Transcript: Opportunity alert: European equities underpriced

Capital flows

SK: The demand for European equities has been weak since Russia invaded Ukraine in early 2022. You’ve had outflows in European equities, no inflows at all. So, you’ve seen reduced demand, as a function of earnings underperformance in the decade after the financial crisis, and then exacerbated by the post-2022 outflows structurally out of European equities. And both factors combined set up a very interesting opportunity from here, because earnings are inflecting, because the macro side is inflecting. And then if you look at European corporates, they have been a buyer of their own equity, in a way that they haven’t been before, where they’re buying back their own shares, which can be a signal that they’re undervalued, and they’re using their strong balance sheets in shareholder accretive ways. And that has the effect of improving their return on equity. So it’s a really interesting phenomenon that’s going on in Europe at the moment.

Companies he’s watching

SK: Ryanair — I’m not sure if you’re familiar with it — but it’s one of the largest airlines in the world. It’s headquartered in Ireland, and it has modeled itself on Southwest and Amazon and Costco, where they lower their price to improve their offering to customers and then win market share, rather than pricing up their product to maximize short-term profits. They’re extremely capital disciplined in terms of how they buy planes at low points in the cycle. Like in 2009 and in 2020, when they ordered massively from Boeing. And then they’re very smart about where they fly. You know, you’re not flying into London Heathrow, you’re flying into Stansted, you’re not flying into Paris Charles-de-Gaulle, but you’re flying into Beauvais. So they make margins of 15% to 18% and return on capital employed of 20%, in contrast to the industry that only just covers its cost of capital. So, a very interesting company that we like a lot. We also like a company called DCC. It’s an industrial conglomerate that has energy, healthcare and technology exposures, but the interesting part is the 70% of profits that are exposed to energy. So they have gas stations, fuel distribution, so from the outside it looks dull, it’s low margin, but it’s a really strong business. Demand is very, very stable, and customers really need the product. And this energy transition that’s going on in Europe will take a significant amount of time, and will be very slow and very profitable. And DCC will certainly be able to profit from that, and has proved that out over the last two years. So it’s something that we like a lot at these levels.

And finally, what is the bottom line for investors looking toward European equities?

SK: The bottom line is we have far less crowding in Europe, and, you know, we have much better value for money. In the U.S., the crowding of stocks with the strongest price momentum is at a record high, you know, almost at the 100 percentile versus history. And we believe from a risk-return point of view, there’s far more interesting opportunities outside of the U.S. and then particularly in Europe. You need to be selective. Very much so. There’s a lot of macro and structural issues in Europe. But if you look at some European companies that are highly diversified internationally— you know, we’ve touched on some of them like Ryanair — and if you’re highly selective and you focus on companies with high return on capital, good free cash flow, strong balance sheets that are run by competent shareholder- and stakeholder-friendly management, on lower multiples, the odds are very much in your favour of doing quite well from here.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Sean Kenzie of Setanta Asset Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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