Interactive Investor

Europe: basket case or buying opportunity?

8th September 2016 13:52

Kyle Caldwell from interactive investor

For the contrarian investor who follows the sage advice of Sir John Templeton that the time to buy is at the point of "maximum pessimism", Europe ticks all the boxes.

It sounds risky and paradoxical, but in terms of valuations Europe trumps other developed markets, including the US and the UK.

Although there may be plenty of gloom, for Europe this is nothing new. Since the global financial crisis of 2008, the continent has had its fair share of problems, most notably the sovereign debt crisis in the summer of 2011. At the time the euro's days looked numbered.

Fast-forward five years and the outlook looks similarly bleak, following the uncertainty that comes with the UK's decision to leave the European Union.

Bleak outlook

Economic growth will continue to be sluggish, with the International Monetary Fund (IMF) moving to downgrade growth estimates for this year and next to 1.6% and 1.4%, respectively. Prior to the vote, the IMF had pencilled in growth of 1.7% for both years.

One fear is that in the short term, until the trade negotiations kick off (which could take two years to complete), European businesses will hold back from investing.

Some see the upcoming consitutional reform referendum in Italy as the biggest concernThis, in turn, will put the brakes on economic growth, at worst leading to another recession. But the big worry is that Brexit will trigger similar impulses in other member states - a possible contagion of referendums.

Over the next 18 months a handful of major elections take place, the biggest of which occur in Germany, Italy and the Netherlands. All have Eurosceptic political parties that have been gathering momentum.

But the upcoming constitutional reform referendum in Italy is the biggest concern, according to Olly Russ, manager of the Liontrust European Income and Liontrust European Enhanced Income funds.

The referendum will ask voters whether they approve of amending the Italian constitution. If the outcome is 'no', Matteo Renzi, the Italian prime minister, has vowed to quit.

Italy poses the biggest risk

In the event of this playing out, Italy's Five Star movement, which recently overtook the ruling centre-left party in opinion polls, could take power. The Five Star movement has called for a referendum on whether Italy should keep the euro as its currency.

"The prospect of Italy leaving the single currency is a huge risk, whereas the Brexit vote will ultimately prove a knee-jerk reaction," says Russ.

There's unhappiness about high levels of unemployment in much of the south of the eurozone"It is much easier and less complicated for the UK to leave, given they have their own currency. If Italy were to vote to leave the euro it would be a real crisis for Europe."

But Russ's central case is that Brexit will not spark a huge domino effect of similar referendums. John Redwood, chief global strategist at Charles Stanley, however, is concerned.

Redwood has been vocal for some time about the growing gap between what voters want in many European Union countries and what they think they are getting from EU policies.

He adds: "There is unhappiness about the high levels of unemployment in much of the south of the eurozone.

"Spain and Ireland had inconclusive elections; Italy has its constitutional reform coming up, while the Greeks have elected a government which strongly disagrees with the euro scheme whilst wishing to remain in the currency."

Fund managers go on the defensive

In response some European fund managers, including Kevin Lilley, manager of the Old Mutual European Equity fund, have switched to a more cautious stance.

Lilley says he has 10% more in defensive businesses than he did before the Brexit vote. He highlights Roche, the Swiss pharmaceutical giant, as an example of a company he has been buying.

"I have rejigged the fund to position it for a 'lower for longer' scenario. Growth will be anaemic, while interest rates won't be going up anytime soon," says Lilley.

It's extremely unlikely interest rates and bond yields will rise, so margins will be squeezed"It is frustrating because prior to the Brexit vote there were signs that the European economy was starting to become heathier, but now with the political timetable that is ahead for the next 18 months, it is going to be a volatile ride. It is therefore prudent to have less in cyclical stocks."

Jacob de Tusch-Lec, manager of the Artemis Global Income fund, which has 33% of its assets in Europe, fears a long period of uncertainty beckons.

He says the way the fund was positioned ahead of the Brexit vote - favouring value opportunities in Europe - has been "deeply unhelpful".

But he adds that his response has been measured, although he has moved swiftly to cut his losses in European financials, given that it now looks extremely unlikely that interest rates and bond yields will rise and therefore margins will continue to be squeezed.

Bright spots

But de Tusch-Lec points out that when going back to the drawing board and looking at company fundamentals such as cash flow and return on assets, a number of share price falls look indiscriminate.

"We will not run away from assets that are cheap and whose prospects remain good. So we retain our Italian TV and telecoms companies - El Towers and Rai Way. Their revenues are predictable and dividends are attractive."

Europe looks attractive on paper vs.the US thanks to cheaper valuations and recovery potentialEurope's accommodative central bank policy is a plus in times of uncertainty. While there is a debate over whether quantitative easing (QE) does what it is supposed to - stimulate economic growth - one thing is for sure: it supercharges stockmarket returns.

In Europe QE was introduced last March, and the central bank has vowed to print even more new money.

Ben Willis, of wealth manager Whitechurch Securities, has been tactically 'overweight' European equities versus the US for a couple of years. This position, he admits, has not panned out, accentuated by the Brexit result.

Willis is sticking to his guns, but has sold out of Invesco Perpetual European Equity Income, which has a value style and a big weighting towards financials, making up 25% of its assets.

Willis says: "Europe still looks attractive on paper versus US: cheaper valuations, earnings recovery potential, accommodative central bank.

A bull point is that European companies still have a way to go with earnings below 2008 levels"However, with the risks on the continent post Brexit, the key is to find good stock-pickers investing in quality businesses. We hold Richard Pease's Crux European Special Situations and Liontrust European Enhanced Income."

Other funds that invest in a similar fashion, seeking out world class businesses, include Money Observer Rated Funds Man GLG Continental European Growth and Threadneedle European Select.

Another bull point is the fact that European companies have some way to go. According to Russ, earnings are one third below their peak in 2008.

Brave investors who prefer to get in on the ground floor before earnings recover and share prices consequently rise will seize this opportunity. The trouble is that investors risk buying too early and catching a falling knife.

How Rated Funds have fared

The past five years have been an economically challenging time for the region, but some of our European fund picks have thrived.

The average fund in the Investment Association's Europe excluding UK sector has returned 50% over the five years to 2 August.

As the table above shows, each of our 10 picks is ahead of the average. Leading the pack is Jupiter European Opportunities investment trust, up 130%.

Managed by Alexander Darwall, the trust has tactically taken advantage of gearing during weak markets in order to enhance returns.

Taking the silver and bronze medals are European Assets trust, up 113%, and Man GLG Continental European Growth, with gains of 109%. Lazard European Smaller Companies is close behind with 107%.

Rated Funds earn their status for strong performance and consistency over various periods.

This article was originally published by our sister magazine Money Observer here

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.