The Case for Eu Equities

8/13/2019 The Case for Eu Equities

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The Case forInvesting in

EuropeanEquities

October 2013This document is intended or institutional investorsand investment proessionals only and should not bedistributed to or relied upon by retail clients.


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The investment backdrop

As concerns about pan-European economicgrowth and structural strains on the Euro-zone continue to dominate headlines, itis understandable why many investors aresceptical about the return prospects on offerrom listed Europe. However, the economicchallenges acing the Euro-zone need notnecessarily translate into a negative view onEuropean stocks. The regions equity marketsare not an exclusive play on the domestic

European economy, but offer real breadth,in both geographical exposure and productdiversification terms. There are many world-class businesses in Europe with the potentialor good long-term returns and which are tradingat relatively attractive valuations.

The problems dominating headlines areovershadowing the real attractions o investingin European equities: access to world-beatingcompanies with very strong ranchises in

businesses ranging rom engineering to luxurygoods. Europes stock universe includesmany companies that are global leaders witha proven ability to withstand macroeconomicheadwinds. Such companies are well diversifiedacross geographies and product lines andcontinue to report strong earnings growth.They are underpinned by solid balance sheetsand many offer healthy, and growing, dividendstreams. However, on most valuation metrics,they are trading at significant discounts to theircounterparts in other global markets because o

wider Euro-zone issues.

Our analysis shows that a large number oEuropean stocks have enjoyed significantcapital appreciation upside in the last sixyears. Given the structural growth potential onumerous European businesses, many o whichenjoy market leading positions on the globalstage, we see no reason why this positive trendwill not continue.

1 The case for investing in European equities

The Case for Investing inEuropean Equities

Chart 1: Many European stocks have enjoyed strong price gains in recent years

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MSCI Europe constituents: absolute total return performance 1 January 2006 - 30 September 2013Source: Thomson Reuters Datastream as at 30 September 2013

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Absolute%t

otalreturnperformance


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The case for investing in European equities 2

The perils of a macro mindset

The macroeconomic concerns that have beendriving most global stock markets have resultedin an extreme risk-on/risk-off mindset withassociated market volatility. For those ocusedon stock ndamentals and a reasonabletime horizon beyond the latest officialpronouncement, this can create excellentbuying opportunities. We would argue that inan environment in which a greater proportiono market participants are overlooking stock

specifics in avour o macroeconomic andsentiment drivers, the potential returnsavailable to bottom-up stock pickers shouldbe enhanced. While there may be periods ovolatility when stock specifics do not appearto matter, when companies do deliver on theunderlying investment case, such stocks willperorm strongly.

Insufficient discrimination opensup stock-picking opportunities

Many listed European companies have shownan ability to withstand broader macroeconomicheadwinds and to thrive in the currentchallenging environment. Many o thesecompanies are not constrained to operatingin their domestic economies and generate asignificant proportion o their revenues andprofits rom outside the Euro-zone. Suchcompanies credit profiles are ofen muchstronger than those o the governmentso their home market. These stronger

ratings reflect their robust ndamentals,underpinned by strong balance sheetsand very healthy cashflow generation.However, macro concerns have led toindiscriminate attitudes, with investorsocusing more on where companies aredomiciled rather than paying sufficientattention to the strength o the underlyingbusinesses. This offers scope or discerninginvestors to buy into potentially well-run andgrowing businesses at attractive valuations.

The valuation gapThe structural, and presently underappreciated,attractions o European equity markets arerther supported by several valuation metricswhich show that Europe is trading at a discountto several other global markets, including the US.

The sharp rally in core government bonds rtherstrengthens the valuation case or Europeanequities. Overall, European stock marketscurrently offer a dividend yield o 3.4%* (higherthan that on offer rom other developed equity

markets) at a time when core government bondsare yielding around 2.5%. More surprisinglystill, several high-quality European stocks areoffering a stronger yield on their equities thanon their corporate debt (notable examplesinclude BMW, Philips and Siemens).

Chart 2: European stocks on a price/earnings basis

1988-91 1992-95 1996-99 2000-03 2004-07 2008-12 2012-30

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10

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25

30

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Europe ex UK USA World UK EMG

Source: Thomson Reuters Datastream as at 30 September 2013

Price/earnings ratios:

*Yield data: Dividend yield on FTSE Europe ex-UK Index - 3.4% as at

30/09/2013. Yield on 10-year US Treasuries - 2.6% as at 30/09/2013.

Dividend yield on MSCI World I ndex - 2.6% as at 30/09/2013. Source:

Bloomberg as at 30/09/2013.


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Identifying the opportunity set

Sustainable long-term returns are primarilygenerated through investment in companieswith leading market positions, strong financialndamentals and a diversified customer base,in which we can establish an attractive entry

point. Continental Europe offers investorsexposure to just such a unique opportunityset, being home to a disproportionate numbero the worlds market leaders in a wide rangeo sectors as varied as pharmaceuticals,engineering and luxury goods. Over manyyears, European companies have created astrong brand presence right around the worldthrough their superior products and innovation.For these companies, their domestic markets(and indeed Continental Europe as a whole)represent only a relatively minor part o theirtotal earnings and their ture growth potential.

Value on offer fromglobal franchises

As we have noted, many o Europes listedcompanies are truly global players. Thesecompanies as a whole generate about haltheir total revenues outside the regions

borders. Consequently, many companiescontinue to report growing sales and strongprofit margins, with some even managingto wield pricing power in the current cost-conscious environment. These global leaderscan offer investors access to successl globalranchises at discounted price levels relativeto their peers listed in other domiciles. SeveralEuropean exporters have invested heavily intheir global distribution networks, ensuring theyare particularly well positioned to benefit romopportunities to grow outside their domesticand immediate regional markets.

Chart 3: The dividend yield on offer rom European stocks frther supports the valuation case

1988-91 1992-95 1996-99 2000-03 2004-07 2008-11 2012-130

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Source: Thomson Reuters Datastream as at 30 September 2013

Historic Dividend yields:

Europe ex UK USA Worl d UK EMG

Chart 4: European stocks enjoy broad geographical revenue exposure

Europe (53.9%)

North America (18.0%)

Other (8.8%)*

Asia Pac ex Japan (7.7%)

Central & South America (4.8%)

United Kingdom (2.4%)

Eastern Europe (1.5%)

Africa (1.1%)

Japan (0.6%)

Middle East (0.3%)

Australasia (0.8%)

India/Bangladesh/Pakistan (0.1%)

* the high percentage of 'other' is a result of the wayrevenue is reported on individual companies accountsi.e., not all revenue is categorised on a regional basis

Source: Thomson Reuters Datastream/Worldscope as at 18 October 2013

Based on MSCI Europe ex UK constituents


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Value from the strongestnorthern economies

It should be remembered as much as 40%o geographic Europe is not tied into theeuro currency and hence enjoys a degreeo insulation rom the problems affectingthe Euro-zone. Some o these northernEuropean economies (notably Switzerlandand Scandinavia) enjoy some o the strongest,most well-balanced growth trajectories in thedeveloped world. Even within the Euro-zoneitsel, some o the stronger economies (mostnotably Germany) continue to grow. Theseresilient economies are home to a range o

innovative global businesses, many o whichoffer compelling investment opportunities.

Value in the periphery

Even in Europes weaker peripheral economies,we continue to find significant value inattractive businesses that we believe have beenoverly penalised by domestic concerns butwhose earnings outlooks, in act, depend moreon actors outside their home markets.

Value on offer from exposure

to the newest economies

Emerging markets have become an increasinglyimportant source o revenues or corporateEurope. European companies tend to enjoy

stronger exposure to such markets than manyo their global counterparts. Around 25% orevenues rom quoted Continental Europe stemrom emerging economies, compared with, orexample, the US level o around 20%. Many othe brands that emerging market consumersaspire to (ranging rom champagne to luxurygoods to cars) come rom Europe. This greaterexposure to markets experiencing seculargrowth should prove a key support or severalEuropean companies.

Stock examples: Nestle and BMWAlthough based in Switzerland, Nestleoperates atruly global business. As the worlds largest ood

company, Nestle products are sold worldwide.These products encompass nearly 30 so-called

billionaire brands, including Nescae and KitKat,which each generate annual sales o around CHF1

billion. Nestle consistently delivers strong resultsand continues to report growth in virtually all its

geographic markets.

Prestige German car manuacturer BMWcontinues

to thrive in an environment in which many o itsglobal peers are struggling. It benefits rom a very

strong product portolio, including Mini and RollsRoyce vehicles in addition to BMW-branded cars. It

also has well-diversified business operations, with

a particularly strong presence in the US and, morerecently, in China. BMW sold more than 1.6 million

vehicles at record profitability margins in 2011 andis targeting a two million total by 2016, making it

the worlds biggest luxury car maker.

Stock examples: GALP and InditexThe earnings o Portuguese integrated oil and gas

company GALPwill be transormed by its exposureto the Santos Basin in Brazil. The company has

a strong balance sheet and one o the bestproduction profiles in the sector, yet trades at a

large discount to the sum-o-its-parts.

In Spain, clothes retailer Inditex(whose ashion

brands include Zara, Pull & Bear and MassimoDutti) is offsetting weak domestic demand by

expansion in countries and regions with moredynamic consumption trends, like China and

Eastern Europe. This has ensured that Inditex

is now the largest clothes retailer in the world,with more than 6,000 stores across 86 different

countries. It has also successlly introduced itsonline offering into a number o its markets.

Stock examples: Jeronimo Martins

Portuguese ood retailerJeronimo Martins derives75% o its profits rom Poland, where the companys

discount ormat is winning avour with cost-conscious consumers. Jeronimos good value, own

brand products are helping the company rapidlyincrease market share beyond its current 12%.

Longer-term growth will be enhanced by its recentinvestment in Colombia, where the demographics

look particularly well-suited to discount retailing.


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Value on offer fromunique businesses

Europes stock universe offers investors a rangeo unique investment opportunities in severalsector niches that are exclusively served byEuropean companies. Some o these businessesoperate in sectors where European companiesenjoy a particularly strong heritage (orexample, luxury goods and pharmaceuticals).Other niches in which European companiesdominate are perhaps more surprising and

include lie science research and developmentand renewables/green energy.

Value on offer from growingdividend yields

Continental European companies have beenattaching a higher priority than ever to dividendsand dividend growth, to the extent that Europe

offers one o the highest yields among developedmarkets. Many European companies provideattractive dividends and have the balance sheetsthat can sustain these dividends. In the currentenvironment o weak economic growth, and

consequent concerns about companies abilityto sustain and grow their earnings, dividendslook likely to prove an increasingly importantcomponent o the total returns on offer romequity investments. Against this backdrop, webelieve Europes premium equity dividend yieldshould prove highly attractive. Many companiesin Europe are increasing their dividends year-on-year and are committed to dividend growthpolicies, indicating that they remain positiveon their own growth potential despite themacroeconomic pressures on the countries

in which they may be listed.

Value being recognisedat a corporate level

Several European corporates with strong cashreserves are now pursuing revenue growth andgreater market share via increasing capitalexpenditure. Recovering capex levels providea supportive backdrop or the regions stockmarkets as does an upturn in M&A activity.Corporates outside Europe are among thoserecognising the value inherent in regionalassets and are buying into European companieswhose valuations currently discount their strongndamentals. Examples o this trend includethe 7.7 billion takeover o Germanys largestcable TV operator Kabel Deutschland by UKmobile phone group Vodaone.

Stock examples: Swiss ReGlobal reinsurer Swiss Reis the second largest

reinsurer in the world. Although based inSwitzerland, nearly hal its business stems rom

the US. The company benefits rom a very strongcapital position alongside positive reinsurance

market dynamics. Swiss Re has established anattractive dividend policy in the wake o extensive

restructuring o its business. It is committed to ahealthy (normalised) dividend o over 5%.

Stock examples: ASML and GriolsASMLis a world-leading semiconductor equipmentmanuacturer which enjoys a very strong

competitive position versus its key peers, which

are mainly Japanese. As it has grown, ASML hascontinued to strengthen its global position and to

take market share rom its peers.

Spanish pharmaceuticals company Griolsis oneo the ew businesses world-wide that provide

blood proteins. The company derives 60% oits sales rom North America and just 8% rom

Southern Europe. Griols looks poised to benefit

rom its leading position in the plasma proteinsmarket, where both pricing levels and volumes are

on the rise.


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Conclusion

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The depth and breadth o the European equitymarket, and the access it provides to leadingglobal companies with strong balance sheets,continue to provide our European equities teamwith many attractive buying opportunities. Theeconomic challenges conronting Europe shouldnot be under-estimated. These inevitably presentpotential risks or companies in terms o ndingavailability, currency volatility, pricing poweragainst a backdrop o economic austerity and alack o customer confidence. However, operating

within uncertain political environments, copingwith volatile currencies and rapidly adapting tosudden changes in economic and political policyis nothing new or many o Europes leadingglobal ranchises. Many Europe-based industryleaders have been successlly conductingbusiness in global regions with extreme marketdisruption or many years. In our view, day-to-day market volatility can result in compellingopportunities to buy into selected, highlyattractive European businesses.

Chart 5: Why stock picking matters: relative perormance o Standard Lie InvestmentsEuropean Winners List since inception

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

cum

ulativerelativeperformance(%)

The Winners List is an equally weighted portfolio of our 20 highest conviction stocks

Source: Standard Lie Investments, cumulative relative perormance (%) to 30/09/2013


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