From the Greek debt drama to the Italian elections and even a bank crisis in Cyprus, political crises have dominated the investment story in Europe for several years. So it might be surprising to note just how strong the stock performance has been in recent months. In fact, European stocks outpaced those in Canada and some broad emerging market indexes in 2012.
Fidelity Viewpoints® recently caught up with Risteard Hogan, portfolio manager of the Fidelity® Europe Fund (FIEUX) and Fidelity Capital Appreciation Fund (FECAX), who gave us his thoughts on the state of Europe and the equity markets there. Hogan sees attractive valuations but a continuation of sluggish growth. How to play it? He suggests seeking companies with above-average exposure to the better emerging markets and businesses, with pricing power through superior technology and other competitive advantages.
The story out of Europe has been debt and crisis, but last year things seemed to change. Can you walk us through what’s happened?
Hogan: Three things changed last year: The potential emerged for a banking union, the European Central Bank (ECB) opened the door to buying bonds, and the political climate shifted. Starting with the banking union, for the first time the European Union is setting up a single supervisor for the banking system, and potentially a common deposit-guarantee plan across Europe.
The second thing that came up, which made more headlines, was the ECB’s saying that it would, under certain conditions, buy bonds. The ECB, unlike the Fed, the Bank of England, and now the Bank of Japan, had been unwilling to effectively go into monetary easing—printing money. So the spreads on the European bonds came in significantly on the back of that—a signal that investors thought the risk had declined.
There have also been some political changes. I think there’s been a softening of attitudes in Germany and other nations toward the Greek situation. It appears that the countries that were funding the shortfalls found that the trade-off in forcing a Greece exit wasn’t worth it in terms of the contagion and what might happen from the economic fallout.
Setbacks are to be expected, however—recently, the banking crisis in Cyprus has reduced confidence that policymakers have a consistent strategy toward their long-term objective, and risks putting some of the good policy work from 2012 in doubt.
What do you think about Cyprus? Could it have a major impact for investors?
Hogan: The situation in Cyprus is evolving quickly, and it is too early to say what the full consequences will be. The process and outcome of the Cyprus bailout has increased the uncertainty of insured depositors and senior debt holders in banks, which may prove unfortunate in the short run. That said, each of the bailout countries in the eurozone periphery has had a unique set of issues, with different terms imposed, and there is little evidence yet of risk contagion into the other critical bank deposit markets. This episode highlights the need to progress more toward banking union agreed in principle in 2012, which is a key step in a real monetary union and currency zone.
Has the risk of Greece’s leaving the euro essentially passed, or are things still uncertain?
Hogan: I think the probability has come down a lot, but it’s not sufficiently small to ignore. I haven’t invested in Greece for that reason. I still think there is a possibility that Greece could ultimately exit the euro because the debt is too high at the end of the day. I’m prepared to invest in the other peripheral countries like Italy, Spain, Portugal, and Ireland.
What does the European economic picture look like to you?
Hogan: It’s very mixed, as you can imagine. Italy and Spain are in recession, and I think they are going to stay so this year. I think the United Kingdom has gone back into a shallow recession. Germany looks OK. Sweden has been strong during the recent challenges, though there are some concerns it might be weakening a little bit, particularly in the housing market. France is a big unknown. The economy in France has been weak, and if there’s an issue that could really upset the European situation this year, it might be related to France.
So do you see the economic outlook improving soon?
Hogan: I see fairly sluggish, slow growth for Europe over the next couple of years, because the debt levels are just too high. Unfortunately, history has shown us that these balance sheet recessions, where debt needs to be worked through, take many, many years. But I believe that, in both good and bad times, there are always businesses out there that are growing, doing better, but that haven’t yet had that priced in by the market.
Markets are focused on the short term. If you have a long-term investment horizon, I think you can identify inefficiencies between the market price and the intrinsic value. And if you’re looking at maybe five years or more, I’m quite optimistic about Europe because it’s doing a lot of the structural adjustments that need to be done: labor reform, government reform, and helping people acquire the right skills.
I think there’s this perception that European companies are stodgy. My argument has always been that there are great companies in Europe that have good technology along with an emerging-market footprint.
Where do you see opportunities today?
Hogan: The market has tended to reward those companies that have the ability to generate growth, and these companies are the ones that typically have exposure outside Europe. The European index of companies has emerging-markets exposure in terms of sales around 25% to 30%. When I’m looking for stocks that can grow, they typically have emerging-markets exposure that’s higher than that, in order to give me some degree of tailwind in my stock selection.
Within that theme of emerging-markets exposure and exposure outside Europe, what trends do you see?
Hogan: Well, I like some luxury goods companies, certain financials that have a universal base, and some chemical and agricultural companies.
Can you give any specific examples?
Hogan: Take luxury-goods firm PPR SA, which sells Gucci and Bottega Veneta, among other brands. About half of its sales are outside Europe and North America. It’s had good pricing power, and in recent years it has grown its earnings double digit. It’s had good free cash flow and a good balance sheet. It has recently been trading around 15 times earnings. It has been rationalizing its portfolio, turning it into a pure luxury player. This is the classic kind of company that I like to invest in.
Another example is Syngenta AG. It’s an agricultural company that sells seeds and crop protection. It has developed good technology and has shown the ability to extract value out of the agricultural chain. It has a lot of patented products, and it has pricing power.
Linde AG, an industrial gas company, is another interesting stock. Industrial gas may not sound that exciting, but Linde has been gaining market share, and about 50% of its sales are outside Europe and North America, with high single-digit sales growth. It has huge exposure to developing themes in oil and gas in emerging markets, as well as shale in the United States. Linde is very defensive, with take-or-pay contracts—the company gets paid whether people use its products or not—in a sizeable proportion of its business. And it has recently traded at 15 times earnings, with double-digit earnings per share growth.
How do you see the competitive landscape for big multinationals versus domestic companies in the emerging markets?
Hogan: Investing in emerging markets through European companies, rather than through the local players, gives me a lot of reassurance in terms of corporate governance, management quality, and track records—and these companies also tend to be a little bit cheaper than the direct players. A lot of the European companies have been there for decades and, in some cases, for more than a hundred years. As a result, they aren’t necessarily perceived as multinational by consumers—they’re perceived as local.
The European market has had strong performance over the last 12 months. Can that continue?
Hogan: Short-term market performance is difficult to predict, but there is a lot to be optimistic about in the medium term. It is important to keep in mind that setbacks are to be expected—such as recent uncertainty around the Italian elections and treatment of bank deposits in Cyprus. Overall, however, I think valuations are reasonably attractive in Europe. I think profit expectations are reasonably well grounded as well—and when you get that combination, the risk tends to be to the upside on the market. However, one risk would be continuing appreciation of the currency, which would hurt exporters, and another is the risk of political missteps on the eurozone banking issues. Lots of things could happen, but if we have an ongoing recovery in China, as we appear to, and the United States keeps moving along as it is, then I think there are good prospects for overseas demand, which will take Europe with it.