Europe is gradually emerging from the morass that began five years ago. Economies in the so-called “core” of Europe have gained strength, although “peripheral” countries such as Spain and Italy continue to be weak.
Meanwhile, markets have rebounded in the past year. And, even though fund portfolio managers say valuations are still reasonable, some European equity funds are raising cash, while others are fully invested but their managers say there’s a need for more wide-spread earnings growth.
One of those in the first camp is Michael Hatcher, head of global equities with Toronto-based Invesco Canada Ltd. and lead portfolio manager of Trimark Europlus Fund: “I’m not sure markets are overshooting, but they’re getting to the point of being reasonably valued. I’m finding less and less to buy. It’s a difficult market in which to make new investments. But that’s part of our philosophy; I don’t get excited by things at fair value. I want to buy things that are undervalued. It’s less attractive than two years ago.”
Hatcher notes that from a macroeconomic standpoint: “There is no silver bullet, and nothing will get fixed overnight. But people [in Europe] are getting more confident that we are on the path of recovery and improvement. The market is certainly starting to price that in; it’s not pessimistic.”
Although Europe is moving forward, Hatcher notes the region needs more time for the austerity measures to make a difference. “We’re on a long road to recovery, and there is less risk of a cataclysmic event. In the worst areas, things are stable; in the better areas, you are seeing an improvement,” he says. “Europe is not one country but a collection of many countries and governments with many objectives. You’re not getting a collective solution, as you would in the U.S.”
From a strategic viewpoint, Hatcher is primarily a bottom-up investor and has about 15% of the Trimark fund’s assets under management (AUM) in cash. “I am having challenges in deploying the cash. You could say that I am modestly defensive,” says Hatcher. “But if I had two opportunities to use the cash, that could change very quickly.”
From a country perspective, Germany accounts for 15% of the Trimark fund’s AUM; France, 14.8%; Switzerland, 14.6%; the U.K., 11.4%; and smaller weightings in countries such as Italy and Spain.
Running a concentrated portfolio with 26 names, Hatcher prefers firms with high returns on capital and significant free cash flows. One favourite is Denmark-based SimCorp A/S, which provides software for the asset-management industry. “[SimCorp] has an integrated platform that’s used for the back office, middle office and front office. [It is] one of the few providers that help to manage businesses from front to back,” says Hatcher, noting that SimCorp has significant market share in the Nordic countries, as well as in Germany and Austria. “[SimCorp] also [has] a very high client retention rate,” he says, adding that the firm has a return on capital in excess of 30%.
SimCorp shares are trading at about 186.50 DKK ($33), or about 19 times earnings. There is no stated target.
Dominic Wallington, chief investment officer with London-based RBC Global Asset Management (U.K.) Ltd. and lead portfolio manager of RBC European Equity Fund, also says that European stocks are still reasonably priced.
“Looking at the trend in price/earnings ratios,” says Wallington, “Europe, as a whole, is still one standard deviation below the long-term mean. Europe is not expensive, but markets have had a good run. What we need to see now is more widespread earnings per share growth – which has been relatively scarce – although we are beginning to see that.”
Countries such as Germany are expected to grow by 1.7% this year, Wallington says, while Sweden’s growth should be more than 2% and Switzerland’s expansion will be close to 2%. “There are areas [in which] we have a relatively robust backdrop,” says Wallington, who admits he is keener on core Europe, Scandinavia and the U.K. “But we need stabilization on the periphery rather than hoping for any kind of growth.”
Wallington argues that there’s a dichotomy between the weaker countries and some successful companies that are domiciled in those regions. That is, in spite of negligible growth in Italy and Spain, some locally based industrial firms have demonstrated fiscal prudence and are far more profitable than before. Says Wallington: “If they are based in the periphery, it doesn’t mean that they can’t be profitable or grow if their businesses are international in orientation.”
The RBC fund is fully invested. Wallington uses a blend of quantitative and qualitative analysis and relies on key factors such as valuations, balance-sheet strength and profitability. “We are overweighted [on] financials, consumer discretionary and industrials, which are considered cyclical areas,” says Wallington, noting that these three sectors account for about 53% of the RBC fund’s AUM. “We also like the health-care sector. And although we’re underweighted in consumer staples, we like household-products companies.”
From a geographical standpoint, the U.K. accounts for 34% of the RBC fund’s AUM, followed by Germany (16%), Switzerland (10%), with smaller holdings in the Netherlands and France.
One top holding in the fund, which holds about 62 names, is Daily Mail & General Trust PLC, which owns the Daily Mail newspaper and has gone heavily digital. “The management team addressed the issue of declining circulation and reallocated capital to online products. The Daily Mail now is the largest English-language daily globally and has monetized its website very effectively,” says Wallington, adding that the firm earns a 37% cash-flow return on investment, about 6.7 times its cost of capital.
Daily Mail & General Trust stock is trading at about £7.80 ($12.90) a share, or 14.8 times forward earnings. There is no stated share price target.
Another favourite is London Stock Exchange Group PLC (LSE). “It has a very broad range of services and its exposure to equities is less than a one-third of the business,” says Wallington, noting that LSE also offers risk management and trading platforms. “Essentially, it has morphed into a technology and software business.”
LSE stock is trading at about £15.60 ($25.85) a share, or about 19 times earnings.
On the cautious side is Paul Musson, senior vice president and head of the Ivy Group at Toronto-based Mackenzie Financial Corp. and co-portfolio manager of Mackenzie Ivy European Fund. He argues that stock markets have been driven not by fundamentals but by central bank actions since mid-2012.
“From an economic perspective, a number of countries have been practising austerity, which should lead to slower growth. We see that reflected in all of our European holdings,” says Musson, noting that many European multinationals are showing negligible growth in their home region but stronger growth elsewhere.
Some academics have criticized the austerity programs for suppressing European growth, observes Musson: “These people are missing the point. Austerity is not a growth program, but a fixing strategy. You need austerity because you have lived beyond your means and need to fix your balance sheet and expect to shrink in the process. Once you have your finances in balance, you can start to grow again. It’s not surprising to us that Europe has not grown strongly and that markets have been strong. [Markets] react to central bank interference. It’s similar to what’s happened in the U.S.”
From a valuation viewpoint, Matt Moody, associate portfolio manager with Mackenzie and the Ivy fund’s co-portfolio manager, argues that stocks are not especially attractive: “Valuations are not excessive. But we are not excited about them, either. We are happy to invest when we find great companies at good prices.”
Musson observes: “We have found it increasingly difficult to find new names. That’s why our cash weighting is over 20%.” The last time cash was around this level, Musson adds, was before the 2008-09 global financial crisis.
From a geographical perspective, the portfolio managers favour the U.K. which accounts for 23.9% of the Ivy fund’s AUM, followed by France (14.9%), Belgium (10.8%) and Sweden (9.5%). There are smaller weightings in markets such as Switzerland.
Consumer staples is the dominant sector, at 31.5% of the fund’s AUM, followed by consumer discretionary (19%), financials (13.6%) and smaller weightings in sectors such as infotech.
One of the top holdings in the portfolio of 17 companies is Skanska AB, a Sweden-based construction and development firm that operates around the world.
“You need very little capital to operate,” says Moody, “and, essentially, build with your customer’s money, which is a kind of ‘float.’ But the problem with construction is that the risks are asymmetrical. If you do well, you can make some money; if you mess up, you can lose a lot. Skanska used to be one of these companies. But [Skanska has] a new CEO, who has changed the culture and made the company quite attractive.”
Skanska’s stock, acquired last spring, is trading at about 126.90 Swedish kronas ($20.45) a share and pays a 4.75% dividend. There is no stated target.
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