For years now, European equities have struggled to keep pace with their US counterparts, but the historically low valuations on the ‘old continent’ mean we could be at an inflection point with investors beginning to take notice at long last.

European equities have attracted increased attention from investors in recent weeks as the US market has charged ever higher, leaving the valuations of global companies listed in Europe looking more attractive in comparison, and the STOXX Europe 600 index recently reached a record high.

Admittedly, the European economy faces headwinds including a weak industrial base and recession in Germany, but many of the STOXX Europe 600’s largest constituents are globally-facing businesses benefiting from broader trends ranging from healthcare spending to the advance of AI (artificial intelligence) and the rise of the emerging market consumer.

On 15 February 2024, Goldman Sachs hiked its 12-month target for the STOXX Europe 600 to 510, up from its previous forecast of 500, with the investment bank’s optimism reflected in cheaper valuations combined with anticipated improvements in the European economy.

CHAMPIONS OF EUROPE, WE KNOW WHAT WE ARE

European stocks do have some significant advantages including the fact that typically their revenues are more geographically diverse than those in the global market.

Europe also offers broader sector exposure than many other markets such as the US, where certain sectors disproportionately drive returns, notably mega-cap tech in recent times, and European companies also have an increasing culture of paying and sustaining dividends to shareholders.

In addition, investors shouldn’t forget the continent is home to some truly world-class companies, exemplified by Danish drugs champion Novo Nordisk (NOVO-B:CPH), whose shares have soared due to the success of its blockbuster weight-loss and diabetes drugs.

Meanwhile, Dutch semiconductor manufacturing equipment leader ASML (ASML:AMS) has established itself as a global champion, and Europe is also the stomping ground of some of the globe’s highest-quality luxury goods, consumer staples and industrial companies ranging from Louis Vuitton-to-Dior owner LVMH (MC:EPA) to cosmetics leader L’Oreal (OR:EPA) and Swedish tool and equipment star turn Atlas Copco (ATCO-A:STO).

Mark Denham, manager of the FP Carmignac European Leaders (BJHPXB2) fund, reminds Shares that Europe also has ‘two of the three world-leading wind turbine companies, Vestas (VWS:CPH) and Gamesa, part of Siemens Energy (ENR:ETR). And the only pure-play wind farm developer you can invest in is Danish company Orsted (ORSTED:CPH). Plus, there are some solar farm companies like Solaria (SLR:BME) in Spain.’

WHEN WILL EUROPE REGAIN ITS APPEAL?

Despite the strong recent market performance, Alexandra Dangoor, co-manager of investment trust BlackRock Greater Europe (BRGE), stresses that European equities still only trade at ‘around 13 times price-to-earnings on a one-year forward view, which is below their historic average and a 30% discount to US equities. Even on a sector-adjusted basis, we think Europe trades at close to a 20% discount.’

Part of the reason why European valuations have been more depressed near-term relates to concerns about recession and ‘given that Europe is an export-led market, this impacts sentiment towards the region more so’, explains the manager. But as 2024 progresses and activity picks up, Dangoor thinks there is room for Europe to re-rate.

‘The life science, semiconductor and chemical sectors should see the end of the de-stocking cycles, while industries which have suffered under higher interest rates, such as infrastructure, construction and some consumer areas, also have the potential to recover from here,’ points out Dangoor.

Longer term, the manager believes the composition of the European market has undergone change such that ‘given the long-term trends, earnings are better underpinned going forward which should lead to a re-rating over time.’

Marcel Stotzel, manager of the Fidelity European Fund (BFRT350) and Fidelity European Trust (FEV), says some of the reasons for Europe’s discount to the US make sense and others less so, with one key factor being Europe’s lack of the same high-growth tech names which dominate the US market.

‘Another reason for the discount is investor sentiment: asset allocators remain underweight the region and consequently European equities saw outflows for much of 2023, driving the relative valuation versus the US market to still lower levels,’ says Stotzel. ‘As a result, European equities are trading at discount levels not seen for decades. The extent of the valuation gap provides potential for this to start to close should sentiment turn.’

Investor sentiment is ‘overly gloomy’ because European companies are ‘incorrectly viewed as direct plays on the European macro environment’, argues Stotzel. ‘Less than one third of the revenue generated by European-listed stocks comes from within the Eurozone. Emerging markets and the US account for an almost equal proportion of sales - it is fair to label MSCI Europe a truly global index. Thus, while European macro has some storm clouds, this hasn’t held European stocks back from being good performers over the long term.’

Stotzel also stresses that Europe’s healthcare and technology sectors are growing and the continent is increasingly exposed to exciting future growth themes. ‘AI was one of the leading stories of 2023, but a lot of the hype was around US companies developing the large language models (LLMs), like OpenAI with ChatGPT, or providing the chips needed to run them’, he explains.

‘Meanwhile, Europe also has a group of companies which have been quietly using these emerging technologies to develop new products which are already benefiting their customers. They haven’t been getting the investor attention they deserve, as the focus is on US-listed companies at the forefront of developing the technologies rather than European companies that will be key AI beneficiaries.’

Hywel Franklin, head of European equities at Mirabaud Asset Management, tells Shares ‘there are plenty of European stocks which look stand-out cheap’ and considers it ‘a scandal that we are losing some of our best companies to other markets because of the advantageous valuations and conditions they feel they can find there. The best European companies can stack up against any companies globally and as more investors become acquainted with them, I am convinced the interest will only grow.’

Also chiming in is Charles-Henry Monchau, chief investment officer at Bank Syz, who believes a better earnings growth outlook is required to push European valuations higher. ‘As China is the biggest trade partner of Europe, an improving economic situation in China would help but it is not visible at this stage. In addition, a better domestic economy would help as well, in particular for smaller capitalisations as this segment of the market has not enjoyed much re-rating since 2022.’

WHICH STOCKS EXCITE THE EXPERTS?

FP Carmignac European Leaders manager Denham is palpably excited about Novo Nordisk, which he believes can continue to outperform because ‘the ongoing penetration of GLP-1 drugs in type-2 diabetes will carry on in the US and outside the US, plus of course with the obesity epidemic which is an even bigger one than diabetes, we think analysts are still scratching the surface of how big that opportunity could be in 10 years’ time.’

Fidelity’s Stotzel is bullish on underground and surface rock drilling leader Epiroc (EPI-A:STO), which operates in a duopoly with a strong competitive position and has an exciting growth outlook over the next 10 years. ‘The need for commodities is one industry we can be confident will continue to grow over the next decade and Epiroc should be able to capitalise on any commodity boom that results from themes such as electrification and growth of infrastructure,’ argues Stotzel.

Evenlode investment analyst Robert Strachan is a fan of German business Fuchs (FPE:ETR), which makes specialised industrial lubricants for use in niche applications and ‘occupies a sweet spot in the market, in between big oil companies that only bother with high-volume standardised products, and smaller niche players who struggle to compete on a global scale.’

‘A great company we hold is Switzerland-based Accelleron ACLN:SWX),’ adds Mirabaud’s Franklin. ‘It is a key player in improving the energy efficiency of marine transport, a notoriously hard to decarbonise sector. Not many investors have heard of it because it recently spun out of ABB (SWX:ABBN), but we see a business with great margins, stability and growth, a rare combination which typically leads to great value creation.’

WHY YOU SHOULDN’T FORGET SMALL CAPS AND THE TWO EUROPEAN FUNDS TO BUY RIGHT NOW

Darius McDermott, managing director at FundCalibre, sees the best value in European small caps, where many high-quality companies are trading below their intrinsic value. ‘As the economy recovers from recession, small-caps will have an edge over their larger counterparts as they can adapt quickly and efficiently to the changing economic conditions. Large-caps, on the other hand, are usually more sluggish in responding to such shifts and have taken longer to bounce back from past downturns.’

For tapping into a European small-cap recovery, McDermott highlights Janus Henderson European Smaller Companies (0747642) which has a valuation tilt and is ‘backed by a large and experienced investment team. This is a true stock-pickers fund where the managers are happy to invest across the entire universe to deliver returns.’

FP CARMIGNAC EUROPEAN LEADERS (BJHPXB2)

Price – 179p

Ongoing charge – 0.55%

Investors seeking a high-conviction, capital growth-focused fund with a socially responsible approach should buy FP Carmignac European Leaders (BJHPXB2).

Stock-picker Mark Denham follows a selective bottom-up investment process to find quality companies with attractive long-term prospects which can grow under their own steam, irrespective of the macroeconomic environment. The process also includes negative screening, ESG criteria integration, and a low carbon emission approach.

Falling interest rates would be a tailwind for Carmignac European Leaders, able to invest up to 8% of its assets in biotech stocks. Top holdings include Novo Nordisk, ASML and German software giant SAP (SAP:ETR).

Denham has recently initiated positions in French luxury goods group Hermes (RMS:EPA) and enterprise software play Temenos (TEMN:SWX). The fund also offers exposure to Argenx (ARGX:EBR), a biotech firm which engineers therapies for rare diseases, and Lonza (LONN:SWX), a contract drug manufacturer bouncing back after a disappointing 2023.

FIDELITY EUROPEAN TRUST (FEV)

Price – 367.5p

Discount to NAV – 8.1%

Ongoing charge – 0.78%

An 8.1% discount to NAV (net asset value) on Fidelity European Trust (FEV) presents a compelling entry point for investors seeking a cornerstone fund for European exposure across market cycles.

Managed by Sam Morse and Marcel Stotzel, Fidelity European seeks to achieve long-term growth in capital and income by investing across countries and sectors, with the managers focused on attractively-valued companies with good prospects for cash generation which can grow their dividends consistently, irrespective of the economic environment.

Names passing muster range from Novo Nordisk and Nestle [NESN:SWX) to ASML, French energy and petroleum powerhouse TotalEnergies (EPA:TTE) and Swiss pharmaceuticals giant Roche (ROG:SWX).

The best 10-year share price total return performer in the AIC (Association of Investment Companies) Europe sector with a 206.5% haul, slightly ahead of Blackrock Greater Europe’s similarly impressive 193% return, Fidelity European carries competitive ongoing charges  of 0.78%.

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