The corporate face of continental Europe has changed over the past 15 years. Not so long ago, European companies had a reputation for treating shareholders with a Gallic shrug of disdain. Dividend policies varied a little from country to country because of tax treatments, but returning cash to shareholders was generally not a priority. Meanwhile, political interference was unhelpful and anti-competitive, with trade unions still powerful.
Fast forward to 2009, and the story has changed. Many senior executives have been trained in American business schools, and attitudes to shareholders and corporate governance are almost identical to those in Britain. The evolution of the European Union has promoted free markets, free trade and competition. Indeed, the European Commission has both more power and, curiously, more will to implement free and fair trade and competition across Europe than any member state in isolation.
In summary, companies in continental Europe are just like British companies. They are under the same regulations and accounting principles, they place the same importance on generating free cash flow, and they have the same attitude to returning cash to shareholders through dividends or buybacks.
The value of an investment is usually considered to be the net present value of future cash flows. For a bond, these cash flows are the coupon payments and the eventual return of principal. For a stockmarket company, the future cash flows are dividend payments: without these, it is difficult to attribute a value to a company.
Stocks with a high dividend yield generally fall into the category of “value” stocks, and it is accepted that value stocks outperform in the longer term.
Dividends are also usually much more stable than earnings; in Europe earnings can fall by as much as 50% before there is a substantial impact on dividend payments. A steady or growing income stream can provide some compensation for the volatility and potential falls in capital value that come with equity investing.
British investors have long been aware of the appeal of equity income investing, and British equity income funds form the backbone of many successful portfolios. However, savvy investors have started looking to apply the same investment discipline to overseas investments.
This process has been accelerated by the diversification benefits of overseas equities and income, given the concentration of yield in just the top 10 British stocks. Also, with most investors having massive exposure to Britain (their homes, their jobs and typically their liquid assets) it makes sense to move at least a small portion of their investment abroad.
So continental Europe has become just like Britain as a place to invest, and high-yielding stocks have always tended to outperform. It is therefore unsurprising that British investors see the potential to diversify their exposure into European equity income. This refocus of the hunt for returns is typical of the more sophisticated British investor picking up early on positive trends in continental Europe.
In the long term, continental Europe is perhaps a better destination for equity income investing than Britain. This is largely because there is a more diverse range of high-yielding stocks. In fact, 58% of total British income derives from the top 10 yielding stocks – compared with just 27% across the Channel, according to Société Générale.
This means that British equity income portfolios tend to be concentrated, and there is often little difference between one fund’s holdings and the next.
In continental Europe there are about three times as many high yield stocks as in Britain. Importantly, these are spread over a broader range of sectors and geographies. Consider the telecommunications sector: in Britain there are just two or three stocks for an income manager to choose from, while in Europe there are 19, almost all outperforming BT.
As well as the long-term advantages offered by the more diverse continental European market, there are other factors attracting British investors. Corporate balance sheets look robust, with a fifth of European companies having no debt or net cash. This will support dividends if top line earnings fall.
Apart from a handful of megacap stocks, the British market looks geared by comparison. Continental European stockmarkets also look cheap on many measures, with the dividend yield well above German bund yields – traditionally seen as a long-term buy signal. Price/earnings ratios are in bargain territory, consistent with excellent long-term returns.
The other factor driving income investors towards continental European equities is the attractive yield; the broader European market is yielding more than Britain’s for the first time in a generation. That yield of about 6% is appealing compared with the alternatives: cash is offering a negative real yield and government bonds little more. According to Warren Buffett, the bubble in government bonds may eventually appear as extraordinary as the internet bubble of the late 1990s.
Corporate bonds offer a reasonable yield, but default rates are rising and, given that there is no longer a proper secondary market, they are almost impossible to value fairly. That leaves investors with yielding equities; British income funds are looking less attractive, given the uniquely poor economic outlook of Britain and its financials.
We have looked at two distinct trends. The first is the growing number of investors who recognise that continental Europe is a great place to go for equity income. This trend is important, and will grow further from here.
But perhaps a far more important trend is the underlying improvement in Europe as a place to invest. It would have been almost impossible to run a viable income fund in Europe 15 years ago. Today, continental Europe is the premium destination for equity income investors, and home to some of the world’s leading companies. Europe has changed, and should now be considered just as important a part of portfolios as Britain and America.