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Relative values

With European equity markets now down by 56 per cent from their 2000 peak, faith in the European equity story is at an all-time low.

Investors have probably thrown in the towel following the shock revelation last week of an accounting fraud at the Dutch food retailer, Ahold, the third-biggest global operator.

European markets have faced many headwinds in recent years from the pricking of the TMT bubble to the stagnation of the region&#39s biggest economy, Germany.

The Ahold scandal, however, has damaged sentiment among investors who had believed that Europe had managed to avoid many of the accounting scandals that have plagued US corporates. With the market capitalisation of the top 100 German stocks now below that of Microsoft and General Electric combined, is there any hope left for beleaguered European investors?

The simple answer is yes, depending on how realistic your expectations are. A recent study by Dresdner Kleinwort Wasserstein highlighted that an investor&#39s expected return from equities is largely determined by the valuation point at which he buys. If you buy the market cheap, you dramatically improve the odds of high returns in subsequent years.

Why is this important? Simply because it will be a key determinant of the longer-term expected return from Europe, not only relative to cash but also relative to other major equity markets, in particular, the US.

On a relative basis, however, European equity valuations look very attractive. The German DAX index has underperformed the S&P Composite from the 2000 peak by over 40 per cent, erasing all the relative gains of the bull market.

This move is reflected also in relative valuations between the US and Germany. The Dax trades on a price/earnings multiple of around 10 times historic earnings while the S&P500 is on nearly 30 times the same earnings. While the difference in valuations may be partly explained by increased volatility in net earnings due to big write-off&#39s and the fact that this analysis is based on historic earnings, it remains the case that, even on other valuation measures, European stocks look much cheaper than their US counterparts.

An explanation for this gap can be found by looking at previous bear markets and recessions. The US significantly outperformed Germany during the 1990-92 recession as investors put their faith in US corporate&#39s ability to restructure their businesses in the face of weak demand.

In the Long term Capital Management hedge fund crisis of 1998, the US again dramatically outperformed Germany due to its status as a lower-risk asset class. Europe has found it difficult to shake its image as the “beta” play on US market direction.

It is clear that European stocks look cheap relative to US stocks but are they cheap relative to history? It would appear so but this fails to take into account the recent weak corporate earnings season. Indeed, on forecast earnings for next year, the DAX trades on 15 times earnings.

The long-run average PER for many markets is around 15 as this tends to reflect the longer-term relationship that exists between equity prices, real interest rates, and real GDP growth.

From a historical perspective, therefore, it would appear that European equities are no better than fair value although, using this analysis, it would be fair to say that US equities remain overvalued in the absence of a significant recovery in corporate earnings.

If valuation is no longer a major constraint on European equity market performance, then the problem must lie elsewhere? We have to look at other fundamental drivers, such as interest rates and earnings growth as well as the more sentiment-driven factors such as the potential Middle East conflict.

In terms of interest rates, we believe the ECB will cut rates by at least another 0.5 per cent as inflation pressures subside, not least due to the strength of the euro against the dollar.

The problem for Europe is that the current interest rate is inappropriately low for countries such as Spain and Ireland while clearly being too high for Germany.

Real short interest rates (short rates less inflation) are now negative in Spain, hence the continued strength in the domestic economy.

What Germany needs is lower rates while Spain needs higher rates.

Nevertheless, a cut in rates by the ECB should ease some of the internal pressures building up within the eurozone although we need to monitor deficits in countries such as Germany and France and how the authorities react to breaking the Maastricht deficit rules.

The picture on profits is more clouded. Any early signs of strength in European profits have been erased by the weakness of the dollar which not only hurts the translation of dollar-based sales and profits into euros but also harms the competitiveness of European companies, particularly where costs are largely in euros and sales in dollars.

Obvious examples include chemicals and autos. A good rule of thumb is that a 10 per cent fall in the dollar leads to around a 5 per cent fall in euro-denominated European profits. This makes the near 40 per cent expected growth in profits this year look unachievable and we should expect to see continued downward pressure on European corporate earnings to persist over the coming months as companies report.

The final key factor is the prospect of war. Typically stockmarkets have rallied on the opening of hostilities (Gulf War) as investors have discounted the worst by that stage. This time, there is almost certainly likely to be a similar short-term move, especially given the oversold position of the market currently.

However, some of the structural problems remain – an overvalued US market, a weak capital investment environment, and, perhaps most tellingly of all, a consumer who is fearful for his or her job and has a commensurately reduced level of spending. It is difficult to make a strong case that we have emerged from the bear market just yet, irrespective of any war.

Taking into account all these factors, how should portfolios be positioned this year? The progression of our views on the market is neatly encapsulated in the table at the top of the page.

This shows the relative valuations for consensus 2003 earnings of different stock types at crucial points in the market over recent months. Nokia represents growth, Nestle defensives, Atlas Copco for cyclicals and Deutsche Bank financials.

As a business cycle investor, we are always interested in the relative valuations of these different types of shares at different stages in the business cycle.

When the Cazenove European fund was restructured in December, there had been a significant rally from the October low in higher-risk beta shares such as Nokia, Atlas Copco and Deutsche Bank while defensive shares lagged.

By the peak of the market at the end of November, Nokia was trading at a 50 per cent premium to Nestle while Atlas Copco and Deutsche Bank had eliminated the majority of the discount they were trading on at the market low in October.

We took the view that, given these valuations and our cautious view on economic and earnings&#39 growth, those defensive stocks such as Nestle offered reasonable value relative to the risk of earnings&#39 downgrades.

As 2003 has progressed, we have seen the process of multiple compression continue – namely the convergence of price/earnings ratios to an average point. Investors have found it increasingly difficult to forecast much further than three months out, given the uncertainty over war with Iraq and the outlook for the global economy.

If we move to current valuations, we can see that relative valuations are tighter than at any point over the last three years. This means there is little reason yet to shift the bias away from either earnings&#39 certainty (growth defensive shares such as generic pharmaceutical manufacturer Stada) or very low valuation (which one may argue some of the more geared financial stocks now offer).

We continue to favour earnings&#39 certainty but have begun to shift gradually towards stocks that have strongly underperformed where we feel that there is a potential for a turnaround in earnings over the next cycle which are not yet factored in by the market. Stocks in this camp include CS Group and Axa in the financial sector, and Italian media company, Group L&#39Espresso.

With relative valuations so tight, many investors are sitting on the sidelines and not trading portfolios. Investors should expect the difference in performance between the best and worst managers to be much smaller than in previous years. We will all have to work very hard for outperformance this year.


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