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In the zone

Most of the current evidence suggests that European companies are generally in excellent shape.

The strong perfor-mance of European markets in 2006 came as a surprise to many investors, particularly given the problems, such as the lack of structural reform, that continue to dog the region.

European markets have been given a helping hand by a healthy economic backdrop. GDP growth in the eurozone has been strong, at about 2.7 per cent last year, and the European Central Bank estimates the zone’s economy should be able to grow at a solid rate, around its long-term potential for a while yet.

Similarly, most business confidence indicators are at high levels. Ironically, for the past three years, European markets have managed to perform quiet well, even when, at a macro level, the eurozone was in a shambles.

This just serves to prove that the health of the European domestic economy is not really correlated with equity market performance.

As an investor, therefore, I am far more interested in the health of individual companies rather than trying to identify opportunities from a top-down perspective.

Most of the current evidence suggests European companies are in generally excellent shape. Looking at the current crop of Q4 results coming through, companies are still mana-ging to surprise the market with better than expected earnings growth and I would expect this to continue for a while.

However, after several exceptionally strong quarters, it comes as no surprise that there have been fewer earnings upgrades than previously. Inevitably, there have been some high-profile disappointments but these are largely the exception to the rule.

So, where is this strength coming from? While it is hard to generalise, a lot of the companies I talk to are benefiting from excep-tionally high levels of global trade. Exports to China from the eurozone, for example, rose by 21 per cent year on year in the first seven months of 2006.

Asian consumer demand, which has been talked about for years, is really beginning to take hold and there are plenty of companies in Europe which are benefiting. Likewise, consumer demand in eastern Europe and Russia has been an important source of growth for European companies. Merger and acquisition activity has also been important and is likely to continue to underpin valuations.

So, looking forward, I would expect European equities to continue to perform well, driven by the anticipation of good Q4 results and supported by ongoing M&A activity.

Of greater importance to stockpickers such as myself, it looks as though earnings growth in the most cyclical sectors is getting closer to a peak. In my portfolios, I have taken steps to reduce exposure to most cyclical companies, focusing instead on what I regard as defensive growth stocks – companies with the most resilient earnings growth.

For example, last year, we trimmed back some mid cap areas which had performed extremely well, such as Modern Time Group (cable television distribution in Russia) and drug development company Actelion.

At the same time, we added to defensive growth plays such as Syngenta (specialist in crop protection products that stands to benefit from the move to biofuels), Vinci (infrastructure company) and Fresenius Medical Care (specialist in kidney dialysis).

Growth as a style has underperformed during the past few years, given the kind of earnings growth being generated by cyclical sectors such as basic industries or chemicals.

In effect, growth stocks have derated and you can now buy companies with good, sustainable earnings growth cheaply. If we are at the point in the cycle where growth stocks can once again stand out, this is, I feel, where active investors should be looking if they want to beat the market.

Cedric de Fonclare is manager of Jupiter European special situations fund.


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