Massimo Greco, head of Continental Europe Funds for JP Morgan Asset Management, sees ongoing stockpicking opportunities in Europe as one facet of the current investment environment.
What impact could the results of the German elections have on investor views of European, especially eurozone assets?
The Germany election results remove an element of uncertainty. Anything that removes uncertainty is good for investors. Anything that signals stability and leads to a smoother path for economic recovery is a positive for Europe.
For German equities, the election is largely a non-event and the bigger influence is that the global economic picture is improving.
We see value in peripheral European markets. For example, Spain and Italy are cheap on a cyclically adjusted basis. If you do get more recovery in growth next year, then Spain and Italy could be major beneficiaries similar to Ireland.
Our European equities team sees opportunity in rotating from defensives towards cyclical stocks. More expensive defensive sectors like food and beverages look less attractive. Meanwhile, sectors that may have been value traps before are starting to be underpinned by fundamentally sound growth.
If you look back at European earnings in aggregate the last five years, they have barely moved. Some growth is expected in 2014 but the expectations are modest. Therefore, Europe is almost certainly at trough earnings. A strengthening in the cycle should very much be a headwind. Companies have had an opportunity to optimise costs and have strong balance sheets, so are well positioned going forward if we do get more global recovery.
If there is evidence that the euro may start to strengthen – partly as a result of concerns interest rates will remain lower in the US for longer, and partly because of rising economic activity in the eurozone – how might this affect investor behaviour?
Yes, US rates and the lack of tapering as well as stronger European growth have no doubt strengthened the euro. If this continues and the Fed stays on hold, then presumably you’d expect the euro to continue to strengthen against the dollar. However, our currencies team would suggest that the lack of action recently by the Fed doesn’t derail the longer term view of dollar strength. The upside for Euro/USD in our view is relatively limited.
In reality, with the exception of some specialist sectors, European clients tend to hedge currency risk. Most of our fund sales are in euro or are hedged to euro and in general we don’t see clients taking major currency bets.
If Europe remains a stockpicker’s delight, what are the types of companies being picked?
Our European equities team is beginning to see value in the periphery. Within equities, cyclical stocks are starting to look more attractive and the team is rotating from defensive sectors into parts of the market that will be poised to benefit from rebounding economic growth. Whereas we correctly judged these parts of the market to be value traps previously, that is changing as they start to show fundamental growth and improvement.
The trends in the market change but core skills for generating alpha in stock picking do not. JP Morgan Funds – Europe Equity Plus fund for example builds a portfolio based on quality, value and momentum. For stock selection, they ask: Is the stock cheap on an absolute basis (price/earnings)? Does it have quality factors (strong balance sheet, free cash flow, etc) that signal return on invested capital? Does it have positive earnings that will drive momentum?
For that team, exploiting market inefficiencies driven by investors’ behavioural biases acts as a roadmap for picking stocks. In their view, cheap stocks consistently outperform because valuations are often based on what is fashionable rather than fundamentals and because investors tend to be inherently overconfident about their conviction (either too pessimistic or too optimistic). High quality stocks with good earnings and capital discipline outperform because investors give insufficient credit to profitability.
Equities overall still look compellingly cheap as an asset class, particularly in Europe. For example, as illustrated in the chart below, the forward price to earnings ratio on the MSCI Europe at 12.8x is still well below its long-term average and the dividend yield at 3.4% outpaces the yield available on government bonds. Meanwhile, many of the MSCI Europe sectors look cheap relative to their own history. However, for investors venturing back into the markets, successful stock picking will be the key determinant of excess returns and ability to generate Alpha.