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Mmmm means Europe

The future is looking bright for European funds but the challenge for IFAs is in picking the consistent front-runners. The answer lies in seeking specific equity opportunities within Euroland rather than tracking its entire performance.

Europe has been one of the best-performing territories this year and most fund managers expect this to continue. Over the past five years, more than 80 per cent of actively managed European unit trusts beat the index compared with just 27 per cent of UK specialists.

Experts suggest this is because European markets are influenced more by medium and small businesses and active stock-pickers can reflect this within their portfolios where index-driven managers cannot. Active managers can select their investment territories and choose to be overweight in centres of real performance while trackers are forced to invest on a weighted basis across Europe as a whole.

In a European context, the difference in active and tracking portfolios is striking. You need to know what you are buying. Success and fund manager skill will be driven by investment process and philosophy and this should be the touchstone for the IFA seeking European opportunities.

But are conditions right for European investment? There is a widely held view that Europe lags behind the UK and the US in restructuring and focus on shareholder value, so it is easier to pick companies that are likely to do well. The economic conditions certainly look reassuring. Estimates for the Eurozone GDP growth are now above 3.3 per cent compared with the recorded 2.2 per cent for the last year and the initial estimates for 2001 reflect a view of continued growth with GDP rising at 3 per cent. But strong economic growth is expected to exert some inflationary pressure with a potential rise in Eurozone inflation from 1.3 per cent to 2.1 per cent and short-term interest rates have risen in response to the strong economic figures with the European Central Bank raising the refinancing rate by 50 basis points to 4.25 per cent in the second quarter of this year.

However, the outlook for the corporate sector looks very promising. Profits in Continental Europe are expected to grow by more than 15 per cent annually between 2000 and 2001. Most corporate results in the first six months of this year are in line with expectation or somewhat above expectations. If there is a dark cloud on the horizon, it is probably in the form of rising commodity prices but this is unlikely to have an impact on these profit fore-casts. The bigger danger is the US.

Any potential danger to shorter-term corporate performance lies in external shocks, possibly from the US, where the chances of rising interest rates may result in reducedlevels of consumer and capital spending in the months to come. Substantial re-rating of high-growth stocks in technology, media and telecommunications sectors reached maturity in the first quarter of this year. Their stock prices have corrected partly due to the influence by changes in the investor sentiment in the US markets, acceleration of the new equity issues in Europe and more sober assessment of the prospects of technology and telecommunications companies.

The European markets have been influenced by changing US sentiment. There has been above average volatility in share prices associated with reduced market liquidity during the summer period. Fund inflows are not as good as they were six months ago, reflecting problems in technology stocks. It was felt by some managers that the market had got ahead of itself but many commentators were surprised by the depth and speed of the recent correction.

There is much to be said for an investment portfolio that retains a diversified exposure across the spectrum of the continental European stockmarkets and sectors but with a distinct preference for countries with convergent macroeconomic characteristics and with growth-oriented industrial sectors and companies.

In the medium to long term, market conditions are likely to favour growth stocks regardless of their geographical location within continental Europe.

The euro has been helping companies sell their wares overseas but unease about the euro is causing central bankers to raise the cost of borrowing which could hit exports. The European Central Bank has raised interest rates by 1.75 percentage points since last November – including a surprise half-point rise to 4.25 per cent in June. It hopes this will keep inflation in check. However, fears about inflation and interest rates were prime factors behind the recent rollercoaster ride in many Continental markets.

Based on FTSE world indices, in sterling terms, the strongest markets were Belgium (which rose by 14 per cent over the past three months to the end of July), Switzerland (up by 12.5 per cent), France (up by 11 per cent) and the Netherlands (up by 10 per cent). Poor performers included Spain (down by 3.3 per cent), Germany (down by 2.8 per cent) and Sweden (down by 2.2 per cent). In fact, fundamentals in Europe are stronger than in the US although the fear of some US fallout remains.

So, within a swiftly changing European dynamic, picking winning funds is about picking winning companies and countries rather than tracking the market as a single unit. While no process is bullet-proof, a sound stock-selection model is the 4M principle which seeks to identify growth potential in European stocks by considering markets (the dynamics), money (and cashflow of the chosen company), management (its quality and innovation) and margin (inherent in the chosen market(s) of the company). This process is by no means simple but it provides a series of robust, analytical building blocks for sound portfolio construction.

From a macroeconomic perspective, a considered understanding of medium-term conditions is vital as well as a clear understanding of economic cycles across Europe, which are increasingly convergent among the European constituent economies. From a top-down perspective, industries to be avoided are those that suffer from cyclical and secular downtrends. The role of the fund manager is to identify industries and companies in structural change and, within that, organisations with medium-term growth momentum.

Focusing on growth is vital. On a specific stock basis, this will mean we need to segregate sustainable medium term growth from cyclical growth. It also means identifying organisations with higher margins and higher return on capital relative to its peer group. We should then seek to overlay the company management track record for adding value and look for product, service and industry leadership across Europe.

The winners within the European context will be supported by macroeconomic conditions of low inflation and reduced government deficits that make equities relatively more attractive. Companies leading the way are enjoying regional corporate restructuring as well as the scale economies of streamlining manufacturing processes. So we look for companies with a clear corporate strategy with a focus on core skills and activities. Forward looking companies are benefiting from outsourcing peripheral activities and implementing new distribution and delivery systems driven by advancing in technology and telecommunications. Tracking the European markets rarely reveals these real performers in the pack.


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