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August 2017

European stocks: a virtuous circle

For equity investors, we think Europe's robust economic recovery and improving corporate prospects make it the most attractive of the major regions

Europe's macroeconomic and corporate fundamentals appear to be improving. What do you find most encouraging? 

TP: In Europe, there are a number of reasons to be optimistic.

To begin with, corporate Europe is becoming more competitive globally. Cost cutting and higher productivity have enabled the region’s firms to boost their global share of exports.

A second positive is subdued wage inflation. Although rising, Europe’s employment rates are lagging those of other regions. Europe therefore has more slack in the system before wage pressure pushes up costs. This gives European companies a competitive advantage over their counterparts in the US, Japan and emerging markets.

Then there’s the improvement within Europe’s financial sector. Many European banks are in better shape than they have been for years, with capital adequacy and leverage ratios above the levels required by regulators. Investors welcomed the recent rescue of two Italian banks and a Spanish bank as the final steps in the ‘clean up’ after successive crises –  as little as two years ago such moves would have caused stock market panic.

More broadly, the balance sheets of governments, corporations and consumers are improving for the first time in many years. We expect this to lead to a significant uptick in both capital expenditure and merger and acquisition activity as European companies deploy the excess cash they're generating – another positive for the region's stocks. 

It's worth noting that as the capacity utilisation of European companies reaches a “tipping point” of 80 per cent, the only way firms can continue to grow is by investing or acquiring. Testifying to this, the first half of 2017 has seen a 135 per cent increase in the value of M and A deals in Europe versus the same period in 2016. Increasingly, foreign companies are recognising the relative value of European assets, with nearly two-thirds of recent M and A deals by value, or EUR550 billion, buyers from outside Europe1

All of this should create a buffer that would allow the economy to cope with any reduction in monetary stimulus from the European Central Bank.

Cash in hand

Free cash flow yield (%) of MSCI Europe ex-financials 


Source: MSCI, FactSet Fundamentals, Morgan Stanley Research, as of 31.03.2017

How do you rate corporate Europe's earnings prospects?

TP: For the first time in seven years, analysts have been upgrading their initial forecasts for European earnings. The consensus expectation now is for 15 per cent growth in 2017. We believe there’s room for further improvement as earnings remain below their long term trend.

Investors see that too. European stocks are attracting investors who have long been underweight the region: the market has drawn at least EUR30 billion of mutual fund and exchange-traded fund inflows so far this year, after close to EUR100 billion of outflows in 20162.

How can equity investors best take advantage of the improvement in Europe’s investment climate?

TP: On the surface, there are plenty of investment opportunities opening up across European equity markets. But not all stocks are the same. It’s as important to be as discerning during the good times as it is during the bad.

We only ever invest in companies which we believe have the ability to generate strong cash flows and reinvest those flows at high rates of return. 

It's an approach that requires conviction, patience and discipline.

We want to own businesses that have the ability to maintain or improve their return on capital employed. To help us gauge this, we put an emphasis on the future rather than on the past, using, for example, our proprietary forecasting model for company free cash flow. A key element of our investment approach is being confident that a business model can maintain these characteristics, and that a company can improve future cash returns. They exhibit a common feature of a promising ability to generate future cash flows which are not properly valued by the market.

While we seek to invest in companies that can generate cash and a high return on capital, we also want value. Therefore, we buy companies at a discount to a conservative estimate of their intrinsic value, which limits potential downside in any investment we make. Unlike many of our peers, this means we establish an absolute price target, rather than a relative reference point to judge a stock's value.

It’s an approach that requires conviction, patience and discipline.

What is more, we build portfolios one company at a time and base decisions on our own research; the benchmark is not the starting point. Accordingly, we seek opportunities across the entire market capitalisation range. We can hold up to 20 per cent of our portfolio in stocks of companies with a market capitalisation of below EUR2.5 billion.

There are at least 2,000 stocks in the European equity universe we cover. But our portfolio construction process is unconstrained by the benchmark and we invest only in our highest conviction ideas, building a concentrated portfolio of approximately 40 holdings.

The active share of the portfolio is well above 80 per cent while our low portfolio turnover of around 30 per cent is further evidence of the conviction we have in our investments. 

All of this is designed to create a portfolio that is well placed to deliver consistent long-term returns and outperform our peers over the long run.