Will James
Premier Miton European Equity Income Fund
A long and slightly uncomfortable journey
2022 has been tough for lots of reasons. As we progress through quarter four, with equity markets showing negative figures for many regions globally – including European indices, it is important to stop, take stock and look ahead. Maybe leaning on the inquisitive nature of my kids when on a long and slightly uncomfortable journey and ask the question ‘are we there yet?’
A pile up of geopolitical, macro and market events
In Europe today, the collision of market, macro and geopolitical forces have presented as large an obstacle as I can remember over the last 20 years of investing. Just as Europe was starting to emerge from the most severe pandemic in a century, comes the largest, most disruptive war at the heart of Europe since World War II.
Looking through an investment lens, European equities as an asset class have understandably been out of favour, with investors adopting a ‘risk-off’ approach as equity markets around the world have fallen. A recent FT article quite correctly highlights that investors have pulled money from European equity exchange traded funds in August 2022 at the fastest pace since the 2016 Brexit referendum.
There have been limited places to shelter from sharp market movements, but is it all bad? Are the investment traffic lights for the continent about to turn from red to amber, signalling the potential for forward progress?
Reasons to look at Europe 1: Europe is unloved
Let us start with the current investor sentiment towards Europe. Investors are the most underweight European equities in a generation, we have seen this before in the last 10 years, with the Sovereign Debt Crisis in 2011/12 and the concerns around the spill over effects into Europe of Brexit in 2016.
2022 has brought with it a war on Europe’s borders, an emerging energy crisis coupled with a growth slowdown and eventually a much-anticipated recession. Europe is quite simply unloved as the complexity of the current situation has tarnished the picture for investing in Europe.
You could ask what else could go wrong or surprise markets, given all that has been thrown at Europe this year? Considering many investors think that 2022 has been more than a speed bump, many have already locked the proverbial car door and handed back the keys. Time to start dusting off that A-Z of the contrarian investment back roads.
Sentiment this low has historically presented strong investment return opportunities
Source: Bloomberg. Data from 31.03.2003 to 30.09.2022.
Reasons to look at Europe 2: Europe looks cheap to me
An outcome of Europe being unloved, underinvested and the poor cousin to the economic powerhouse that is the US, is that it looks cheaply valued to me. As highlighted above, a lot of unwelcome news maybe already reflected in European valuations.
The measure of valuation we are using is Price-to-earnings ratio (P/E ratio). The price-to-earnings ratio is the ratio for valuing a company or aggregate market, as we have done here, that measures its current price relative to its earnings.
Let us define cheap here. The relative value of European equities represented by the FTSE World Europe ex UK is the lowest to the S&P 500 (US equities) than at the height of the COVID-19 pandemic or even the Sovereign Debt Crisis as shown in the chart below.
Price to Earnings multiple of FTSE World Europe ex UK relative to S&P 500
Source: Bloomberg. Data as at 30.09.2022.
Now it is clear there has been some divergence in the fortunes of these two markets, so a degree of discount is merited as has always been the case. With European equities looking ‘cheap’ they may also be effectively pricing in poor future economic news and future profit warnings. This is an environment where it is vital to understand a business and the interaction between its current and future profitability, balance sheet and market valuation.
For me, as a fund manager focusing on company selection in Europe, this disparity naturally creates opportunities to identify not only cheap but undervalued companies that happen to be listed in Europe. A thorough look under the bonnet is required in these situations, to distinguish between companies that are well maintained and those that have the corporate equivalent of a shot gearbox.
Reasons to look at Europe 3: European companies are embracing dividend payments
The traffic jam of negative forces that we referenced at the start of this insight note has made company selection more important. Focusing on the equity income sector there are plenty of arguments for investing in the region. Europe is home to many of the strongest industrial, financial, and healthcare companies in the world, which makes it a fertile ground for equity income investing. From an investor point of view receiving a dividend provides something very tangible when it comes to valuing a stock.
Equity income is not just for income seekers, dividends can be reinvested to produce a higher total return. Even in falling markets as an investor you are getting some benefit using this approach, because the dividends distributed by an equity income fund can be used to buy additional units in the fund at lower prices.
Looking at the below chart, the FTSE World Ex UK index on a price return basis (without dividends being reinvested) compared to a total return basis (with dividends reinvested), we can see that dividends have accounted for greater than 50% of total returns over this period.
FTSE World Europe ex UK Index: The cash compounding attraction of dividends should not be underestimated
Source; Bloomberg, data from 31.08.2007 to 31.10.2022. Please note that this chart as been rebased to 100 on the Y axis.
Please remember that dividends can be cut too, and in the current environment where companies face higher debt interest payments, inflationary costs, and a weak economic outlook, dividends could come under pressure. This is a risk for equity income funds.
It has been a long and winding road, but patience will pay dividends
I do believe growth will remain hard to come by given where we are in the economic cycle with a clear regime shift from supportive monetary policy towards higher interest rates.
But with this shift, there is an opportunity for fundamental stock picking to start to pay dividends again over the medium term. The starting point for this is the ongoing focus of European companies on paying shareholders dividends coupled with valuations that look historically low, especially compared to other equity markets.
While there are plenty of reasons to paint a negative picture for Europe, European equities in my view may present an opportunity for those who have previously overlooked this continent and the world class companies it is home to.
While we may not be there yet, and there have been quite a few potholes on the way, there is a clear bend in the road ahead, one where the sweeping views from the driving seat look increasingly positive.
