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Europe’s Ugly Duckling Stocks Deserve More Love

Investors are looking at a very different Europe compared to one year ago. Even though Brexit talks are likely to drag on and Italy’s turbulent political environment is a potential wild card, political risk in Europe has eased dramatically.

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Macroeconomic growth is also looking up, with the euro-area economy expecting a surge of more than 2% this year, while companies in the MSCI Europe Index are poised to deliver double-digit earnings growth. And yet at the end of 2017, European stocks traded at a 20% discount to their US peers.

We believe that stock pickers can exploit this widespread mispricing of European equities to find stock candidates that are much healthier than widely believed. By focusing on company-level fundamentals, investors can transcend industries and countries to spot so-called “ugly ducklings” – underappreciated companies with high-return potential.

Amer Sports: Identifying a Healthy Business

Amer Sports is a good example of how unappealing data can make a company look worse than it deserves. Shares of the Finnish sportswear company underperformed in 2017 as investors worried that weak inventory figures in the US might signal a deterioration in the popularity of its brands such as Wilson and Arc’teryx, which are stronger in North America than in Europe. We think investors are looking at Amer Sports through the wrong lens, lumping them together with US sports retailers who have been stuck with too much stock amid an onslaught from online rivals.

Weak inventories don’t signal that Amer is losing market share, but rather are a symptom of the market’s transition toward more online sales, which has caused distortions in inventory. In fact, the company has healthy cash flows, and we believe market inventories will ultimately stabilise to new normals that reflect the new online market reality.

CaixaBank: Tarnished by Location

Sometimes, stocks may look ugly simply because of the neighborhood they’re in. CaixaBank of Spain, for example, was tarnished last year because it’s based in Barcelona and was considered vulnerable to local turmoil related to Catalonia’s independence bid. Yet we think CaixaBank’s business is actually quite resilient—and it has little to do with local politics.

With the largest retail network in Spain, CaixaBank commands 18% of the country’s retail banking market. As Spain’s economy continues to recover from a prolonged economic slump, CaixaBank is seeing improvements in loan quality, funding costs and stabilising margins. And, with a very strong position in the retail market, the bank benefits disproportionately from cross-selling financial services products such as insurance and investment funds to its customer network.

Airbus: Perpetually Misunderstood

The corporate transformation of Airbus is long behind it, yet the company still struggles to rebuild its reputation. Many investors still think Airbus suffers from weak corporate governance because it was run by four European governments before its ownership structure was changed in 2012. Shares of Airbus seem to be perpetually depressed, trading at a 20–30% discount to its main rival Boeing on simple earnings metrics, even though the two companies sell similar products to similar customers, with similar cash margins and are subject to similar market forces.

Why the extreme negativity? We think it has more to do with the product cycles than a fundamental weakness of Airbus. Airbus manufactures the A350 long-haul commercial airliner, which competes with Boeing’s 787 Dreamliner product. Boeing is several years ahead of Airbus in its product cycle. That means Airbus is still spending heavily to build the jets, while pricing has yet to stabilise. These factors have suppressed Airbus’s cash flows dramatically when compared with Boeing’s. This could change as Airbus’s product cycle starts to catch up.

By over-emphasising the importance of location or confusing the indictors of a sound business model, investors could be missing out on opportunities offered by underappreciated companies. Investors who take a selective approach to spot these “ugly ducklings”, and avoid being distracted by background noise, are more likely to be rewarded over time.

Tawhid Ali , March 2018

Article also available in : English EN | français FR

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