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Fundamental arithmetic

The eurozone crisis is not holding back the continent’s most dynamic companies

European and UK equities are presently the cheapest in the world.

The aversion to European stocks is providing us with the opportunity to invest in under-valued companies that are exposed to long-term global structural growth trends that will see demand for their goods and services increase for generations to come.

We think the sovereign debt crisis is blinding investors to the fundamental value to be found in Europe’s top companies.

Despite record levels of business confidence in core Europe, equities are as cheap compared with other assets as they have been in a generation. Great franchises such as Rolls Royce or Schneider Electric are on low-teens multiples.

This makes us think the market is discounting much of the risk of sovereign contagion. The FTSE 100, for example, is trading at a 12-month forward p/e of only 11 – far below what one might expect, given that Europe’s top companies now have strong balance sheets and are expected to produce double-digit profit growth.

Indeed, with the EU sovereign debt crisis seen as the number one tail-risk by global investors, regional allocation has turned the eurozone into a possible contrarian buy.

As in the US, European investors are presently being paid more to own equities than to take on risky credit with risky upside. In Europe, the earnings yield is 9 per cent for the FTSE World Europe index, compared with 6.6 per cent on a trailing 12-month basis on the S&P 500.
Right now, the yield on junk bonds is circa 7 per cent in the US and 7.7 per cent in Europe.

The fact that truly global European companies are trading as if they were purely domestic ones is of particular interest to stockpickers like us.

Unilever, which derives 60 per cent of its revenue from emerging markets, trades on 13-14 times earnings in Europe while its subsidiary Hindustan Unilever trades on 20 times. Even if you believe the domestic boom in Europe’s core cannot be sustained – it is worth remembering that many of Europe’s world class companies largely trade outside the continent.

By force-feeding strong growth in a number of key emerging markets, QE2 helped core Europe by generating strong demand for exports from developed economies, and Germany in particular – which exports only a little to the periphery.

But it is Germany’s deserved reputation for quality, and servicing its goods, which lies behind the $1.35trn it exported in 2010 compared with China’s $1.5trn.

Europe is home to world-leading companies, whose products are in demand in emerging and developed countries and is a manufacturing and technological powerhouse. Its unique technological heritage provides so many of its industries with robust barriers to entry through supply clusters of supporting industries that cannot readily be challenged. Europe has also fostered the development of intellectual property. The pharmaceutical sector in Switzerland, the capital goods sector in Germany, and telecoms in Sweden are all cases in point, protected by patents and strong brands. Sectors like French cosmetics benefit from being seen as an arbiter of good taste by the new rich in emerging markets.

For now though, the soft patch in global growth looks like it is only temporary, exacerbated by the disruption of supply chains following the Japanese earthquake.

In the UK, where the export sector is doing well, manufacturers’ plans to invest for future growth by recruiting suggests there is confidence they will be able to navigate this and other challenges.

Besides, the solid finances of countries like Sweden, Germany, and Switzerland would continue to attract inflows of funds, if concerns about inflation and global growth give investors reason to pay more attention to high quality corporate equities in developed markets.

The eurozone’s crisis is not holding back its most dynamic companies, which is why we think this will be an opportunity for shrewd stockpickers.

Jeremy Whitley is head of UK & European equities at Aberdeen Asset Management


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