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On the level

Bottom-up investing comes to the fore as several forces are distorting European valuations

Many investors believe that they have a gift for predicting how markets will perform. There is certainly no shortage of day traders prepared to try although how many are generating consistent profits is debatable.

I have always believed that no one is better placed to know a company’s prospects than its own management. They are forecasting sales and making decisions about where to spend capital and when to return money to investors.

As a bottom-up investor, my approach aims to avoid getting caught up in market noise and concentrate on fundamentals. This essentially quantitative approach removes sentiment from decision-making and avoids kneejerk reactions. By default, it keeps a fund manager level-headed and hopefully prevents them from making decisions that, with hindsight, they may come to regret.

I say this because I believe that European markets are being pulled by several forces that are starting to distort valuations. A pattern has emerged in which some low-growth sectors are looking expensive. Take utilities for example.

Private equity groups have bid up prices and takeover speculation is now priced into almost every utility and infrastructure stock. The danger is that investors price in expectations that may not be fulfilled.

Private equity is also encouraging companies across Europe to releverage at potentially the wrong time in the economic cycle. The US economy has already slowed and inflation is proving stubborn. Central banks are concerned that liquidity may be excessive and the European Central Bank has not backed down from its tightening rhetoric. Since it came into being, the European repo rate was arguably set too low for countries such as Ireland and Spain.

While cheap money allowed their economies to expand and catch up with their wealthier neighbours, there is growing concern that it has also led to overheating in areas such as Spain’s construction market.

The parallels with what is happening on the other side of the Atlantic are only too clear. Recent turmoil in the sub-prime lending market has already seen the cost of insuring against default on riskier credit increase. Companies that have previously felt chast-ised for not gearing up could well begin to look increasingly attractive.

More worrying is the notion that the period of disinflation induced by the industrialisation of China is coming to an end. Initially, globalisation brought down the cost of products and kept consumer price inflation low in the West. More recently, there have been signs that the growing wealth and economic expansion of developing nations is starting to exert pressure on scarce resources and bid up the price of commodities and capital goods.

The most obvious beneficiaries of this have been the mining and oil companies since new production cannot be brought on stream immediately. This supply-induced price response has led to a big uplift in profitability. Oil companies also profit from the fact that demand for their product is largely inelastic.

Similarly, companies in the consumer staples sector may benefit from pricing power. If the public believes that food prices are climbing, it presents an opportunity for companies such as Unilever to disguise higher margins through inflating prices on its branded goods.

It is no surprise that my quantitative screen is therefore suggesting that many Scandinavian companies look good value.

A future of higher prices, concerns about growth and increasing risk aversion may not paint the rosiest of outlooks. However, investors in Europe can take comfort from the fact that as a region it has fairly low levels of household debt.

As ever, there will be winners and losers but a focus on companies with solid balance sheets and attractive valuations should mean investors are well positioned, whatever the economic outlook.

Nick Sheridan is manager of the New Star European value fund

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