Europe continues to give investors a real conundrum. It looks cheap but could get considerably cheaper if events take a turn for the worse. Looking at figures from the Investment Management Association, it seems private investors have already made up their minds. This sector has seen the largest redemptions this year, though ironically it has also been one of the best sectors to be in since June rising by 19 per cent. It has been led by the rebound in bank shares as well as the Spanish and Italian markets – areas previously the most depressed by political and economic concerns.
Has anything fundamentally changed though? Barry Norris, manager of the Argonaut European Alpha Fund doesn’t think so. He refers to many stocks in the troubled European banking sector as “zombie equity”. He believes it will take many years for them to repair their balance sheets sufficiently to return to a reasonable level of growth.
Whilst many analysts anticipate a rebound in profits across the European financial sector in 2013 as bad debts dry up, Barry Norris believes this is highly optimistic. A year ago, the estimated earnings growth for banks in 2012 was 22 per cent, but it is now minus 19 per cent. Today, estimated earnings growth for 2013 has risen again to 28 per cent – hence the near 40 per cent rebound in certain banking stocks from the middle of this year. The pattern looks all too familiar, and Barry Norris believes hopes will be dashed once more. Each new announcement from politicians tends to get the market excited, at least for a while, but he believes the ECB has done nothing towards stimulating economic growth. Non-performing loans are not showing any improvement in the periphery, and while the ECB has promised to buy Spanish short term sovereign debt, he believes this will be difficult in practice. Spain will need to promise further cuts to spending – no easy task when the population is already protesting against austerity.
The fund has had almost no exposure to Spain and Italy for almost four years and contains no bank stocks. Barry Norris is only interested in buying into areas with healthy earnings growth potential. Germany, for, example, has been far more resilient. Yet this emphasis on quality has seen the fund underperform in recent months as the “zombies” (as they have a tendency to do) returned to life.
Looking at the portfolio I see no reason to be down heartened by this relative underperformance. It is full of good-quality stocks with real growth potential regardless of the economic and political situation in Europe. The fund’s current top holding is Nestlé. It trades on a price-to-earnings ratio of 16, which may seem a bit steep, but it is yielding 3.6 per cent and has not cut its dividend in 53 years. If it continues to compound its dividend as Barry Norris expects, its average yield over the next ten years could be 7.5 per cent. What has been transformational for Nestlé is its cost of borrowing. This has fallen to historic lows whilst sales volumes have grown at 5 per cent and margins have also increased.
Barry Norris sees two distinct asset classes in Europe: lower risk “nifty fifty” equities like Nestlé, and the zombie equity – the banking sector and domestically-focused companies operating in low-growth sectors. During periods when better sentiment dominates, the zombies rise and the fund will tend to underperform. Yet Barry Norris believes it is a risky game owning these companies unless the economic cycle really does turn, and I’m inclined to agree. In the prevailing environment these riskier assets could lead to disappointment, whereas owning world-class international companies with good visibility of earnings should be an excellent long-term strategy.
Despite a disappointing year so far the fund’s performance has been good since launch in May 2005, up 94 per cent against a sector average of 52 per cent. I suspect few people can be tempted into investment in European equities, but the truth is you don’t tend to make money buying equities when all the news is good. Patience and courage is required during the darker times; a regular investment strategy of placing money gradually into an area usually works well as it removes emotions from the equation.
Mark Dampier is head of research at Hargreaves Lansdown