European Equities: Is there value in the periphery?
The most troubled countries in Europe appear to be turning a corner. Joseph Mariathasan looks at the opportunities in their equity markets, and asks if investors should go for quality or the more abundant domestic-focused and cyclical stocks
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
With those words in July 2012, spoken in London on the eve of its Olympic Games, Mario Draghi, president of the European Central Bank, managed to transform perceptions of risk within the euro-zone. Striking evidence of this can be seen in the spreads in peripheral country sovereign bonds, which came down dramatically in the months after Draghi’s comments. Even the prospect of Greece leaving the euro-zone looks remote now.
The effect on European equities has been dramatic, too. Few, at the beginning of 2012, would have forecast European equities to provide an annual total return of 18%. But in addition to the ‘Draghi put’, the peripheral euro-zone boasts plenty of successful international companies listed on their stock exchanges – Italian firms like Salvatore Ferragamo in luxury goods or Pirelli, one of the world’s top five tyre makers; supermarket chain Jerónimo Martins in Portugal; and high street fashion store operator Inditex from Spain.
So where does recent performance leave European equities now and in particular, how much appetite is there now for the peripheral euro-zone markets at the heart of the sovereign debt crisis?
The views of active fund managers on the attractiveness of these markets remain sharply divided. Hermes Sourcecap, for example, had exposures in 2007-08 to stocks in Spainish,
Italian, Greek and Irish equities; today, its flagship pan-European strategy has a zero exposure to the periphery.
“What happened during the crisis was that we began to see the full extent of how badly it was managed, fewer and fewer stocks in the periphery had the growth profile and the visibility of earnings that we required,” says CEO Andrew Parry. “Utilities, for example, are highly leveraged and they take their pricing from government and became unattractive, like banks, because they were not in control of their own destiny. Large swathes of the periphery became unattractive. If conditions change and we see economic growth and structural reform, then we will increase our exposure, but at the moment we are sceptical of leaping blindly in just because of a drop in the risk premium.”
In contrast, Nigel Bolton, head of European equities at BlackRock, says his firm is overweight. “The real value in Europe today is in the periphery – and in companies that are focused domestically,” he insists.
Divergences like this are to some extent a reflection of the breadth of the universe of companies encompassed by a fund manager’s investment approach.
“You need to be careful not to conflate investing in European companies with the state of European economies,” says James Inglis-Jones, European portfolio manager at Liontrust.
“Europe has world class companies in international businesses that happen to be domiciled in Europe.”
Some of these companies are listed in exchanges in the euro-zone periphery, and the way these high quality international stocks behave is fundamentally and structurally different from the majority of stocks that are essentially domestically focused. Attitudes and weightings to peripheral markets reflect the answers to two questions. First, do the high quality international companies happen to look good value relative to their peers elsewhere in core Europe? And second, does the expected risk and return of more domestically focused companies justify investment?
Quality growth companies have enjoyed exceptional returns over the past five years, but some bottom-up fund managers that focus exclusively on quality growth companies irrespective of the economic cycle, like Parry at Hermes Sourcecap, say that while firms like Spain’s Inditex and Amadeus “merit comparisons on a parri passu basis with stocks in Germany, Sweden and the UK because their domestic funding and economic pressures are less”, they are few and far between and simply not at attractive valuations relative to the equivalents in the ‘core’ economies.
“There is a dual nature to the index [in Italy and Spain],” he says. “The more international, franchise-driven, growth-oriented companies have continued to trade almost independently of the domestic situation. Because of the domestic pressures on [other] Spanish companies, Inditex is rated higher than it might have been otherwise. Italy is the same, dominated by banks and utilities. There are some very good stocks, but they are fully priced.”
Inglis-Jones runs an aggressive portfolio of 20-40 equally weighted stocks, with a focus on high-quality cashflows and management that is focused on shareholder value rather than ‘empire-building’, and manages to find a number of international companies fitting this description listed in the peripheral markets: Pirelli, Jerónimo Martins, Spain’s Amadeus (which provides IT solutions for the travel industry) and Irish gaming company Paddy Power. Nonetheless, Liontrust still finds itself underweight the periphery relative to market capitalisation.
Matthew Benkendorf, manager of the European Equity fund at Vontobel Asset Management, also seeks companies with defined quality characteristics – “High quality in the sense of high return on equity and invested capital, and high predictability of earnings streams” – and has also invested in peripheral stocks. But he adds: “If you look at the bulk of the sort of high quality investments we look at, they tend to be in the UK and Switzerland, with a little bit in France and Germany. Scandinavia is also a fairly decent playground for us, and Sweden in particular.”
On the valuation question, however, Benkendorf is more enthusiastic about quality in the periphery. “We own high quality businesses and are prepared to pay more for them,” he says. “There are three great examples we have in the periphery: Paddy Power, Prosegur in Spain and Luxottica in Italy.”
Berkendorf is enthusiastic about Ireland, arguing that taking tough fiscal decisions early in the crisis leaves it with “a lot going for it” now, and Paddy Power in particular has evolved from a traditional, domestically-focused bookmaker to become a leading online gaming company whose key markets are the UK, Italy and Australia. Security company Prosegur is also outward-looking – like many Spanish companies the bulk of its business comes from Latin America, promising high growth potential. Luxottica designs, produces and distributes spectacles and sunglasses, owning global brands such as Ray Ban, and its vertical integration has worked well in both developed and emerging markets. “The euro-zone crisis had not much impact at all on Luxottica,” says Benkendorf.
The recovery conumdrum
Not everyone believes that quality growth – core or peripheral – is the place to be right now. Bolton at BlackRock argues that if Europe is recovering quality growth stocks will underperform.
“When I look at the behavioural aspects of the market and the effect of fund managers crowding into an area, the biggest area of risk is in quality growth because that is where you see relatively expensive valuations compared to their history and a heavy degree of over-ownership,” he argues.
In the peripheral markets, while companies like Salvatore Ferragamo might be great for the long term, the question is whether they are really cheap now.
“I would say probably not – perhaps just a bit cheaper than fair value, but not drastically,” says Bolton. “A lot of the stocks that were cheap prior to July 2012 are no longer, therefore you need to go into more risky names.”
Value, out of fashion for 5-6 years, could now outperform, Bolton suggests. For dedicated quality growth managers such a move would be anathema – but for everyone else who is style-agnostic, that opens up a universe of investment opportunities in the peripheral markets.
“We don’t need massive economic growth for that to happen, just a combination of value, under-ownership and a recovery in the economic cycle will all provide upside for a number of those stocks,” says Bolton. He includes financials in this category. “If you have not included financials, you will underperform because they are leading the market charge. We see a 15% total return in the coming year with 4% being dividends, 9% being earnings growth and the remaining small fraction being re-rating.”
Bolton’s positions in peripheral markets include names like Ryanair, Luxottica and Jerónimo Martins, which he sees as long-term holdings, but he has also acquired banking stocks like Unicredit and other domestic-focused stocks such as Telecom Italia, which he sees as cheap as a result of the reduction in risk perception.
Sovereign risk is a critical piece of the analysis for Bolton. A key part of the re-rating of equities in the peripheral markets has been the re-rating of the risk premia in bonds.
“We need to watch out closely, in case policy makers make a mistake,” he says. A year ago, Bolton met a range of policy makers in Italy and, as a consequence of structural reforms BlackRock started to buy value names such as Atlantia, which constructs and runs toll roads and was at a 20-year valuation low. “By Q2 2012, we were overweight Italy,” he recalls.
The timing is significant – Q2 2012 saw the last big wobble in the euro crisis. Bolton was concerned, but at the same time his view is that real structural change in Europe to some extent relies upon the threat of crisis. “We had the belief that politicians would pull back and keep the euro intact,” he says – and the ECB’s August statement concerning outright monetary transactions was a sign that was happening.
Bolton is overweight Portugal, Ireland and Italy, but not Spain, where he sees less attractive relative valuations and has concerns about the banking sector.
“Italian banks like Unicredit and Intesa Sanpaolo did not experience the construction bubble seen in Spain and took steps earlier to tackle the problems,” he says. “Banco Santander and BBVA are high-quality banks, but the whole banking sector within Spain needs recapitalisation.”
If Bolton is right, domestic stocks in the peripheral euro-zone look a better opportunity than both quality growth stocks listed in those markets as well as the wider universe of stocks in the core euro-zone. Few expect anything but anaemic growth in those markets, but Bolton’s rejoinder to this is that there is no correlation between GDP growth and stock market returns, whereas there is a correlation between changes in growth expectations and equity market returns – this, after all, is a value opportunity. Bolton sees domestic equities in the peripheral markets benefiting from a change in expectations from a half per cent drop in GDP growth to flat GDP growth in the coming year.
Perhaps it is time to delve deeper into the unloved stocks of the peripheral markets. But investors must remember that another crisis of confidence in the euro-zone may well leave the international businesses with customers in the emerging markets relatively unscathed, and it will be the domestic companies in the peripheral markets which will be hardest hit.