Many value orientated equity investors are looking at European equity markets as an opportunity for attractive returns over the medium term. Value investors argue that we have entered a period where deep value based equity strategies may start to perform well after a period of dramatic under performance against growth stocks. The graph below illustrates how high quality growth stocks in Europe now trade at a substantial premium to value stocks based on a simple price to book ratio.
Figure 1. The difference in price-to-book between high quality and value stocks
During the European Central Bank’s extended monetary easing programs over the last few years investors have become more and more worried about the impact that low interest rates could have on bank earnings, for example, an area of the market currently out of favour with investors. When interest rates fall, bank margins fall, whilst deflation hurts their earnings as customers do not want to borrow. Therefore, financials have been out of favour in a deflationary world. Our view remains that banks will continue to suffer and that this sector remains one to avoid even if values remains depressed.
On the flip side of value stocks investors’ risk aversion have propelled well-known European growth stocks in the consumer and healthcare sectors to unprecedented valuations. Businesses with low yet predictable growth prospects like L’Oreal, ABI Inbev and Coloplast offer strong shareholder returns as value compounders over the long term but for many businesses like these, return expectation are low in the medium term as valuations are already stretched as investors have shied away from value stocks into these names.
Are economic growth forecasts able to help earnings growth in Europe?
European equity investors should not rely on strong growth to help earnings growth in the short to medium term. In Europe, slow growth is expected to continue, with the IMF forecasting a GDP increase of 1.5% this year and 1.6% in 2017, low by historical forecasts. Elsewhere in the US the impact of a slowing US economy has ramifications for Europe as the export driven industries relies on a strong US and Chinese consumer. The graph below shows that broad economic indicators in the US is mixed at best with the services sector showing weakness over the last few months.
Figure 2. ISM Purchasing Managers’ Index
The external global economic environment remains supportive for European exporters, but the trade flows which were well supported by the weakening euro last year are likely to fade as the recent rally in the Euro acts as a natural brake on the economy. Year to date the Euro has rallied by over 5% which will eventually cause German export goods in particular to become less competitive versus a basket of other goods produced outside of Europe. Also, higher oil prices in 2016 from multi year lows will diminish the income gains of lower energy spending for European consumers later this year.
What European businesses can benefit in a world of low growth?
As one of the leading pharmaceutical businesses in the world we invest in Roche. Roche develops and manufactures pharmaceutical and diagnostic products. The Company produces prescription drugs in the areas of cardiovascular, infectious, autoimmune, and respiratory diseases, dermatology, metabolic disorders, oncology, transplantation, and the central nervous system.
Roche has generated a 12% compound annual growth rate in free cash flow over the past ten years, providing management with ability to invest in research and development and return excess cash flow to shareholders. Revenue are expected to grow in the mid-single digits over the medium to long-term. Given its terrific long term returns on capital versus its competitors (Figure 3) we believe Roche can continue to deliver decent shareholder returns for investors over time.
Figure 3. Returns of Invested Capital for Various Healthcare Names