundtown, information services business Wolters Kluwer and testing expert Bureau Veritas.

DISCLAIMER: The author owns shares in Henderson EuroTrust.

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