Shifting to Europe for better returns
For global investors who can literally go anywhere, developed markets have been an attractive place to be during the past few years as a source of both dividend growth and the best risk-adjusted returns.
It’s driven a lot of money into U.S. stocks, where valuations are still reasonable and the business cycle is still in its middle stage. But with the European Central Bank implementing quantitative easing, corporate profitability growth in Europe is poised to outperform that of the U.S.
“On an absolute basis, Europe looks pretty cheap. It also looks cheap on a relative basis,” said Andy Nasr, a portfolio manager at Middlefield Capital Corp. “And the most important thing to remember is that earnings are still very depressed because you haven’t had a huge margin uplift. It’s been a lot tougher for corporations to get lean.”
The Middlefield Global Dividend Growers Class, which is part of Nasr’s roughly $1.1 billion in assets under management and is up about 20 per cent in the past year, had been heavily overweight U.S. equities. However, about nine months ago, Nasr started reducing that exposure to about 35 per cent, while increasing the fund’s European weighting to roughly 40 per cent.
“Now that QE is in place, the economy is stabilizing, so you should have a bit of revenue growth, and some more flexibility when it comes to tax and employ- ment,” he said.
The combination of those things should result in earnings estimates getting revised higher, then margins increasing. There hasn’t been much of that yet, as corporate profit margins in Europe are still about 300 basis points lower than where they were in 2007, prior to the financial crisis.
In addition to the ECB’s aggressive efforts to rekindle inflation and economic growth, the weakness of the euro goes a long way to boost the competitiveness of European exports. Lower oil prices are also a big benefit to the European economy, as are low interest rates.
As a result, Nasr is finding value in parts of the European consumer sector — specifically some auto-parts stocks, as new-vehicle registrations are near multi-decade lows. He highlighted the opportunity in companies Valeo SA
(FR/EPA) and Perelli & C. SpA (PC/ BIT) that sell auto parts that help reduce carbon dioxide emissions, as more stringent standards are coming in the next decade.
“This is not just happening in Europe, but China and North America as well,” Nasr said.
The portfolio manager is also overweight the European banking sector, with holdings such as In- tesa Sanpaolo SpA (ISP/BIT Italy).
“Historically, the banks have been transmission mechanisms for accommodative monetary policy,” he said. “If you’ve got low interest rates and you’re trying to accelerate growth, you typically do that with higher lending.”
Nasr likes both Germany and Spain, but Italian banks are particularly attractive since a ‘bad bank’ package is closer to being implemented, along with some consolidation in the sector. This will enable banks to clean up their balance sheets and accelerate lending.
“Lending to small- and medium-sized enterprises is really what fuels the European economy,” Nasr said, adding that both capital ratios and valuations are attractive for a lot of European banks. “We think there is going to be some pretty good lending growth, so there should be upside to earnings as ROEs improve gradually.”
Financials also happen to be a favourite of Nasr in the U.S. market for some similar reasons. The group generally has strong balance sheets and capital ratios, and should also benefit from the acceleration of consumer and corporate lending growth.
“You’re probably going to see ROEs expand pretty meaningfully and U.S. financials still remain one of the cheapest parts of the S&P 500,” Nasr said. “I think they will actually lead the U.S. equity market performance during the next couple of years.”
It’s been a lot tougher for corporations to get lean