European equities have risen more than 200% since the 2009 financial crisis, but the market’s current dividend yield signals that investors should still expect meaningful returns from these levels, according to Thomas Buckingham, fund manager, Europe Strategic Dividend Fund, JP Morgan Asset Management.
With European dividend yields today hovering around 3.5%, this suggests that we can expect total returns in the high single digits, as much as 10% annualised in the next five years.
Buckingham says there are multiple pillars supporting European equities earnings growth:
- Increase in the money supply supports risk assets. He points out the sheer size and scale of the European Central Bank’s ambitious quantitative easing programme, which is projected to grow the central bank’s balance sheet by more than half. As a percentage of equity market capitalisation, ECB QE is nearly equivalent in scale to US QE 1, 2 and 3
- The weaker currency is a strong indicator of future GDP growth. On a trade weighted basis the Euro is now more than 20% below its highs. Buckingham thinks the velocity of this move represents the most powerful tailwind in approximately 20 years, if the euro stays flat on a trade weighted basis. The lower currency also translates as a massive positive input for European exporters.
- Lower oil prices are also supportive of European GDP. Because nearly all European countries are net importers, a 10% decline in oil prices directly translates in some countries to as much as a half of a percentage point of GDP growth. Also, lower oil prices have a huge benefit in boosting consumer confidence levels and supporting consumer spending.
With significant tailwinds supporting the outlook for earnings growth, Buckingham predicts that European equities will start to close the gap with US equities. Earnings growth for European equities has lagged their US counterparts by as much as 45% in recent years, but historically tight correlations suggest that European equities are due to snap back.
With this backdrop, Buckingham argues that European equities do not look stretched on a valuations basis. He admits that the market looks fairly valued on a P/E basis, but points out that we’re at cyclically depressed earnings levels relative to history. Therefore, using a cyclically adjusted P/E to judge valuations, which shows the market still has significant upside potential, makes more sense.
Buckingham is finding attractive investment opportunities in higher yielding European equities, which offer premium yields relative to the world’s other developed markets but aren’t any more expensive. In fact, he notes that on a median price to earnings basis, high yielding European stocks actually haven’t kept pace with the market average. European equities as a whole are trading on a current P/E ratio of approximately 17x, yet the market’s highest yielding stocks are just 14x.
Importantly, valuations on European dividend shares are also extremely attractive relative to other income playing asset classes. 70% of European companies today have a dividend yield greater than what their own corporate bonds are yielding! This compares to a historical long run average of just 18%. In other words, there is a huge valuation mismatch with bonds being very expensive relative to equities. It also means debt financing for European corporates remains attractively cheap.
Buckingham notes that stock selection is critical for European dividend investors. For example, many of the best stocks are found outside of the traditional equity income sectors. He systematically looks across the universe of high yielding stocks to pick those with the best yield and growth prospects, irrespective of sector. With selective exceptions, he’s avoiding traditional ‘bond proxy’ sectors like beverage companies and utilities, which he thinks look overbought, and instead is finding that cyclical sectors such as financials and media render some of the most interesting opportunities.
He cites the European automotive companies Daimler and Michelin as stocks that tick multiple boxes. Both are significant beneficiaries of weaker oil prices, which help to bring down the running costs on cars, making them more attractive to prospective buyers. Both also have dollar linked revenues but a euro cost basis, helping them benefit from lower currency. They should also be beneficiaries of rebounding European consumer confidence helping auto sales.
Buckingham cites Easyjet as another income pick that benefits from lower oil input costs and rising consumer confidence.
Financial services have been a fertile income hunting ground for Buckingham, as Intesa Sanpaolo and ING are among his favoured holdings. He notes that both have undergone major restructuring and now offer attractive dividend policies.
In concentrating on the highest yielding 30% of the European equities market, Buckingham also importantly avoids yield traps that may underperform. Where he does hold selective companies in more traditionally defensive sectors, Buckingham looks for strong profitability and growth prospects. A typical holding he cites is Belgacom, Belgium’s largest telecommunications company. He sees the 4.3% dividend yield as fundamentally sound and strong upside for the company based on the limited smartphone penetration in Belgium relative to other European countries.