European fund managers are not exactly jumping for joy at current prospects for their region, but they are seeing things look up a bit.
At least that is what the latest Bank of America European fund manager survey points to, with an improvement of 66% of respondents expecting a downside for the European market over the coming months (down from 73% in June), and a majority of 55% projecting an upside over the next twelve months (up from 52%). Furthermore, a net 78% expect global inflation to decline over the next twelve months, with a record net 95% expecting European inflation to come down.
Europe remains German asset manager DWS’s preferred investment region, it said in its July outlook, citing the fact the valuation discount for the region versus US stocks continues to be high. And according to JP Morgan analysis, European equities are valued roughly in line with UK equities and approximately 15% cheaper than US equities on a forward P/E basis.
Valuations give rise to opportunities
The premium for US stocks, LF Montanaro European Income fund lead manager Alex Magni points out, reflects the market’s relative assessment of the strength and momentum of the US economy. This compares to Europe or the UK where sentiment is very bearish and where equities are being shunned at large, though this is not wholly a bad thing.
“This invariably gives rise to opportunities, especially as there are still many excellent European companies increasingly being priced at discounts to their growth prospects,” he says. Magni is starting to see valuations last seen in the 2008-2012 gloom years, “and which set the stage for excellent eventual returns”, he says.
Small and mid-cap UK and European equities are commanding low-teen P/E multiples while those in the US are priced in the upper teens, providing headline discounts of as much as 30%.
European small and mid-cap equities are valued roughly in line with their historical average valuation, 16.5x forward P/E, according to JP Morgan. But, this is only half the story, says IFSL Marlborough European Special Situations fund manager David Walton.
“Behind the average, the analysis shows there is a greater dispersion, in that the most highly valued stocks are more expensive versus their historical average valuation while the cheapest stocks are cheaper,” he says.
The weighted average forward P/E of the IFSL Marlborough European Special Situations fund is approximately 12x, which reflects the fund’s higher weighting in the industrial and consumer discretionary sectors. Walton says: “We see the best value in sectors like this, which have been derated by investors concerned about the impact of slowing economic growth and rising interest rates.”
Small and mid-cap companies he holds in the fund are continuing to expand and are now facing less competition from private equity for acquisition opportunities. But broadly speaking SMIDs are more domestically focussed in their business models, meaning recessionary fears in Europe, plus higher inflation and interest rates can create greater challenges.
Large caps look attractive too
And when the market as a whole is worried about recession and liquidity is withdrawn from equities, naturally the impact is the greatest on the smaller, less liquid names. Tom O’Hara at Janus Henderson, who manages the fund house’s European Focus and European Selected Opportunities funds, favours large caps for these reasons.
He says: “From our point of view while acknowledging the higher degree of pessimism embedded in small/mid-cap valuations, there are arguably structural reasons to favour select large caps in an era of higher interest rates, greater geopolitical complexity and significant technology investment demands.”
This “big is beautiful” view encompasses the greater procurement flexibility and scale, plus bigger balance sheets to invest in next generation technologies like AI, as just some of the potential advantages that being bigger could bring.
Large cap Europe is home to global champions which are key enablers of the profound capital investment cycles we will see over the next decade, Tom believes, as the world becomes multi-polar and goes through a process of partial de-globalisation. “Supply chains will be recalibrated and re-tooled, investments in energy security, automation, digitalisation and electrification will require significant investment,” he says.
“We are already seeing evidence of this, but it should provide a long-duration opportunity to Europe’s “picks and shovels”, in areas such as semiconductor capital equipment, industrial automation and the many materials companies that will prove critical in an asset-heavy era,” he adds.
Whether SMIDs or large caps, despite the doom and gloom hovering over the continent, there are a number of growth drivers supporting European companies.
These include investment in climate change mitigation, nearshoring of manufacturing capacity from China, and upgrading of corporate and public sector IT infrastructure.
In this respect, Europe abounds with opportunities (alongside the well documented risks) and is currently offering them up to investors at pretty attractive prices.
Darius McDermott is managing director at FundCalibre