European Union: Investment Q&A – Hunting For Value In Europe

Last Updated: 20 November 2012
Article by Jonathan Davis, Christopher Bates and Michael Quach

European equities, as measured by the EuroStoxx 50 index, have risen by 20% since their low point in the summer of 2012, although this has only taken the level of the index back to its earlier peak level in March this year. Mark Pignatelli, manager of the Smith & Williamson European growth fund, explains what lies behind this volatile performance and how his fund seeks to profit from it. Mark joined Smith & Williamson in 2008 as head of European equities after an earlier career at Barings and Schroders. These are his personal views.

European equities have massively underperformed since the global credit crisis? Why such an extreme reaction?

A 100% chance of losing 10% of your money represents exactly the same risk as a 10% chance of losing 100% of your money, but clearly you can recover from 90 whereas you cannot from zero. Therefore the perceived tail risk of a collapse in the single currency has caused a wholesale stampede out of European equities by professional and private investors alike.

Many people might say that was a rational response to the uncertainty over the fate of the euro. Are they wrong?

It is understandable at an aggregate market level, but the interesting dynamic behind the sell-off has been the indiscriminate nature of it. This has resulted in extreme levels of intra-market valuation discrepancies. Both good and poor quality companies have been penalised in much the same way. This is typical of markets at their most extreme. The silver lining is that such moments can create an exceptional opportunity to buy good stocks at bargain basement prices – assuming of course that you have the ability to separate the wheat from the chaff!

What, if anything, has changed since the summer to justify the market's rise?

After three years of crisis, Europe now has begun to put in place the two things that are required to make it a fully functioning sovereign state, in the sense that the US and UK are sovereign states. One is that the ECB, after years of sticking to a narrow anti-inflationary mandate, has publicly committed itself to supplying sufficient liquidity to keep the region's economy moving – a necessary development in a world characterised by shrinking balance sheets.

The second is that Europe's political leaders have finally agreed on a mechanism to recycle surpluses from the richest countries in the eurozone, such as Germany and the Netherlands, to those, such as Greece, Portugal and Spain, with the biggest deficits. This is the same kind of transfer system as the UK and US operate between their richer regions and states. This second function has been constitutionally enshrined for the first time in the articles of the European Stability Mechanism (ESM), the permanent bailout fund which came into existence at the start of October.

What kinds of share have done best since the market turned?

Value stocks and financials have led the market rally. These are the same sectors that were abandoned with most alacrity over the previous two years. The aversion to financial stocks, whose fate is obviously closely tied to that of the euro as a viable currency, is more understandable than the shunning of value stocks, which I define as shares which are cheap on fundamental measures such as dividend yield, price-earnings ratio and so on.

Will the rally last?

In my opinion, the answer to that is yes. I believe that we are at the beginning of a meaningful bull market in European equities. All the conditions that are needed for an enduring rally seem to be in place: terrible investor sentiment, extreme absolute and intra-market valuations, low ownership by professional investment institutions and an improving fundamental picture.

Of course nothing about equity markets is ever 100% certain and investors need to be sure that they wish to take on the still not insignificant risks involved. As the manager of a fund whose mandate is to own European equities, I can only report my honest conviction that current market conditions are the most favourable for European equities we have seen since the onset of the global financial crisis in 2008.

What approach are you taking in your fund to investing across the region?

The Smith & Williamson European growth fund takes a contrarian stance on this issue. Most investors, according to the analysis we have done, hold lots of extremely overvalued defensive stocks and have little in the way of entrepreneurial spirit in their portfolios. My fund has a growth mandate and therefore the portfolio is overweight in shares that we think have the greatest growth potential.

Where have the most striking valuation anomalies developed in your view?

'Value' as an investment style is one of the strongest long- term drivers of outperformance (buying stocks which are reporting positive earnings per share revisions is another). Buying value stocks has seldom resulted in more than one year of drawdown or underperformance. Yet in both 2010 and 2011 value was the worst performing investment style in Europe and it is still marginally in negative territory this year. Therefore my belief is that the best returns will accrue to those who buy value and avoid comfort zones.

Can you give some examples of the companies your fund owns – and why?

Smurfit, the Irish packaging company, has a free cash flow yield of nearly 20%. Dufry is a Swiss duty free shop which is currently trading on a PE of 13x. According to my analysis, that does not reflect its longer-term growth potential. Many European banks are meanwhile priced at 0.6x their book value; we own some in our current portfolio. As with all funds, you look to moderate the risk of the individual holdings by diversifying across a range of companies, sectors and countries.

What risks remain for investors looking to increase their European exposure?

Despite the positive market reaction to the ECB's recent announcement that it will do "whatever it takes" to save the euro, the eurozone is not out of the woods for certain yet. The economic crisis in Spain remains a concern. You have to differentiate between a woeful social backdrop for a country (which is clearly unfortunate) and whether these socio- economic issues have any direct impact on the pricing of risk assets. Looking forward, my belief is that the problems have been ring fenced – from a stock market perspective – by the actions of the ECB and the introduction of the ESM. Time will tell whether that confidence is justified.

Important note

The opinions and views expressed here are those held by Mark Pignatelli at the time of publication and are subject to change. His investment style is a contrarian one and these views may not represent those of Smith & Williamson as a firm. Our investment managers have discretion to tailor individual portfolios to the specific needs and risk profiles of clients rather than follow a specific model or fund portfolio. This material is for information purposes only and should not be taken as or construed as a recommendation or advice relating to the acquisition or disposal of investments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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