Gear up for the Great Switch to European stocks

Forget America the future belongs to Europe. Canny investors should ditch their anti-EU bias and snap up European stocks, says Jonathan Compton.

"Europeans are lazy welfare junkies. They work the shortest hours in the world but demand high pay, long holidays and massive retirement packages. When facing global threats they are supine, favouring appeasement, or hiding behind America's skirts. Not only is the European Union (EU) undemocratic, corrupt and incompetent, but European companies and countries have poor repayment records and resort to a xenophobic legal system to avoid their obligations."

With apologies to any continental readers, this view of the EU (which usually excludes the UK and Scandinavia) is common globally, especially in Australasia and the Americas, whose populations are largely "economic migrants" of European descent. At best, the EU is seen as a quaint theme park and holiday destination.

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As a result, the level of foreign investment in European stocks has always been relatively low compared with other advanced or developing economies.

The fund monitoring agency Morningstar UK records three times as many funds investing in Indian equities than there are global funds with aggressive EU exposure, for example. That's even though India's total market capitalisation is a fraction of that of the combined eurozone markets.

Even Europeans themselves don't much like their own stockmarkets, and as investors they are naively parochial.Both domestic, institutional and retail funds have a strong bias towardsholding "safe" domestic bonds. And on the equity side, they tend to have excessively high exposure to their home country, and then their immediate neighbours, followed by large-cap companies in North America.

This global anti-EU bias has made sense both before and after the 2008 financial meltdown. Despite its considerable recent strength, Europe's markets have lagged the other major indices, both since 2000 and over the last decade.

Using the MSCI indices, for example, the sterling return for the Europe ex-UK index is just 3.8% a year, compared to 8.2% for America and 5.9% for Asia.Yet suddenly, Europe's markets have turned. So far in 2015, European shares have outperformed their US counterparts by the widest percentage for 25 years.

In sterling terms, Europe's markets are up some 5.7% year-to-date, versus a flattish US market. And despite Europe's obvious problems, there are good reasons why this outperformance should continue and why the "Great Switch" from America to Europe makes financial sense.

The boom that never happened

The starting point for the currently open global economy was the fall of the Berlin Wall in 1989. This resulted in the rapid dismantling of controls over trade and of the movement of capital and people. Suddenly, more than half of the world's population joined the free enterprise system.

The EU should have been one of the biggest beneficiaries as it had become, and remained, the world's largest economic entity (it still was by a whisker in 2014, although the weakness of the euro means it will fall behind America this year).

However, this European boom never happened, and a superficial snapshot of the EU today is hardly encouraging. An aggressive Russian government is probing for internal weaknesses along its joint frontier. Greece's retro-socialist government threatens to destabilise the euro experiment.

Italy appears incapable of reform. Spain is mired in financial and political corruption from the royal family to the humblest municipality, even as its richest areas seek independence. The Portuguese are suffering obsessive gloom small wonder that Latin Americans view Iberia as an irrelevant Ruritania.

Welfare across the EU has become unaffordable and economic activity is anaemic. Politically both in Brussels and at the national level fractious squabbling remains the norm, so that, as in a convoy, reform has had to move at the speed of the slowest ship. So it's understandable that the consensus is that the sudden recovery in Europe's stockmarkets is a flash in the pan. This is wrong.

Returns from the eurozone look set to exceed the hopes of the few optimists left standing. A key reason is the recent and much anticipated announcement byMario Draghi, chairman of the European Central Bank (ECB), that it would buy up to €1.1trn of domestic bonds at the rate of €60bn a month.

In effect, the eurozone has abandoned Germany's aversion to playing fast and loose with money, and has began a meaningful quantitative easing (QE) programme.Forget the much-publicised concernsthat it will be unable to buy the volumeof bonds required.

The certain resultwill be that yields on shorter-dated quality bonds will remain ultra-low or negative, while those on other bonds will continue to fall. Hence, for the first time in history, the longer-dated bonds of stronger euro governments now trade at lower yields than their Japanese counterparts. German ten-year bunds now yield 0.22%, less than half that of their Japanese equivalents.

QE programmes are like buses

One of the lessons to be learned from QE in the US, UK and Japan is that its greatest impact is on the equity and bond markets, less so on economic activity. Another is that QE programmes are like buses you wait for an age then several appear at once. So when euro QE expires and the overoptimistic growth forecasts fail to materialise, more printed money will follow.

One reason the US's markets have done so well since 2008 has been that successive money-printing experiments mean that interest rates have been suppressed for seven years. Europe's game has only just begun.

Another reason is the exchange rate. The ECB has finally joined the great global devaluation game. Since May last year, the euro has fallen by nearly 25% against the dollar to $1.06; at its peak in early 2008 it was $1.60. A weak currency is not a universal panacea but it can go a long way to rebuilding national finances.

Even before the plunge in the exchange rate, the eurozone was seeing some extraordinary changes. In 2014 the current-account surplus (see page 45) was 2.4% of GDP. Such a surplus causes economists to swoon, as it is seen as a sign of contraction in part true but more importantly, it means the eurozone is becoming more competitive, more profitable and financially a little less unwell. (By contrast, the UK and US run a deficit of 4.4% and 2.3% respectively beware.)

But even before Draghi's announcement, the euro-corpse was starting to twitch. Company profits largely beat hopes in 2014, while forecasts have become slightly more optimistic than analysts' expectations. Major companies, such as L'Oral and Renault, are a useful guide to the wider market.

Despite having businesses in Russia, results for these two were unexpectedly good, which they attributed to a mild improvement in demand within Europe, not to exports or cost-cutting. This means that there is scope for further improvement, which should accelerate, given low interest rates (which make domestic borrowing cheap) and a weak currency (which prices out foreign rivals).

The falling euro will have another, significant impact on profits. Just as a weak dollar after the financial crash helped American companies to recover, the effects on listed companies in Europe will be more extreme. More than 40% of their earnings come from international sources, compared to less than 30% for US-listed companies.

Moreover, European firms have considerably less debt than their counterparts in America. There, QE experiments significantly improved cash flow and balance sheets as firms refinanced and often took on more debt.

Record low interest rates offer a major opportunity for European firms to follow the same pattern to borrow and invest more as demand improves from rock bottom, and even to imitate American companies by initiating massive share buy-backs. Although this is a dubious use of cash or debt, it is another reason why, over the last five years, American firms have performed better than their international counterparts.

Europe's economic recovery

Most forecasts start in the wrongplace, and so end up hopelessly lost. Hence I repeat the mantra that there is little correlation between economic growth, corporate profits and stockmarket returns. Even so, a small improvement in GDP is a better background than the eurozone's long-term, grinding contraction. And there are signs of both modest economic recovery and bottom-up reform, despite government inertia.

Remember those stories about the "lazy Greeks"? The latest data show that they now work 42 hours a week that's not only the highest rate in Europe, but puts them in the top five among developed countries. The Spanish and Portuguese are up there too. Eurozone unemployment in January 2015 was high at 11.2%, but that was also the lowest rate seen since April 2012.

The trend is for it to fall further. Moreover, the 88.8% of the workforce in employment appear to be taking slightly fewer holidays and are being a bit more productive. It's also worth remembering that the official unemployment statistics can be suspect Europe's black markets appear to be in robust health.

That may be bad news for government revenue, but it's another small sign of improving economic activity, and perhaps one major cause for the distinct upturn in disposable income from mid-2013.

America faces headwinds

The US economy, by contrast, is coming off the boil, hence the continuous postponement of the widely forecast rise in interest rates, "reflecting the strength of the economic recovery". The surging dollar is a headwind, while the benefits of booming domestic energy production and lower oil prices are slowly waning.

The first QE experiment over in America did avoid a financial collapse but subsequent exercises show that every dollar borrowed by the government created only 35 cents' worth of growth. Hardly sound financially. Moreover, the main beneficiaries have been capital markets and the very rich.

Most equity markets globally look expensive on a historic basis. Yet real (after-inflation) interest rates in the developed world are zero and likely to stay so for far longer than expected (as has been the case for the last two years). So logically, market valuations should actually be high. In fact, they should be super-elevated which they are not.

Within these justifiably high relative levels the standout misvaluation is America's stockmarket versus the eurozone. The former trades at a near record 27 times its cyclically adjusted price/earnings ratio (Cape a measure of value that uses ten-year average earnings), while Germany the nation at the eurozone's core is on 16 times.

Other measures show a similar disparity. In 2015, the yield on the eurozone equity index is expected to be 3.6%. That compares to the US on 1.9% and it's a record premium to government bond yields. On a price-to-book basis essentially the core asset value of a given company Europe trades at 1.6 times, compared to America at 2.5 times, a56% premium.

American companies have significantly more loans their debt-to-equity ratio is 58% versus 39% for Europe. Then there is growth in earningsper share the core valuation and direction indicator for any market. The pessimistic consensus for Europe is for an acceleration to 5.1% this year, versus an overoptimistic and falling 3.8% for America.

So however the numbers are diced, they suggest that even the gloomiest prognosis for Europe is wildly overdiscounted.The surge by European markets has already begun. Foreign fund inflows especially have soared from miserable levels. Some sectors, such as vehicle manufacturers, have risen by more than 40% just this year.

This is only the beginning. Although often painfully slow, many trends are turning and, as profits recover, so the real kicker again already enjoyed by America will be multiple expansion. This could continue for a very long time. We look at some of the best ways to profit below.

The four stocks and one fund to buy now

The heart of Europe is Germany, so I've picked three companies there. Lighting manufacturer Osram Licht (Germany: OSR) has underperformed since its listing in 2012 because of old products, such as light bulbs (which may be spun out).

Over half of its sales are now generated from LED systems and specialist lighting for industrial customers. Earnings growth this year should exceed 11% and its operating profit margin is set to grow to 15%. Next year should be better still. The yield is 2%, but strong free cash flow suggests dividends will rise.

Results from Lanxess (Germany: LXS) are likely to show a turn after several poor years. As a major producer of polymers, pigments and intermediary chemicals, the company had been squeezed by lacklustre demand, high oil prices and heavy investment costs, all of which have now fallen sharply.

Around 64% of sales come from outside Europe, so a weak euro will give a huge boost to profits. As earnings have been depressed, the multiple may seem high at 31 times earnings for 2015, but this will tumble. The stock trades on only 0.5 times sales.

QE always results in good gains by banks and other financial companies and many in the EU have already responded. An exception is Commerzbank AG (Germany: CBK). Given its less-than-wonderful history, you may want to hold your nose especially given a high 16.2 p/e, a paltry 3% return on equity and a high cost-to-income ratio of 76% (the eurozone average is 59%). But again, these numbers represent trough earnings the only way is up.

It is also one of the few quoted entities with strong exposure to the German Mittelstand firms (small and medium-sized businesses), which are major beneficiaries of a weak euro. That, along with the low price-to-book ratio of 0.5, means it is highly geared to even a mild recovery.

One from France Veolia Environnement (Paris: VIE). Once a market darling, it traded at a 60% premium to the index, buoyed by growth at its specialist waste-management and transport operations and benign regulation of its French water works. It became overstretched and earnings collapsed after the bankingcrisis.

However, increasing environmental awareness and its high exposure to specialist waste and energy projects within and beyond France should lead to a 60%-plus jump in 2015 earnings. The yield is an attractive 4% and debt is under control.

If you prefer funds, I have screened those which invest in small to mid-caps: if Europe continues to outperform, the better gains will be there rather than in the more widely owned large caps. I've looked for those with no UK exposure, a good spread across the continent by both geography and sector, and a range of interesting, lesser-known businesses.

One consistently near the top of the league tables has been the Baring Europe Select Trust (LSE: BAREUAC). The annualised returns over five and ten years have been good at 11.7% and 13.9% respectively.

Jonathan Compton spent 30 years in senior positions in fund managementand stockbroking.