Is there value left in Europe and, if so, where?

Morris-Eyton-MarcusBy Marcus Morris-Eyton

Having been out of favour for a number of years, European equities are finally seeing the return of investors. However, with Europe having outperformed the S&P 500 by 6.3 per cent in US dollar terms for the year to date (as of 13/06/2017), how much outperformance potential is left?

To answer this question one needs to understand the depth of the underperformance over the past decade; with MSCI Europe having underperformed the S&P 500 by around 80 per cent in US dollar terms since June 2007. Europe, due to a combination of the market structure and the austerity agenda, has lagged the US in terms of its economic recovery, and remains arguably 18-24 months behind the US in the cycle, as highlighted by the divergence in recent data. This is evident in the delta between both regions’ profit margins, earnings and ultimately valuation multiples, where European corporates trade significantly below US peers.

In recent years, European politics and the well-documented rise of populism have understandably deterred many international investors, leaving the region under-owned globally. We have always argued that the impact of domestic politics on underlying corporates is often overstated by investors, particularly when investing in companies with secure business models and strong pricing power. However, the magnitude of inflows Europe has seen since the election of Emmanuel Macron in France has reinforced that, while politics rarely alters the course of Europe’s best-positioned companies, it clearly influences global investor sentiment. It is, therefore, welcome to see political risk subsiding, but we urge investors to remain cognisant of the Italian political situation.

Of far greater importance to bottom-up investors is the cyclical recovery that Europe is currently seeing. In Europe, we have just come through the best quarterly earnings results season for seven years, with 11 out of 12 sectors beating consensus expectations. Significantly, unlike in previous quarters, these wins were broad based, with revenue also surprising on the upside, rather than companies simply cost cutting. For the first time since 2011, we are now seeing more European companies’ earnings expectations upgraded than downgraded, with the earnings revision ratio standing at 1.18. This provides encouragement, but also raises the bar from which companies must now over-deliver, particularly as certain base effects wane.

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