European markets have been very challenging, beset by worries of sovereign debt, social unrest due to austerity measures in Greece, France and Spain, and, most of all, sluggish economic growth. Although some European equity fund managers are optimistic and see good stock-picking opportunities, others are less encouraged and have become increasingly defensive.

One of those in the latter camp is Paul Musson, lead manager of Mackenzie Ivy European Class, and senior vice president with Toronto-based Mackenzie Financial Corp. “There is more macroeconomic risk than there has been in a long time,” says Musson, who shares duties with associate manager Matt Moody.

Europe, says Musson, like the U.S., is suffering from excessive debt accumulation and social and retirement programs that are too expensive to sustain.

“Change needs to happen,” he says. “You can raise the retirement age or reduce benefits or increase contributions or some combination. But none of these things are very palatable.”

Over the longer term, Musson believes, gross domestic product growth in developed countries will be slower than that experienced during the past few years. This has had an impact on the Mackenzie fund’s portfolio, which used to have a balanced approach that split the fund’s assets under management between cyclical and defensive holdings.

“But over the years, we became more concerned. And that is reflected in the valuation models of each of our businesses,” says Musson, noting that slowing GDP growth will affect assumptions about a company’s top and bottom lines.

By way of example, Musson points to CRH PLC, an Ireland-based building materials firm that has large exposure to the Irish and U.S. housing markets. “It’s a fine business,” he says, “but we had concerns that the housing market was going crazy and things could get ugly in the U.S.”

After Musson and Moody plugged CRH into their valuation model, they concluded the stock was expensive and sold the fund’s position in 2006.

Today, the Mackenzie fund has 25% of its AUM in cash, compared with 17% a year ago. “We look at sovereign debt levels and changes in social problems that need to happen,” says Musson. “There’s nothing out there that makes us feel that global economies will be humming over the next five to 10 years.”

This heavy cash weighting is not a top-down view, however. It is a byproduct of the stock-picking process, which has created a fund of about 20 names. “Because of what’s happened in the stock market and valuations,” says Moody, “we have trimmed some of our holdings. We have identified some cyclical names that we would love to own, but they are not there. The valuations don’t justify holding them.”

With a bias for companies with strong balance sheets and free cash-flow yields that can sustain them through tough times, Musson and Moody favour Nestlé SA. “It’s a well-run business with great brands, and it is fairly resistant to economic downturns,” says Moody, adding that the Switzerland-based packaged foods firm has seen its operating earnings per share grow by around 10% a year since December 2005.

“Because we believe [its] earnings could continue to chug along if times got rough — compared with CRH — we have ended up with a fairly heavy weighting. We believe the valuation is attractive,” he says, adding that the free cash-flow yield is around 5%.

Nestlé stock trades at about 52.3 Swiss francs ($54.90), or 20.5 times trailing earnings.

Another favourite is England-based William Morrison Super-markets PLC. Its stock was previously in the Mackenzie fund, but the holding was sold in 2005 when the firm accumulated a lot of debt to acquire a larger competitor. A year ago, Musson and Moody returned to the stock after Morrison had restructured and gained market share by using its strengths as a vertically integrated operation.

Morrison shares, which have a 2.8% dividend yield, are trading at about 300 pence ($4.85) each.



Equally Cautious Is Ian Scullion, manager of CIBC Eu-ro-pean Equity Fund and vice president and head of the Eu-rope/Asia/Far East team at To-ronto-based CIBC Global Asset Management Inc.in Montreal.

“The world is still pretty difficult. Consumers are not back,” says Scullion. “You will have small blips of better economic figures from time to time. But at the end of the day, growth will be pretty anemic. That’s the message we’re getting from our global companies.”

He adds that there are pockets of strength in Asia and emerging markets, but he believes overall global growth will not return for some time to levels reached before the 2008 financial crisis. By way of example, he turns to the health-care sector, which should be growing because of the aging populations in Europe. However, governments are constrained fiscally, putting pressure on companies and reducing their pricing power.@page_break@“These companies are still growing. But we have to reset the growth parameters and growth profiles going forward,” says Scullion, adding that many firms are slashing their expectations of top-line growth for the next two or three years. “A lot of water has to flow under the bridge before things get better.”

Although governments are hobbled by high debts and costly social programs, corporations have been gaining ground by cutting costs and squeezing suppliers. Still, volume growth is difficult to achieve, says Scullion: “Companies that used to grow by 7%-8% [on their] top line, are now growing by 2%-3%, although they are still delivering at the bottom-line [earnings] level. It’s going to be a slow-moving beast. We’ll have little blips as we move along, but then it will creep down again; it will be volatile.”

As a bottom-up investor, Scullion is upbeat about consumer non-durable companies that will continue to deliver strong earnings: “They have very strong business models with huge capacity advantages, so they can gain lots of market share over the weaker players. They are using this environment to prop up their operations.”

One longtime holding in the 45-name CIBC fund is Essilor International SA. The France-based firm is the world’s largest maker of plastic and glass ophthalmic lenses. Says Scullion: “It [has] been delivering 6%-7% revenue growth and 11%-12% operating earnings growth for the past 30 years. Nobody can catch up to these guys. There’s lot of growth.”

Scullion adds that Essilor is benefiting from the 30% of its global sales that come from emerging markets.

Essilor stock is trading at about 50 euros ($70.30).

Another favourite is Schneider Electric SA, a France-based global supplier of electric breakers, programmable logic controllers and power conversion equipment. Says Scullion: “The company is leveraging the electrification of emerging markets, but also helping to upgrade the grid in the U.S., which needs to invest massively.”

Schneider stock is trading at about 97 euros ($136.40).



A More Upbeat View Comes from Simone Loke, manager of TD European Growth Fund and vice president at Toronto-based TD Asset Management Inc.

“A lot of governments are bringing in austerity measures. And the private sector is deleveraging, which will continue into next year,” says Loke. “But we are not seeing a double dip. A lot of leading indicators are expansionary, although [economic growth] is slower than before.”

Referring to the European purchasing managers index, Loke notes that a rating above 50 is expansionary: “Depending on the country, we’re pretty much above 50 — with the exception of Greece. On top of that, we are seeing a very benign inflationary environment, which means the risk of monetary policy tightening around the world is quite low. This is accommodative for growth.”

Still, Loke admits, there are risks in the system. Sovereign debt, which came to the fore last spring, remains a concern. Pointing to Greece as the chief offender, Loke notes that the country has suffered from three issues: credibility, liquidity and solvency. She adds that Italy and Spain also have liquidity issues, but have succeeded in rolling over their debt.

Loke notes that Greece has received the second tranche of an International Monetary Fund-sponsored bailout package. but adds: “There are a lot of challenges, which will not be solved overnight.”

From a strategic viewpoint, Loke is cautiously optimistic because corporate earnings are healthy and balance sheets are very strong: “Companies can withstand further shocks. And valuations are at a 20-year low. Europe is down to around 10 times earnings, vs an historical average of 13 to 14. Valuations are not at the very bottom, which was the case in March 2009, but they are attractive.”

A growth-at-reasonable-price investor, Loke is running a 70-name fund. With an eye on companies that will benefit from superior growth in emerging markets, Loke is favouring banks such as Standard Chartered PLC. The Britain-based institution is a traditional, conservative bank and very active in Asia.

Standard’s stock, which has a 2.8% dividend yield, is trading at about 1,875 pence ($3). Loke believes it has about 15%-17% upside within 12 months.

Another favourite is Koning-klijke Vopak NV. The Netherlands-based firm is the world’s largest independent owner of oil and chemical storage systems, which it rents to many global oil companies and chemical manufacturers. “[The company is] benefiting from global trade and imbalances of energy and chemical needs,” says Loke, adding that it has long-term contracts with clients in the Middle East and Far East. “[Koningklijke has] proven to be very resilient in this downturn.”

Acquired about two-and-a-half years ago, Koning-klijke stock is trading at about 35.7 euros ($50.30). Loke believes the stock could go above 40 euros within 12 months. IE