By Gene Salamon
Managing Partner and CIO,
Three Bridges Capital
This is a great time to invest in European equities. The storm clouds that have been hanging over Europe for the past six years have finally lifted. Macro-related risk fears are moderating and a gradual recovery continues to progress. Yet as a whole, European equities are still at depressed levels, creating an exceptional opportunity for investors.
Sensational news coverage in recent years, and perhaps the recent experience with the U.S. sub-prime crisis, led investors to extrapolate those concerns into the excessive tail risk fears we saw during the past four years, particularly in 2011 and much of 2012. With macro tail risks reduced, the bearish view on Europe should be reversed. Our firm opinion is that the opportunities offered by European equities have never been better, particularly for fundamentally-focused stock pickers.
Fear over macro events in the periphery of Europe has created a disconnect between current stock valuations and corporate fundamentals. European equities have underperformed the S&P 500 but now valuations in many cases look highly attractive. Whereas MSCI Europe trades on a price/earnings ratio of less than 11x, the S&P is at 16x. Dividend yields are at unprecedented high levels compared to corporate bond yields. Nearly 50% of European companies have dividend yields (in most cases well covered) in excess of their current bond yields. We fully expect a substantial increase in equity prices in Europe to act as the primary driver closing this yield gap. Adding to this constructive environment are improved PMI (Purchasing Managers Index) levels across the continent and solid third quarter earnings.
In addition, while many of the region’s biggest companies have always had multi-national operations and/or sales channels, many of them have earned the right in recent years to be considered global leaders. It is noteworthy that despite the de-rating of the European equity markets, many European companies have achieved the status of becoming world leaders in various different sectors. Inditex (parent company of the Zara brand) and H&M are good examples in the retail sector, auto companies BMW and Volkswagen also meet this criteria, as do pharmaceutical companies Roche and Novo Nordisk, and technology companies SAP and ASML. None of this mattered to investors in recent years as despite strong fundamentals, European equities were de-rated almost across the board. Now, in addition to benefitting from well-positioned exposure to global growth, the high operating leverage inherent at most European companies will allow them to benefit from even a slight improvement in the domestic European economy.
When assessing the opportunities in Europe, one misconception needs to be cast aside. Although the term “European debt crisis” has frequently hit the headlines, the reality is that from the beginning, the crisis in Europe generating those scary headlines has been a sovereign debt issue in the periphery of Europe. Aside from the periphery, Europe does not have a sovereign debt problem. Europe, even including the periphery, has lower debt and smaller deficits than both the U.S. and Japan. The core European economies have relatively favorable ratios of government debt to GDP and deficits as a percentage of GDP compared to other regions. We believe that the issues in Europe are more political in nature than economic. The real challenge for mainstream Europe has not been deficit reduction but finding the political will to build a structure that is properly equipped to deal with the difficulties faced by the peripheral countries. This process is already taking shape and creating a political structure more easily capable of dealing with problems among member states as evidenced by the fact that the ECB is poised to take over as the region’s bank supervisor next year. Quantitative easing, further movement toward political and banking union and debt relief for the periphery are solutions offered by the ECB, IMF, and European politicians that have already begun to have a significant impact.
ECB President Mario Draghi’s pronouncement in the summer of 2012 that, "Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough," marked an important turning point. For the past year, tail risk fears have moderated, creating the opportunity for investors to revisit Europe. This year, concrete signs have indicated that previous European risk concerns have been stabilized. The market impact from inconclusive Italian elections early in 2013 was painful but short-lived, in contrast to similar events in Greece during 2012 that took Europe on a downward spiral for months. Likewise, the Cyprus bank deposit confiscation in March was also painful but is now mostly forgotten. Market reaction to these events suggests that while risks remain, apocalyptic extrapolation of these tail risks is gone. As investors are less focused on macro headlines from Europe, fundamentals have come back into the equation, creating a healthy environment for stock-picking. Reinforcing this improved environment is the behavior of the currency. The Euro has remained much more stable in recent years than most investors expected, since currency markets recognize what stock investors have not. Europe is in much better fiscal health than media attention has suggested, with both overall government debt as well as annual deficits on a more sustainable trajectory than most other regions in the world.
European equities represent approximately 30% of global equity markets, yet many investors have largely abandoned or under-allocated to the region. The de-rating of Europe in recent years has created an unprecedented disconnect from fundamental factors. With macro tail risks reduced, the bearish view on Europe held by most investors should begin to reverse. Our firm opinion is that the opportunities offered by European equities have never been better, particularly for fundamentally-focused stock pickers. Investors that return to Europe at this phase of the recovery are likely to be well rewarded.
Gene Salamon is the Managing Partner and founder of Three Bridges Capital with responsibility for managing the Three Bridges Europe Funds. He has over 19 years of experience in the investment industry focused almost exclusively on European equities. Prior to forming Three Bridges in 2011, he was a Partner at Indus Capital Partners where he launched the Indus Europe Fund (now rebranded the Three Bridges Europe Fund) in 2006. Before joining Indus Capital, he was a Partner and Portfolio Manager of a European equity long/short strategy at Omega Advisors, a $6 billion private investment fund based in New York, from 2003 to 2006. Previously, Mr. Salamon was a Managing Director at Objective Capital and Orchard Capital, Europe long/short private investment funds based in New York, from 2000 to 2003.