LONDON: J.P. Morgan Private Bank on the Case for European Multinationals
Sep 03, 2012
London, 3 September 2012 - Raj Tanna, European Equity Strategist and César Pérez, EMEA Chief Investment Strategist at J.P. Morgan Private Bank look at the case for investing in European equities.
"It is easy to see why European equities have been out of favour for so long. In asset allocation terms, being underweight Europe versus the US has been an outstanding call. With European equities underperforming their US counterparts by 36 per cent since the beginning of 2010, many investors have chosen to avoid the region altogether in their asset allocation, leading European equities to the lowest weighting in globally managed portfolios in five years.
"However, we have taken a closer look at a segment of the European corporate sector, the one with little exposure domestically and with most of its profits coming from abroad. The fundamentals at the company level for this sub-sector of names in Europe are stronger than they have been in a number of years. Yet the uncertainty caused by Europe's sovereign debt crisis has led to the share prices of those companies being negatively affected despite these constructive underlying fundamentals. Despite all the uncertainties still to come, we believe the recent market volatility offers opportunities to get exposure to the shares of a few carefully selected large-cap multinational companies listed in Europe.
"The European Union, as a whole, has seen a significant increase in total debt levels, yet the balance sheets of certain European multinational companies outside of the financials sector are in better shape than the countries in which they are listed. The solid growth outlook coming from their global revenue generation leave these companies relatively well placed over both the short and long term.
Corporate profitability is at multi year highs
"Company profits are close to multi-year highs in Europe and other parts of the globe and we are often questioned on the sustainability of profit margins at these high levels.
"A very large part of the cost base of a company is labour, and with economies far from full capacity globally, we don't expect significant wage inflation and an increase in labour costs. Companies also continue to cut costs and have seen impressive gains in productivity alongside this. Both of these factors lead us to be optimistic on the sustainability of margins seeing only a case for mild contractions. The strong rebound in profitability has also led to an equally strong rebound in cashflow generation over recent years. This is important for us as we consider cashflow to be the true profit of a company. During previous periods of economic recovery, companies used excess cashflow and took on additional debt to drive business expansion in anticipation of growing demand. During this recovery, however, companies haven't increased leverage with capital expenditure and acquisition activity remaining at all time lows. Instead, management teams are increasingly likely to pay cash back to shareholders via dividends or share buybacks."
Solid growth prospects
"Despite economic growth being anaemic in Europe, European companies have become increasingly global in nature and now generate a significant portion of their revenues from outside of the region. So the relationship between weaker GDP growth in Europe and sales / profits growth is less direct than it has been in the past. European multinationals also have particularly large exposure to developing economies, which are expected to continue to grow at a much healthier rate than that of the European region. Many of these economies are also shifting from export led growth to domestic demand led growth.
High dividend yields to shareholders
"On average, European companies pay a dividend of around 4%, which compares very favourably to that of deposit rates or even longer term government debt in Europe. We want to focus on companies where those dividends can be sustained through low leverage and global diversification. Of course there are risks to owning equities, but we believe the prospect of owning stakes in those companies with multinational profits, strong balance sheets, along with high dividends yields are persuasive.
"Given all the concerns at the macro level it is understandable that on most conventional measures, European equities appear attractively valued. On a price to earnings basis, for example, European equities trade on 10x forward earnings versus their 20- year history of 13x – well below their US counterparts. On a price to book basis, European stocks' discount to their own history is just as marked: 1.1x versus 1.5x. What is more striking is the comparison between multinational companies in Europe and those in the US. We looked at the average valuation of the largest companies by sector in the US versus their direct peers in Europe. In most cases, the European companies were at a clear discount – often despite better fundamentals.
Skilled stock selection
"Of course, avoiding the losers is just as important in successful investing, and demands skilled stock-picking. Utility companies, for example, were traditionally thought of as solid income stocks until the 2008 recession. Demand subsequently collapsed, leading to very depressed power prices. The sector now faces falling demand, excess supply and large amounts of debt on its balance sheet. As a result, a number of companies have cut their dividends over the last 12 months. Europe's banks, too, face multiple challenges. Their traditional business has been hit by Europe's weak economic growth in a moment where they were highly leveraged and too dependent on wholesale funding which has now disappeared. The ECB had to intervene giving them close to 1 trillion euro through the 3 yr LTRO window to help their funding problems.
"Sovereign debt issues also affect Europe's banks more directly than any other sector. Spanish and Italian banks, for example, have a combined market capitalization of €120bn, alongside total sovereign debt exposure of €500bn – so investors in those banks are essentially taking on leveraged exposure to sovereign debt. As political leaders grapple with the crisis under huge uncertainty, now is clearly not the time to take on this exposure, in our view – so we remain significantly underweight the banking sector. There are, of course, exceptions to this: those banks with emerging markets exposure, will benefit from much higher growth potential.
The opportunity ahead
"While no one doubts the substantial difficulties facing the Eurozone, investors are overlooking some of Europe's positives. One of these is Germany, which continues to be the region's bright spot.
"Of course, for all of Europe's internal problems, the region's growth is also dependent on growth in the rest of the world. We believe that global demand, especially from Asia, will continue to benefit European multinationals from a trend, rather than cyclical perspective. So, while Emerging Markets growth will be very weak in Q2 and Q3, monetary policies in EM countries will likely be supportive this year given slightly less concerns on inflation fears. Also, given the strictly weaker global composite PMI data year to date, the Emerging Markets slowdown is already in the price. With regards to the speed of the global recovery, the PMI surveys suggest that the expansion will stay on track this year and global growth will likely equate to around 2.0%-2.5%.
"We believe that we are at a point in Europe where the ongoing political uncertainty for the past two years has depressed many equity prices to levels which in some cases are disconnected with the fundamentals. We are talking in particular about a sub-set of companies with strong balance sheets, high profit margins and revenue exposure to growing markets across the globe.
Capturing the opportunity
"The contagion of Europe's sovereign debt crisis into its equity market offers investors a targeted opportunity to build exposure to shares in large, well-diversified, high quality multinational companies. The broad-based sell-off means these shares trade at significant discounts to global competitors – largely because they are listed in Europe. We sometimes refer to these companies as being "listed in Europe by mistake". Whilst the crisis will continue to make headlines, certainly over the medium term, it is important to note how low investor expectations are in terms of seeing any real progress towards resolution. These companies' large dividends effectively pay investors to wait for the shares to gradually close the valuation gap with their global peers. Notwithstanding, stock selection is extremely important, with a focus towards large capitalisation companies with international revenue exposure, and strong balance sheets combined with high profit margins."
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