The impact of higher rates, together with the effects of the credit crisis, has had a negative impact on many European economies.
First-quarter results in Europe demonstrated the fact that an inflection point in the quality of earnings has been reached. We should expect the polarisation between good and poor earnings to become more pronounced as Q2 results start coming through.
In our view, companies will report some tough year on year figures. A strong euro, rising inflation and weaker consumer sentiment are all expected to create headwinds. Furthermore, we believe that although analysts have revised down their estimates for 2008 earnings, they still need to alter their 2009 forecasts. These still factor in a sharp recovery in the US – a view which may well prove too optimistic.
In this environment, we continue to look for companies that have the ability to outgrow the market because of their positioning or their innovation. We believe that identifying companies with strong fundamentals such as pricing power, good returns and strong balance sheets is more important than ever in an economic slowdown.
For example, we like companies that are benefiting from an extended operating cycle such as specialist engineer Alstom and oil services company Geophysique. We also include companies which benefit from strong pricing power such as utilities E.ON and Fortum, agrichemicals producer Syngenta and companies with strong consumer franchises such as Nestlé.
European financials continue to go through the process of cleaning up their balance sheets following the sub-prime crisis. Once this issue is resolved, there will still be residual risks for this type of business, including bad debt. For this reason, we remain significantly underweight financials. Having said this, it is an area that we intend to build up opportunistically as the credit cycle matures.
Last year has seen a transitional period as we moved from bull market conditions to a slowdown in economic growth and the second half of the year was dominated by macroeconomic factors. In this environment, we have been disciplined in taking profits in some of the stocks (mainly in the mid cap space) that did well for us and appeared to be fully valued. We recycled this money into companies with good earnings visibility and strong balance sheets, where we felt the historical premium was low and therefore attractive compared with cyclicals.
We believe that 2008 will prove to be a stockpicker’s year. There will be a clear differentiation between winners and losers and we are confident that, once again, our proven investment process will continue to add value to investors’ potential returns.
Market sentiment continues to be very negative which suggests low equity exposure relative to cash. We believe that shares prices have already discounted some of the bad news. Therefore, we should be alert to opportunities while remaining selective. At a time when the availability and cost of company financing remains a problem, it is important for investors to focus on businesses that can grow organically or by acquisition.
Cedric de Fonclare is manager of the Jupiter European special situations fund