Worries about the fiscal situation had driven valuations to historic lows, resulting in significant opportunities for bottom-up investors to take advantage of mispricing arising from a volatile and macro-driven market.
Despite the recent rally, valuations still remain attractive.
But we believe that the market continues to miss the bigger opportunity, beyond the near-term optical valuation gap.
This valuation gap can be seen in a variety of metrics, with Europe at a discount to both peers and history. Enterprise value/sales is close to its lowest point in recent memory, despite the fact margins are holding up well and sit in the middle of their range over the past ten years.
The market is also trading on a substantial discount to global equities when viewed on a price/book metric, with the MSCI Europe at 1.5x while the MSCI World is at 1.7x. On a price/earnings basis, Europe is at a discount to other markets and its own history at 12x forward earnings.
However, a focus on these measures of valuation, particularly price/earnings, fails to capture the potential for an earnings recovery which is clearly available in Europe and may not be in other markets.
As seen in the chart below, European earnings have declined and remain considerably below their 2007 peak. However, US earnings have returned to their peak and emerging markets have surpassed it, although this has recently dropped away. So Europe’s rating offers at first glance an opportunity at attractive valuation ratios but also the underlying potential to rerate when the market believes the earnings cycle has turned positive.
The trade-off between financial productivity and valuation, provides further insight. The European market’s return on equity is broadly in line with the rest of the world, indicating significant upside potential if and when Europe’s earnings close the gap with other developed countries.
The irony of this situation is that Europe remains at a discount to the rest of the world despite the fact its companies have been growing the proportion of their revenues coming from outside the region. In 2012, revenues from outside Europe exceeded those generated internally for the first time. This indicates that Europe should have rerated over this period but in fact the reverse has happened.
From the perspective of an equity investor, Europe became unloved and underowned. A significant valuation discount has been created by top-down investors taking a negative macro view of the region and corresponding underweight positions. We have seen the wholesale avoidance of periphery countries and entire sectors, such as financials, and this creates significant opportunities for bottom-up investors with a focus on fundamentals to take advantage of mispricings.
However, the case for investing in Europe is not just about valuations. The potential for earnings recovery, as well as the structural reform taking place, paint a compelling picture in the medium to longer term.
