We think now is a good time to be investing in Europe. European equity valuations are at the lowest level in more than 40 years, by some measures, and we are seeing green shoots in the region’s downtrodden economy. Meanwhile, European companies in several industries have right-sized their cost structures or refocused their businesses, setting them up to be more competitive on a global scale.
In some cases, these structural changes remain unrecognized by the market, creating some of the best long-term investment opportunities we’ve seen from the region in years, in our view.
Second-quarter GDP growth for the euro zone – the first economic expansion for the region since the third quarter of 2011 – grabbed attention in August, but we had seen signs for several months that Europe’s economy was improving.
New orders outpaced inventory buildup since last September. The ratio of new orders to inventories moved up considerably from May to July. When that ratio trends up, positive earnings revisions typically follow.
We see improvements in some of the most important industries in Europe’s economy as well. Earlier this year, European auto sales in terms of numbers of units fell two standard deviations below its long-term mean. We believed that marked a tipping point because U.S. auto sales hit that same low-water mark before rebounding sharply in 2009. By late spring, companies supplying parts to Europe’s auto manufacturers noted a pickup in orders, and we since have seen auto sales turn positive in some of Europe’s largest countries.
A rebound in the auto industry would go a long way toward getting the region back on its feet. In Germany, which still drives the bus when it comes to the European economy, we estimate that 12% of the country’s GDP is tied to the auto manufacturing chain.
Meanwhile, much of the economic activity that drives bank earnings also has reached an inflection point. For instance, loan growth reached its trough, nonperforming loans peaked, and banks largely have completed asset write-downs.
Stock valuations don’t reflect the economic improvements we are seeing, however. European equities are undervalued and trading at a deep discount to U.S. stocks. While European equities are appealing in general, we think there are specific areas of the market that are particularly attractive.
In the industrials and financials sector, we think the market is overlooking structural changes taking place at a number of companies that could mean substantial improvements to the bottom line of these companies for the next decade or longer.
Over half the industrials companies covered by our European industrials analyst are restructuring. Management teams are getting the upper hand in bargaining with unions, as many unions realize they must make stronger concessions to survive. Even in France, which has some of Europe’s most aggressive unions, we’ve seen the unions back down. Other companies are shedding business units that were unprofitable.
European banks offer another attractive investment opportunity. Most of these banks are trading well below their historical levels and the valuations of banks in the U.S. and Asia. We think the market is underestimating some of the cost-cutting measures taking place at these companies.
Part of the reason the market is underestimating cost cuts is that they are often behind the scene and difficult to measure. For instance, banks are sensitive to publicizing layoffs, but one of our analysts in Europe has noticed a number of staff reductions and other small cuts taking place in various departments.
Measuring the sum of all these parts is difficult, so investors have been skeptical that the cuts will really take place. But in general, banks have delivered on cost-cutting guidance ahead of schedule, and sometimes beyond managements’ initial estimates, increasing our conviction that future cuts can be carried out.
We by no means expect a V-shaped recovery in Europe, but as companies right-size their cost structures, it should substantially improve margins if the economy improves even modestly. We see early signs of those improvements, making it an opportune time to invest in Europe.
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