Two years ago, Europe was on the brink. Publications like Time and The Economist ran apocalyptic stories on the region’s impending doom. The cost of insuring European bank debt ballooned by a multiple of 50 from pre-crisis levels. Conditions were so dire that, throughout much of 2011 and 2012, oddsmakers put the likelihood of a Eurozone breakup at over 50%.
The creation of the euro may have facilitated easier trading, but a one-size-fits-all currency also created challenges for diverse economies. For instance, based on purchasing power parity, the old Finnish markka would currently trade at US$1.52, while the old Portuguese escudo would trade at US$1.01. Yet, these two economies share a unit of account equivalent to US$1.37 (as of May 2014).
The varied needs of diverse European economies and the independence of the European Central Bank effectively precluded using devaluation to address southern Europe’s debt and growth conundrum. Furthermore, without fiscal union, the central bank couldn’t improve tax-and-spend policies among a confederation of sovereign nations. The European experiment appeared ill-equipped to deal with a systemic crisis.
Yet, European countries have managed to restore export competitiveness, jumpstart economic growth and right-size fiscal balances, despite inherent policy constraints. Growth has returned to trend, with the periphery regaining export competitiveness and domestic demand recovering. Credit risk has diminished as sovereign spreads tighten in the periphery, where all countries are now running current account surpluses. In fact, the IMF predicts the Eurozone as a whole will be running a surplus roughly as big as China’s (as a share of GDP) for at least a few years. In this improved environment, consumer confidence recently reached its highest level since 2007.
Deflationary pressures persist and significant risks remain, but crisis-era hysteria has faded, at least for now. Had Mario Draghi described the Eurozone as an “island of stability” two years ago, he would have been laughed out of Frankfurt; when he did so in March, the assessment was largely accepted. The low point of the European debt crisis was a great opportunity for value investors to increase weightings in fundamentally sound companies trading at record discounts.
Of course, a Eurozone breakup would have likely turned many of these value stocks into value traps. But the costs associated with dissolution would have far exceeded those required to keep the Eurozone together. Fortunately, cooler heads prevailed, and European equities have rebounded.
Value investors spend a lot of time in environments of pessimism and skepticism. While it may not be pleasant, investing against the consensus can be oddly reinforcing: it leads you to suspect you’re doing something right.
This suspicion is confirmed at the point in the cycle when skepticism changes to optimism. That’s about where sentiment is now on Europe, which is becoming a consensus overweight.
Opportunities still exist
This doesn’t mean opportunities have dried up. On the contrary, valuations among diversified multinationals domiciled in Europe remain historically attractive, and still-depressed profit margins and earnings offer significant recovery potential over the long term.
A good example is BNP Paribas, France’s largest lender. It’s maintained double-digit returns on tangible equity and a payout ratio of around 30% during one of the most volatile periods in the history of European banking.
Even after doubling in the last two years, BNP continues to trade below tangible book value (0.93x, compared to an average of more than 2x in the decade before the financial crisis), a discount that seems completely unwarranted for a well-capitalized, highly profitable bank with leading franchises in some of Europe’s strongest retail and commercial lending markets.
The consumer discretionary sector is another area offering bargains amid recent pessimism, and U.K. home improvement retailer Kingfisher stands out. With the U.K. housing market in the doldrums, Kingfisher focused on things it could control.
It cut costs, optimized its supply chain, developed a multi-channel sales platform and strengthened its balance sheet. The company has made acquisitions across Europe and emerging markets, and hasn’t hesitated to return cash to shareholders when prudent. All of this has put Kingfisher in a good position to benefit from the nascent cyclical upturn in European housing.
The depressed European energy sector offers less mature bargains with an attractive potential long-term upside. Negative sentiment has recently made well-positioned oilfield services firms like Holland’s Fugro and France’s Technip more attractive, since they’re trading at roughly 30% discounts to long-term forward P/E multiples. These companies provide the technology and expertise needed by both state-owned oil companies and oil majors as they extract hydrocarbons from increasingly remote and capital-intensive areas.
From a bottom-up perspective, Europe has been the greatest value source of any major region over the last couple years. Still earlier in its cycle than the U.S. or Japan, Europe remains the world’s most attractive bargain-hunting ground for disciplined value investors with a long-term horizon.
Read: A tour of global markets
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By Lisa Myers, a portfolio manager at Franklin Templeton Investments. The views expressed in this article do not reflect those of Franklin Templeton Investments.
Originally published in Advisor's Edge Report
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