Sector Watch: Tiptoeing through European equities

Peden, noting that the benchmark MSCI Europe index (in euro terms) has given up all its gains from earlier this year, adds: “The slowdown in China is the main issue, but [economic malaise] has spread to major resources-producing economies such as Brazil. Europe is not immune to that.”

Greece has achieved a fiscal solution of sorts, although, Peden argues, whether that country will really implement the reforms demanded by the European community remains to be seen.

“There is a very long road ahead in terms of securing the further tranches of the bailout,” he says. “But whether it succeeds or fails will not matter as much as the global events we are seeing now in emerging markets.”

If China has a deeper slowdown than anticipated, it will affect trading partners such as Germany, Peden says: “Even a deceleration in the world’s second-largest economy, and a major driver for global growth, will have an impact on revenue growth over the next three to five years.”

Peden grants that economies, such as that of the U.K., that have implemented structural reforms are growing at around 2.6% a year, while Germany’s annual gross domestic product (GDP) growth is 1.7%. But the GDPs of so-called “second tier” countries, such as France, are growing at about 1%.

“I have serious concerns about the long-term competitiveness of [France]. It has some structural growth issues over the long term,” says Peden.

From a valuation perspective, Peden maintains that European stocks are fair to slightly overvalued. The MSCI Europe index is trading at 17.6 times price/earnings on a trailing basis and 14.3 times on a forward basis.

“We are seeing companies with high emerging markets exposure looking much more attractive – especially compared with companies that focused on western European economies, which have not sold off as much,” he says.

Peden is a value-oriented investor. About 19% of the Invesco fund’s assets under management (AUM) is in cash, largely because Peden maintains there is a lack of attractively priced opportunities. From a geographical standpoint, about 46% of invested AUM is in the U.K., 45% is in continental Europe and there are small holdings in countries such as Poland.

Running a concentrated portfolio of about 23 companies, Peden likes Unilever NV, a U.K.-/Netherlands-based maker of food and personal-care products (such as Dove soap) that generate about 60% of the firm’s revenue in emerging markets.

Unilever stock, which generates a 3.47% dividend, is trading at about 35 euros ($50.50) a share, or 19.7 times forward earnings. There is no stated target.

Investors have to make a distinction between macroeconomic factors affecting Europe and underlying corporate profitability, says Dominic Wallington, chief investment officer with London, U.K.-based RBC Global Asset Management (U.K.) Ltd. and portfolio manager of RBC European Equity Fund.

“Corporate profitability is very healthy. That’s our main area of concern,” says Wallington. “Many of the companies we look at are ‘winners’ because many have been around since the middle of the 19th century – and they tend to be global Number Ones.

“While I don’t want to suggest that what happens in Greece is not serious, for the vast majority of companies in our portfolio, the impact is likely to be muted, even if the worst-case scenario develops,” says Wallington, who is a bottom-up investor. Although the economies of France and Italy are struggling, Germany, the U.K., Scandinavia and Switzerland are in positive territory, and even Spain and Ireland are recovering.

“I don’t see any particular risks of economic crisis at the moment,” says Wallington, noting that regional economies began to improve in late 2013, long before quantitative easing was introduced early in 2015.

As for valuations, Wallington argues that based on long-term trends, stocks are trading just below the long-term median.

“But it’s a two-horse race because there are the global type of companies that we invest in and domestic companies that have suffered for one reason or another,” he says. “I’m fairly satisfied that the valuations of the firms we follow are acceptable.”

The RBC fund is fully invested. About 34% of its AUM is in the U.K., 11% is in Germany, 8.8% is in the Netherlands, 8.3% is in Switzerland and there are smaller holdings in countries such as Denmark. Financials represent the largest sector at 18.3% of AUM, followed by health care (17.8%), consumer discretionary and consumer staples (each at 17.5%), with smaller holdings in industrials.

One top name in the 52-holdings RBC fund is Novo-Nordisk AS, a global leader in diabetes care based in Denmark. “[Novo-Nordisk] is in a high-return, low capital-intensity business and has had fabulous growth in [its] dividend,” says Wallington, noting that dividend yield has grown by about 150% since 1995. Novo-Nordisk stock, which pays a 1.3% dividend, is trading at about DKK 357.30 ($68.50) a share, or 24 times 2016 earnings.

That may appear expensive, yet Wallington maintains the valuation is reasonable based on his estimation of the firm’s 40% cash flow return on investment. There is no stated target.

People are focused on China, and rightly so simply because of its size and the market volatility it has experienced lately, says Matt Moody, vice president with Toronto-based Mackenzie Financial Corp. and portfolio manager of Mackenzie Ivy European Fund.

“If there were to be a Chinese crisis, which could turn out to be quite ugly, you would see all manner of impacts on Europe,” he says. “As China has been an engine for growth for European companies, they would feel the impact. There could be increased competition in a number of industries that would face oversupply. That would be generally bad for Europe.”

As for Greece’s debt situation, Moody says, it has merely retreated to the background: “They’ve had a Band-Aid put on it, and we’ll see how long it lasts. It does not look like a sustainable fix.”

In the same vein, Moody is concerned about the European Central Bank’s monetary easing program: “There is the potential for unintended consequences. Maybe it will turn out fine, but maybe not.”

For now, growth of economies in Europe is “plodding along,” says Moody: “Some years, they do slightly better. This year, looks like sub-2% growth.” He notes that Spain is surprising on the upside with about 2.5% GDP growth.

“We are still on the other side of a huge financial crisis,” he says. “Growth can suffer in this kind of environment. We have seen that for a number of years and it doesn’t appear to be changing.”

A skeptic about valuations, Moody is running about 30% of AUM in cash. “When you see generally high multiples for European companies and generally very little earnings growth, it’s hard to make a valuation case,” he says. “We have a strict valuation discipline. If we believe there is undue valuation risk, we will reduce or sell some holdings. If there is undue risk in the companies on our watchlist, we won’t buy them. That’s why the cash [component] has gone up.”

On a geographical basis, 32% of the invested portion of the Mackenzie fund’s AUM is in the U.K., and 67% is in continental Europe. The largest sector weighting is consumer defensive, at 27.5%, followed by consumer cyclical (21.3% ), industrials (14%) and financials (10%).

One favourite name in the 17-holdings Mackenzie fund is Publicis Groupe SA, a global advertising firm based in France, which generates about 60% of its operating profit in North America.

“The world of advertising and communications has become increasingly complex with the rise of digital marketing and multi-channel selling,” says Moody. “But there is greater value in firms such as Publicis that can deal with the complexity and craft an integrated communications strategy.”

Publicis stock, which generates a 2% dividend, is trading at about 59.30 euros ($100) a share, or at roughly at 16 times 2015 earnings. There is no stated target.

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