Tim Crockford, European Equities Portfolio Manager at Hermes Investment Management, takes a look at the valuation conundrum facing asset allocators and identifies hidden gems behind the tainted branding of ‘European Equities’.
Asset allocators are facing a valuation conundrum. We are seeing historical peaks in terms of relative valuations between the US market and other regional benchmarks. According to Bank of America Merrill Lynch, US stocks are at a 60-year high versus European stocks. In fact, almost every equity market in the world is trading at a substantial discount to US large cap stocks. While we tend not to make top-down market calls, it is hard to envisage a scenario where the US market can continue to extend its gains before the rest of the world begins to catch up.
Looking across the cycle, the S&P 500 trades on a cyclically-adjusted PE of about 26x, versus a STOXX 600 CAPE of about 16x. Even when the most extreme Trumponomics-inspired tax cuts have been priced into the earnings figure, it is questionable how much gas is left in the equity market cycle, now in its eighth year. There are brewing headwinds too: Trump’s aggressive protectionism may have many undesirable effects on his own economy, such as squeezing up cost inflation, cancelling out some of the gains from lower taxation. Exporters, meanwhile, are likely to face further hurdles in the form of a strong US dollar and increasing trade war retaliation.
Growth has a long way to run in Europe
Across the Atlantic, we are at a much earlier stage in the economic cycle in Continental Europe. Eurozone unemployment, at just below 10% has retreated from its 2013 high of over 12%, but is still some way off its early 2008 low of 7.2%. Growth rates vary across the region, however most countries on the continent continue to trend in the right direction. While investors are likely to remain cautious on Europe, particularly given the frenzied electoral agenda this year, if 2016 is anything to go by, the uncertainty could end up being worse for markets than the move that transpires once the results are known – even if the result is not what the markets were hoping for.
In terms of sectors, we are currently finding most of our European ideas in the industrials and technology space, and we generally prefer mid-caps to mega-cap names. In particular, we are looking for secular growers that also have a cyclical element to their revenues. As always, we recommend focussing on the individual companies, and we pick the ones that we expect to be winners from these secular trends.
KION can benefit from global manufacturing uptick
In the Industrials sector, for example, we like German-listed KION Group, which as the world’s second largest forklift-maker, stands to benefit from the recent acceleration in manufacturing across the world. More importantly, however, following its 2016 acquisition of US-based Dematic, KION Group is now one of the leading global providers of hardware and software to automate warehouses and supply chains, for the likes of Amazon, IKEA and Tesco, and many other medium and large-size corporates that are looking to increase the degree of automation in their distribution centres to cut costs, increase supply chain analytics and improve the customer experience. We see upside to earnings expectations after an initial period of integration for Dematic’s operations, which we expect to last a year or so.
Apple growth to power Dialog Semiconductor
Technology is our largest sector overweight, and again we continue to prefer selective mid-cap exposure. One of our most recent additions is Dialog Semiconductor, which stands to gain from the launch of Apple’s 10-year anniversary iPhone later this year, in which it will supply the Power Management chip. Longer-term, however, we expect to see its valuation multiple re-rated, as it slowly diversifies its revenue exposure away from Apple’s iPhone by winning new customers and growing in recently entered markets, such as fast charging and smart Bluetooth, where Dialog is quickly gaining market share.
Political jitters still on the agenda
With Dutch, French, German and at some stage, Italian general elections next on the agenda for 2017, investors will no doubt be weary of the potential for increased volatility in the run-up to and around these events. This is why we continue to stay underweight equities that are purely macroeconomic bets, or highly politically sensitive, such as the bank sector.
For long-term investors that are willing to pick stocks, rather than buy the market, the political volatility serves as a great opportunity to buy into or increase positions in secular growers, such as KION Group or Dialog Semiconductor.
After all, Europe has had a decade of political uncertainty, macroeconomic volatility and bad news headlines, but that hasn’t deterred the emergence of young, innovative companies, in sectors such as technology, industrials and life sciences tapping the new economy for growth. Many are still trading at old economy valuations, as they stand tainted under the general branding of “European Equities”. We encourage investors to persevere, as hidden gems await those willing to give some European companies a second-look.
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