The past five years have seen headwinds for value-biased investors in Europe. Gross domestic product (GDP) growth, which typically supports upward revaluations of stocks, has been muted across the region, although this was offset at different times by external factors, including low oil prices and a weaker euro. The fund invests, in the majority, in companies which are mispriced against their sustainable return profile – stocks that we believe represent good value. This has meant that, overall, we have benefited from seeing a higher return on investor capital than average, while paying a lower multiple in the market for those returns.
Although ‘deep value’ stocks are part of the fund, they are not the majority – for a number of reasons; not least because they carry disproportionate financial risk and tend to work in very concentrated periods of time. Stocks categorised as ‘deep value’ normally face material supply and demand imbalances and it is only when these normalise, in the main due to supply reducing as companies go bust or foreclosures increase, that they perform. In my view, the best environment for “deep value” strategies, because of their high operational gearing, is when you start to see a pick-up in GDP growth.
The macro background
While the benefits of labour market gains and strong private consumption have until recently been offset by political uncertainty, recent economic growth in Europe seems to be based on fairly broad and certainly more solid foundations. The European Commission’s Spring 2017 Economic Forecast, released in mid-May, suggested euro area GDP growth of 1.7% in 2017 and 1.8% in 2018, slightly up from the previous forecast, and EU-wide growth of 1.9% in both years. The report was not entirely optimistic, citing the potential downside risks of Brexit – indeed, the UK economy slowed more than expected in the first quarter – and US President Trump’s trade policy, but it is encouraging to see the state of public finances improving across the euro area, and more broadly across the EU.
Uncertainty is often an opportunity
Fear and uncertainty are factors that can leave otherwise excellent businesses priced at a level that does not reflect either their intrinsic asset value or their potential for future earnings. Recently, political risk in Europe has been centre stage, supplanting fears over the state of the region’s peripheral economies.
At a geographic level, we have favoured France in recent months, reflecting what we saw as compelling fundamentals, rather than a play on politics. This positioning was not supportive at the start of 2017, with the prominence of Marine Le Pen’s far-right Front National party growing in the face of scandals around Republican front-runner François Fillon. Four months on, however, and valuations on French stocks moved forward following an unexpected victory for centrist ‘outsider’ Emmanuel Macron in the first round of the election on 23 April, as the chart here shows:
Election rally for French equities
Source: Thomson Reuters DataStream, in euros, rebased to 100 at 30 December 2016.
Real value investing requires a longer-term horizon and we assess companies first and foremost on their underlying qualities, rather than the potential impact of short-term market trends or news. Nonetheless, as France showed, political uncertainty can be a welcome opportunity – the ‘uncertainty principle’ – contributing to what we see as mis-pricing for value-focused investors, and contributing to an increased likelihood for better performance in the long term. As always, entry price is key.
Recent changes to the portfolio
We have been fairly active over the past few months. Recent additions include German financial services firm Allianz, Luxembourg-listed metals and mining conglomerate ArcelorMittal, Spain’s Banco Santander, as well as auto components manufacturer Faurecia. Overall, we remain constructive on the outlook for European – and euro area – equities. Valuations continue to look inexpensive compared to other equity markets, notably the US. Political uncertainty has cleared somewhat in recent months, with favourable ‘anti-populist’ results in France and the Netherlands. This optimism is set with a cautious note, given that we still have to face the German election, a possible Italian election and further anticipated fallout from Brexit negotiations.
Away from politics, economic data in Europe continues to impress; purchasing managers’ indices (PMIs) have reached a six-year high, as has the German Ifo Business Climate Index. We are also seeing this improvement come through in corporate Europe, with the latest earnings season beating expectations, particularly in more cyclical, or economically sensitive, areas of the market. Outside Europe, economic data has been a bit more mixed, leading to a slight loss of confidence. Providing this does not progress into something more sinister there is, in our view, a clear argument in favour of value strategies in Europe.