Finding untapped potential in Europe

Marcel Stötzel, co-portfolio manager of Fidelity European Trust PLC, provides an insight into the risks and opportunities facing investors in European equities. With valuations trading at historical lows, he highlights why he believes there is still room for headway to be made and, within this, outlines the enduring potential of investing in pricing power.

The macroeconomic backdrop facing companies in Europe is still challenging. The twin pressures of sluggish top line volumes and refinancing of upcoming debt maturities at higher rates are likely to pressurise profit forecasts. This could expose vulnerabilities among some companies reliant on multiple expansion for meaningful share price appreciation.

However, as bottom-up stock pickers we believe that there are opportunities to identify individual stocks that are attractive, particularly in an environment where the weak economic backdrop has hit sentiment broadly and valuations look compelling.

European equities are not the European economy and offer diversification benefits.

From a revenue generation perspective, the European equity market is very well-diversified and not overly exposed to the region. Less than one-third of the revenue generated by European-listed stocks comes from within the Eurozone. Emerging markets and the US account for an almost equal proportion of sales - it is fair to label the MSCI Europe as a truly global index, particularly when compared to the S&P 500 where we see a much more pronounced reliance on the domestic US market. Clearly, in absolute terms the US economy is larger - but from a revenue risk perspective, diversity of earnings is an attractive and often under-appreciated benefit of investing in Europe.

The MSCI Europe Index is also far less concentrated towards the largest holdings compared to the US. Around 25% of the S&P 500 is concentrated in just five names in contrast to only 13% for MSCI Europe. Furthermore, sector exposure is more diversified compared to countries such as the US and Japan, where concentration in specific sectors is more acute.

The US is heavily weighted towards IT stocks whilst Japan is skewed towards industrials and consumer discretionary. In Europe, exposure is far less concentrated with no sector comprising more than 20% of the index.  As such, with superior diversification and some insulation from domestic European economics, European stocks could benefit from an improved risk-reward ratio whilst also having a cushion against global headwinds. Further, the underappreciated distinction between the European economy and company performance may have led to negative economic sentiment being disproportionately detrimental to valuations.

Over the last decade, the financials and energy sectors have gone from almost a combined 35% of the MSCI Europe Index to less than 25%. In the same period, sectors with strong structural growth drivers such as industrials, healthcare, IT and consumer discretionary have increased from 30% to 50%. This changing composition of the European equity market towards sectors that are positively impacted by structural trends including digitalisation, e-commerce and aging populations is a strong bottom-up driver for higher and more stable EPS growth.

How we’re playing the AI theme

Whilst the European equity market lacks the high-octane growth companies that have driven the US market over recent years, many of Europe’s largest companies boast very attractive attributes of low volatility growth, stable balance sheets and good dividend yields.

Artificial intelligence (AI) was definitely the most hyped area of the market during 2023. However, a lot of the hype was around US companies developing the large language models (LLMs), like OpenAI with ChatGPT, or providing the chips needed to run them. Meanwhile, Europe also has a group of companies that have been quietly using these emerging technologies to develop new products that are already benefitting their customers. In our view, they haven’t been getting the investor attention they deserve, which has resulted in the European-listed beneficiaries trading at more attractive valuations.

LLMs’ effectiveness increases with the amount of data you feed in to generate insights and, in Europe, we are fortunate to have several companies that have evolved from offline data vendors to online data and analytics providers that possess vast amounts of data. Most importantly, they are only in the early stages of benefitting from the additional capabilities AI brings to the analysis and insight part of their product offering. We expect companies like Dassault Systèmes, Sage, SAP and RELX to be strong long-term winners in this space.

Looking ahead

The prospect of recession loomed over the global economy for much of last year, yet equity markets have proved remarkably resilient. Much of the market’s focus remains on central bank monetary policy and the timing of the Fed’s pivot towards cutting rates. Attention will also be focused on how quickly the ECB and Bank of England follow suit as inflationary pressures continue to ease.

Meanwhile, macroeconomic indicators have been soft and when meeting with companies we can see that slowing demand is beginning to come through. We would expect aggregate growth expectations to come down further. Consumer weakness is also likely to prevail as individuals are no longer benefitting from Covid stimulus measures, while we are seeing mortgage and consumer credit rates rise sharply.

As we move through 2024, our strategy will be to identify businesses with strong pricing power and to avoid companies with stretched balance sheets. Our continuing focus on well-funded and cash generative companies which can grow dividends consistently should also give us added protection if we enter a more recessionary environment.