The quality of some companies has improved, while valuations have shrunk.
(Runtime: 2 min, 43 sec; size: 2.23 MB)
Alessandro Valentini, portfolio manager, Causeway Capital Management.
Europe still offers very interesting opportunities for us. While MSCI EAFE is not just Europe but Europe is a large component, it is important to point out that over the last five years, the return on equity for the EAFE Index has improved by over 1% while the price to book has actually decreased by 13%. This implies that while the quality of the company has improved, the evaluation has shrunk. For comparison, the MSCI USA index has seen returns improving by 1.6% but the evaluation, the price to book evaluation, has increased by 11%. And that is a pattern more normal than we should expect.
We have seen several companies in Europe taking several steps to improve their business in their returns, in part to counter the political economic challenges we have discussed. Take Volkswagen. After the dealer scandal, management focused on improving operating margins through reduced labor cost, has introduced more disciplined capex, and has improved the product mix to improve profit growth. Or again, UniCredit, which is another good example of opportunities emerging in Europe even in the face of economic challenges.
Italy’s struggling to emerge from a near zero growth scenario and the recent political events are not helping confidence. But as we’ve talked about in the past, UniCredit is improving its return through non-performing loan disposal and driving efficiencies in the business. The client management that’s laid out is not dependent on the Italian macro or the European macro, but it’s self help that management will deliver on and that should lead to a re-rating of the stocks.
One of the unique characteristics in the market right now is, again, this dichotomy evaluation within defensive and cyclicals. And nowhere is that more evident than within financials. Financial and banks specifically look very attractive to us after the recent selloffs. The evaluation of UniCredit and Barclay’s are at levels close to those of the financial crisis or the Euro crisis of 2011. At the same time, these banks have three times the amount of capital they had before the crisis, and the loan books do not screen nearly as risk loaded as they were in 2007.
To us this looks like a classic case of recency buyers. The market is looking at banks, and banks were the problem the last time around, so they must be the problem this time. We strongly disagree with that. The higher quality balance sheet, the better management and the higher ROE business is matched by a higher level of capital, and that should lead to outperformance as the real performance of the bank shines through.