It is cold, dark and wet across Europe and I have a right to be depressed. After another 20 per cent returning year in European markets, are things really looking anything like as rosy as that performance suggests?
The politicians certainly do not give me much hope. Germany’s coalition has raised taxes but deferred reforms, Spain seems content with a massive housing bubble and a 9 per cent current account deficit and Italy is seriously applying the fiscal brakes.
The economic following winds have been strong, with European GDP growth up from 1.2 per cent in 2005 to close to 2.8 per cent in 2006, and Germany, France, Italy, Spain, Sweden, Portugal, Switzerland and Norway are all seeing year on year acceleration. In 2007, we will see the impact of tighter fiscal policies in Italy and Germany, perhaps the expected 50 basis points of further rate rises as well as those of the stronger Europe and of the US slowdown on the export sectors.
Against this backdrop, what has happened to equities? Well, a huge amount. For starters, they have gone up a lot, with total returns of 21 per cent for Europe last year, with real estate posting 57 per cent and metals almost doubling.
Some of the catalysts are clear, with 2006 seeing record levels of M&A at $3.2trn globally and $1.2trn in Europe. As the “gear it up and flog it off” cycle moved up, the private equity sector found itself with a record low ratio of investments to funds raised, with the result that the sector’s average deal size ballooned and quoted sector M&A reached a record 35 per cent of all spending during the year.
How have the businesses themselves performed? Unbelievably. If you look at European earnings per share back to 1970, you see that current levels are a full 35 per cent above the trend line.
Using Deutsche Bank aggregates for European quoted companies ex financials, net profit margins are running at 7.6 per cent, up by 1.1 per cent on 2006 which was itself up by 0.5 per cent on 2005.
One can indeed always find reasons to be less than cheerful, with GDP growth expected to slow, record levels of M&A, rising interest rates and peak corporate profitability, but this misses the point entirely. Many of the issues raised above applied just as well at the start of last year as they do now. What they prove is that forecasting economies and markets is a mug’s game.
However, what we and other active investors are paid to do is find stocks which will go up, in our case a portfolio of only 50 investments from an opportunity set of more than 1,000. That is a very different problem.
So, what are we seeing in the micro world when we take Europe stock by stock as opposed to those macro predictors above?
On our European 4Factor funds, we look for companies which are higher than average quality, genuinely cheap (better than average value on a cash basis), showing improving expectations of current profitability and where those improvements are starting to be reflected in the share price. From our work at stock-specific level, we find that industrials, insurance and banks are still attractive while food producers, autos, pharma and household goods and personal care are to be avoided. Some counter-intuitive calls maybe but if 2006 taught us one thing, it was to expect a degree of change beyond our most fevered imaginings.
So let’s not be too depressed. Instead, let’s raise a glass to taking investment stock by stock and avoid depressing ourselves with the so-called bigger picture.
Ben Williams is co-manager of Investec Asset Management’s European funds