European equities: volatility equals value opportunities

With pricing correlations between assets beginning to break down, Nick sees a pick-up in attractive opportunities based on fundamental corporate analysis.

What are your thoughts on recent market volatility?

Many commentators have speculated that not only have global quantitative easing (QE) measures inflated asset prices, but also served to dampen volatility across all financial assets. If the start of 2016 is anything to go by, it looks like the decision by the US Federal Reserve to start normalising interest rates had the opposite effect, depressing markets and increasing volatility. It would be very easy to write recent market falls off to experience and focus on the positives for Euroland assets: the potential benefits of the European Central Bank’s accommodative monetary policies; relatively low valuation levels compared to other developed markets; the potential for a long-overdue recovery in corporate profit margins in the region; and the attractive income yields on European stocks.

Unfortunately, being an optimist in markets potentially carries a very high price. Thus, to my mind, it is always worth looking at the problems and trying to strike some sort of balance. Euroland equities have re-rated against broadly stagnant earnings in recent years, so any threat to a widely anticipated recovery in company profit margins would be problematic.

However, just as Europe seems to be on more solid footing for a sustained (albeit protracted) recovery, China seems to be slowing quite quickly. One solution to kick-start growth in the world’s second largest economy would be to devalue the renminbi; however, should this happen, any European recovery would end. Given China is a ‘command’ economy, the market cannot dictate the level of the renminbi and any move will ultimately be politically driven. In addition to this, the US remains in something of a quandary. Many companies have used the opportunity afforded by historically low interest rates to swap equity for debt. ‘Normalising’ interest rates could therefore cause problems for US Federal Reserve chair Janet Yellen. Against this backdrop we expect volatility to remain at elevated levels for the time being. While this is bad for investor sentiment generally, it provides an environment in which we typically find some of our best long term opportunities.

Have you changed your positioning as a result of market moves?

For investment managers considering a longer-term horizon, market uncertainty should be seen as an opportunity, rather than something to be feared. As shareholders get nervous, pricing correlations across assets begin to break down. This can create attractive mispriced prospects for active managers focused on corporate fundamentals, such as ourselves.

A good example of this is car manufacturer Renault, which came under selling pressure at the start of 2016. Market uncertainty combined with news that Renault – as with all other car manufacturers in France – was undergoing testing on its engines, following the issues with Volkswagen last year. We were convinced that this report would turn out to be something of a damp squib, and indeed that was the case. It did, however, provide an opportunity to add to our holding at attractive levels.

In terms of my strategy, during times when the market looks exceptionally good value, we will normally look to hold around 40 holdings – towards the more concentrated end of the scale for us. When we are unsure about what the short-term direction of markets is likely to be, or if stocks look a bit expensive, we will tend to be a bit more diversified, around 50 stocks.

Stylistically, however, some characteristics of the strategy will tend to remain the same. For example, looking at the Henderson Horizon Euroland Fund, the combined price to earnings (P/E) forecast for holdings should be cheaper than the wider market, reflecting our bias towards undervalued stocks. This currently stands at 14.35x versus the market average of 14.46x (as at 31 January 2016). The return on equity of our holdings on aggregate should be higher than the market (currently 18.4x vs 13.1x) and with better operating margins (13.8% vs 13.4%). We do not manage the strategy to any target for beta, forecast tracking error, or active share stance.

What are your expectations for Euroland equities?

Politics aside, notably the Brexit negotiations, the Euroland region seems relatively well supported. Exchange rates and the current low oil prices (which while deflationary are good for both consumers and businesses) remain a tailwind, while purchasing managers indices still point to slow expansion. Monetary policy is likely to remain very stimulative in Europe, while bank lending is improving, which should support internal spending within the Euroland area and possibly lead to higher capital expenditure for companies.

While we are sanguine about the economic backdrop in the Euroland, probably the biggest potential impediment to our expectations is the risk of external shocks, namely a slowdown or currency devaluation in China, or US market weakness caused by earnings contraction as the cost of borrowing bites. It is important to keep in mind that investment in any one region can never be isolated from another, and short-term market moves, if not politically inspired, are normally correlated. On the other hand, long-term shareholder returns are generated by profits made on a firm’s underlying assets and in this sense Euroland seems to be recovering.

Aside from the economy, one of the long-term metrics I use to gauge value in the market is the Shiller P/E ratio, a valuation measure applied to broad equity indices that measures earnings per share over a 10-year period. Currently, as shown below, the Shiller P/E rating remains significantly discounted versus its long-term median, suggesting above-average returns for investors within the single currency area over the longer term.