There has been a longstanding perception in many parts of the world that Europe is imploding. With investors firmly focused on the European political scene, we have witnessed large behavioural see-sawing that is distorting valuations. However, if one bothers to look a little deeper, there are undoubtedly some interesting opportunities. The key is to appreciate the behavioural biases at play and get back to the principles of good investing.
Energy and financial companies are still considered to be generally attractive
In order to better understand the European landscape, it helps to address the political concerns and some of the more optimistic economic data of recent times before outlining the process that underpins our core thinking.
The debate surrounding the European Union pulls at many heart strings. There are loyalty issues, economic inferences, security complications and many other implications that would need a detailed thesis to comprehensively address. Yet, one of the most effective ways to illustrate the economic challenges that have impacted investor confidence in the region is to apply a basic timeline of European equities relative to the rest of the world.
Volatility Falls and Investor Sentiment Rises
Now that the French elections are behind us, volatility has eased to near record-lows and fund flows are reverting. On a short-term basis, the ‘risk-on’ trade seems alluring – with some of the best economic conditions in a decade and a series of corporate earnings upgrades creating a short-term tailwind that has unwound some of the previous underperformance.
Yet, the economic reality is still incredibly complex. In the long-term – the period most investors should care about – the stability of the European Union is not solved and there are still questions about whether it is feasible for a block of nations to operate on a “single speed”, under one currency with the same monetary policy framework.
Questions such as these are always interesting to ponder. If one puts an economist hat on, it seems intuitive that a strong nation and a weak nation should have different interest rate policies combined with a floating currency so that equilibrium can be achieved. After all, a German that has worked for more than 20 years in the Mercedes headquarters is less likely to face personal economic turmoil than a Greek public servant.
However, the truth is that we don’t have a great deal of facts when it comes to the stability of the European Union. Much of the political turmoil is ‘unknowable’ and should be classified as such. For example, would the E.U. ever really fall apart? And if it does, what would be the impact on fundamental drivers of asset classes such as dividends? The answers to these questions are very complex and the extrapolations are easily exaggerated. Therefore, while this political hyperbole allows for fascinating intellectual conversations, it does not provide the answer most investors are looking for. After all, there are a plethora of other considerations at play.
Focus on the Important Stuff
Critically, investors need to focus their efforts on exploring mispricing and valuation-based opportunities – as this is where Europe is arguably most compelling. After years of negativity and behavioural prejudice against Europe, which has resulted in a deteriorating relative performance, investors have been presented with interesting opportunities.
In order to exploit these opportunities, investors need to take a step back and focus on the long-term fundamental drivers of returns while patiently waiting for market prices to ‘normalise’ back to that fundamental baseline. This is clearly easier to do in theory than in practice as it requires an ‘edge’ and the fortitude that enables an investor to buy from those that have sold in panic and/or sell to those that are buying in greed.
The below shows our valuation-implied return framework and is a depiction of relative value. It tells us how much one could expect to earn from an asset on the assumption that prices return to their fundamental baseline over a 10-year period. In doing so, it presents recent performance in the opposite way to the norm and encourages investment in unloved markets that have the potential to outperform.
There are opportunities within unloved areas such as Italian equities, which eclipse both German and French equities according to our fundamental analysis. Italian companies were punished through 2016 as the so-called banking crisis arose and the referendum created intense fear. The fact that more than 55% of the Morningstar Italy Index is in financial and energy companies has ensured that investors have remained behaviourally fearful, creating the valuation-driven opportunity that still exists today.
By extension, energy and financial companies are still considered to be generally attractive on a relative basis across the entire region. The sectors are largely uncorrelated, yet each stack up as attractive areas of investment when looked at holistically.
We have included emerging Europe as it has distinct appeal and is often disregarded by investors. Part of the reason is that gaining exposure can prove problematic for end-investors, as it is not typically covered in the broad Morningstar Europe Index and makes up less than 15% of the broad Morningstar Emerging Market Index.
Therefore, to access such an opportunity, it is important to either; 1) pick a high conviction fund that is benchmark agnostic, or 2) think of emerging markets as effectively three regional blocks – Latin America, emerging Europe and emerging Asia. The key is not to be afraid to allocate a dedicated position to a regional fund, especially when disparity in valuations is apparent.
