High quality defensive companies with predictable earnings in sectors such as healthcare and consumer staples have thrived since the financial crisis, whereas more cyclical areas such as materials and the banks have struggled. Since 2007 value has had flashes of outperformance, but in each case quality growth has returned to favour. I believe that a combination of factors suggests we have now hit an inflection point for value in Europe.
Changing economic backdrop
For value to start performing, rates must stop falling. This is clearly what we have seen in Europe since the beginning of the summer. There has been a definite change in attitude from policy makers in recent months. Since the financial crisis, the core approach to stimulate growth has been cutting interest rates and quantitative easing (QE), which further pushes down rates. In some cases, yields have even turned negative.
Central banks are now learning that there is a limit to how much rates can be cut without it damaging the economy, the so- called “reversal rate” as it is known in academic literature. We are perilously close to this in Europe today and so the probability of further cuts is low. A shift from monetary to fiscal stimulus is now looking more likely, which has resulted in rates stabilising and in many cases rising in recent months in Europe.
While the stabilisation of rates has proved to be the catalyst for value, it is the scale of today’s valuation support for certain companies that should enable prolonged outperformance in Europe.
Earnings risk vs price risk
The price differential between value and quality growth is extremely wide, at levels that we haven’t seen for many years. Although value has made a comeback recently, it has barely made a dent in the underperformance of the last nine years. With many investors still preferring the perceived safety of quality growth, we believe this story has further to run in Europe.
Some investors seem to have forgotten the importance of price risk, and instead focus solely on earnings risk. While many high quality companies have very low earnings risk, they have been bid up to levels that are no longer sustainable in Europe
Opportunities in European banks
At trough margins and tough earnings, we believe that banks are one of the few sectors that could experience both an earnings expansion and a re-rating as the cost of capital rises. It is not uncommon to find well capitalised European banks paying dividends yielding more than 5%, trading on price-to-book multiples of 0.5-0.7x, and price-to-earnings ratios of under ten times. BNP Paribas and Societe Generale are good examples.
The recovery in banking stocks in Europe since the depths of last February has been relatively modest, and we expect further upside. While value stocks and particularly the banks have been more volatile than their quality growth counterparts in recent years, the risks to their earnings are receding. This receding earnings risk coupled with extremely low valuations is a potent combination. When considering both earnings risk and price risk, banks are less risky investments than the majority of so-called defensive European companies.
There is more to this value story than banks, though. Selective opportunities also exist in materials, industrials, energy and consumer discretionary in Europe.
We remain wary of more defensive companies residing in the consumer staples and healthcare sectors, which look expensive in Europe.
History is on value’s side
It is understandable that investors in Europe remain wary of value strategies given both the volatility and the degree of underperformance in recent years. But it is this tough period that has provided an excellent long term entry point. We believe the value recovery is set to continue, and will reward those investors who capture this opportunity in 2017 and beyond.
Rob Burnett is investment director, head of European Equities at Neptune