European equities: the ‘new bonds’

published 12 July 2006

Barry Norris, Head of European Equities, Neptune European Opportunities Fund tells MoneyWeek where he'd put his money now.

In Europe, everyone likes bonds. Thanks to their regular coupon payments and track record in preserving capital, they have become the asset of choice for many investors.

In recent years, sales of bond funds have dwarfed those of equities. From a domestic point of view, this isn't surprising, given that many Europeans' first experience of equities was getting into the tech bubble just before it burst in 2000. Thanks to the strength of the euro, foreign investors are also attracted into European bonds. But they are deterred from investing in European equities because they fear the strong currency will slow what is already anaemic economic growth.

For me, the first principle of equity investing is to look for dividend income, which (unlike coupon income from bonds) will increase over time with the success of the firm. On this basis, European equities look good. I would even suggest that dividend yields are so compelling that today, equities can be considered the new bonds'.

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Over the last 20 years, European government bonds have, on average, yielded two times more than the equity market. Yet today (benchmark ten year), European government bonds yield 3.7% and equities 3.5%. This near yield parity is a buy signal and (since this relationship is not visible on any other major markets) a compelling sign to buy European equities.

Of course, the strength of the Euro will not help some parts of the equity market, notably exporters, to grow next year, but it makes no difference to domestic earners such as banks and telecom operators and boosts importers' purchasing power. Moreover, corporate Europe is flush with cash; dividends are more than twice covered by excess cash generation. This means most firms can afford to pay higher dividends, even if profits don't grow.

Although the equity market as a whole yields 3.5%, it is possible to find a wealth of firms yielding in excess of 4%, which are likely to grow those dividends over the next few years. In addition, there are a number of companies offering spectacular yields.

Take Motor Oil Hellas (MOH), an oil refiner in Greece. After years of under investment, there is a lack of oil refining capacity worldwide. In particular, there is a shortage of refineries that can turn high sulphur OPEC crude into a low sulphur, environmentally friendly product. Motor Oil is one of only two firms in Greece with this ability. Although the company is investing much of its excess cash flow in optimising its production process, it is also offering a yield of 8%. Better still, there is scope for this to grow handsomely over the next few years.

The telecom sector also offers opportunity. The most spectacular play is Hungarian telephone firm Matav (MATAV). It currently offers a yield of 9% and when its restructuring is completed, this is likely to rise sharply.

I'd also highlight Findexa (FIND), the Norwegian Yellow Pages company. Although, like most firms in this area, it is struggling to grow its revenues, investors would seem more than compensated by a whopping 13% dividend yield.

Finally, a word about Frontline (FRO), the Norwegian oil tanker firm I recommended in MoneyWeek a year ago. Despite returning a cash dividend of 59%, in addition to a 245% share price return (and shares in new firm Ship Finance) over the last 12 months, I am loathe to exclude it from my list of European dividend opportunity stocks, given the continued boom in tankers' rates and (despite the share-price rise) a prospective 15% cash dividend.