Thus far, underwhelming earnings growth has done little to support the market’s upward march. In our view, that is poised to change.
We have a real and sustainable economic recovery underway following four consecutive quarters of positive real GDP growth. It’s important for investors to remember that absolute levels of growth aren’t as important as improvement in sentiment and expectation toward higher GDP.
Much of the weakness in the Eurozone observed at the aggregate level has been in part due to aggressive austerity and declines in government spending. Going forward, less fiscal drag should support growth.
Meanwhile, improving consumer confidence should encourage households to spend less on reducing debt levels and more on consumption, helping corporate revenues.
Profit margins are on the rise and will be an important driver of earnings. Nominal growth has been dampened, particularly in the periphery, by inflation trending lower. Export-oriented European companies have suffered from the emerging markets slowdown and the stronger Euro, but both of these drags have moderated. Further, if companies are able to control costs as nominal growth accelerates, profit margins should rise, bolstering earnings growth.
The better economic data, acceleration in nominal growth and changes in consumer behaviour set the stage for stronger earnings growth. And continued low interest rates and loose monetary policy will also act as a tailwind for improving profits and bolstering earnings.
Taken together, this backdrop should contribute to an environment where company fundamentals are more important in determining equity valuations than they have been following the Eurozone crisis.
Investment opportunities
Fundamentals coming back into focus will mean the market pays more attention to factors like quality, value and momentum when rewarding individual companies.
For example, this is very much the case in the European automotive sector, where we are overweight in stocks such as BMW and auto parts supplier and tyre manufacturer Continental. Car demand has recovered earlier and faster than analyst expectations (sales rates have come in at almost double the expected rates), creating positive surprises. The average age of a European car is now 8.7 years, the highest it has ever been.
This is incentivizing consumers to take a close look at financing options for new car purchases rather than continuing to service old vehicles. Meanwhile, automotive companies have massively increased their balance sheet strength since the financial crisis, boding well for sustainable growth and capacity for business investment. The sector is still trading at relatively attractive valuations.
Another theme we’re playing is consolidation, which is evident in stocks like Orange SA. In the tough economic conditions following the financial crisis, you’ve seen transformation within certain industries, with weak players being overtaken by consolidation. In the French telecom industry, the big five players have reduced to four with potential for further consolidation under the encouragement of the French business minister calling for greater efficiency. This development has benefitted Orange SA.
Seeking relative value is a key part of our investment process and contract catering company Elior is an interesting example of that. They serve a wide variety of businesses carrying out support service functions and operating in the travel food and beverage sector. Given the strength of the business and its growth prospects, we think it is trading on cheap valuation to peers yet it delivers a high return on invested capital.
