As Europe Day was marked this year – a day of peace and unity in Europe on 9 May – we were looking to the market for peaceful returns for investors, while taking a unified valuation approach to uncover opportunities.
To best describe Europe, we can paraphrase Warren Buffett, when he famously observed that, while he does not like pessimism, he does like the prices pessimism brings. Keeping this quote in mind, it must be said that European stocks did not fare well in the first quarter, with widespread lockdowns forcing economic slumps across the continent.
Investor sentiment fell heavily, and investment flows retreated, following an expectation for lower profitability and the compression of already low valuations (relative to US peers). Stimulus efforts have also been less impressive than in other regions – in part because the monetary policy was already so loose, with Europe having negative rates before Covid-19.
For context, since the global financial crisis, European equities have lagged global equities. The double-dip recession and Europe’s higher market exposure to financials amid falling interest rates and high loan loss provisions set the backdrop for a low growth environment overall. Relative to the global market, Europe has higher exposure to cyclical businesses, which struggled to restore profits at the same pace as the US.
Consequently, European stocks now offer a much better reward for risk than their US peers. This is particularly so for regional heavyweight Germany – notwithstanding specific risks to the sizeable auto industry. Auto manufacturers trade at low valuations, as the combination of forced shutdowns and plummeting auto sales create significant near-term headwinds.
Strong balance sheets
This point resembles last year, when we witnessed market pessimism surrounding cyclical industries as uncertainty around trade wars dampened Europe growth. Looking through these challenges, however, many of these companies have strong balance sheets and franchise values and will regain their footing once economic conditions normalise.
It is not surprising that cyclical sectors recently experienced deeper losses as investors priced in negative expectations from Covid-19. A key question for investors is the extent to which COVID-19 is ‘systemic’ compared to being ‘episodic’.
Those expecting a systemic shock or global financial crisis have inevitably rotated out of cyclical sectors. Those who believe COVID-19 is unlikely to have any structural implication on the economy, however, will find opportunity in the sell-off. In essence, businesses that are tied to the economy are not inherently bad businesses.
On the contrary, we have seen businesses across the financials, industrials and energy sectors deleverage and restructure their capital expenditures to improve cashflows amid weak demand. With lower financial and operating leverage relative to the pre-financial crisis era, they will be relatively better able to weather the next storm. Contrarian investors will view market pessimism as a positive signal that these assets are becoming cheap enough to hold and be rewarded for over the long term.
Positive energy
We also have a positive view on European energy companies, which shine as a contrarian investment opportunity on our analysis. We are finding opportunity in Europe oil majors, given their ability to restructure costs following the 2016 oil price recession. They have been hit not only by Covid-19 on the demand side, but also face OPEC supply challenges, which has caused oil prices to collapse to unprecedented lows.
Questions around their ability to maintain dividends and therefore sustain yields weigh on markets, but the ability for some of these companies to recover cashflows through reductions in capital expenditure looks under-recognised. Of course, portfolio diversification will need to be an important consideration, especially as these cyclical plays are more likely to materialise over the long term.
To give an idea of the investment merits of the energy sector, our research points to positive expected long-term returns even if oil is permanently stuck at $30 (£24.60) a barrel, in what is considered a bearish case, with dividend cuts and dilution from capital raisings.
European financials also look attractively priced, on our analysis, as do European telecoms, which have undergone an extended period of weakness relating to concerns around future revenues, changing business models and a heightened regulatory environment. Nonetheless, current valuations should provide an attractive reward for risk, with investors appearing overly pessimistic on the outlook for these sectors.
One final note here – the sell-off has pushed the valuation gap between growth and value to historical extremes. This is also true outside of the US, where our valuation models now point to a seven-percentage-point difference in expected returns between global value and growth stocks over the next decade. As a result, value stocks are another area that look relatively more attractive following the sell-off.
Leslie Alba is senior investment analyst, capital markets & asset allocation at Morningstar Investment Management Europe
