Ian Scott, Joao Toniato, and Dennis Jose, Barclays’ analysts for European Equity Strategy, are overall bullish on European equities, and expect earnings and revenues to surprise on the upside during 2014 as well as 2015.

In their March 24, 2014 research note, they add another angle that enhances the potential for European equities – falling fixed income yields. This works in favor of companies and sectors that traditionally carry highly leveraged balance sheets.

Cheap versus US peers

Investors can tilt the risk- reward ratio in their favor by focusing on companies/sectors that are quoting at higher than normal discounts relative to their US peers on a historical basis.

“European equities as a whole currently trade on a price / book discount of 32% compared with the US market,” says the note. “Looking back over the 17 previous times since 1974 when European stocks were similarly lowly priced, they outperformed their US peers over the subsequent year on 80% of occasions, rising to 88%3 of times when measured over the subsequent three years, for an average relative gain of 15%.”

Credit Yields European Stocks

Analyzing where the discount (value) resides

The table below provides a sector-wise analysis of the prevailing discount versus the US counterpart. Note that the energy, consumer discretionary, telecom and utilities sectors suffer discounts of 12%, 15%, 42% and 27% respectively. These sectors could offer potential for appreciation going by the historical trend discussed above.

2-sector-discounts Credit Yields

Looking for leverage in the discounted sectors

By plotting the valuation discount against the debt equity ratio, the Barclays analysts find that the most heavily discounted sectors also carry the highest leverage. This is not surprising, say the analysts, because US investors are far more tolerant about leverage on company balance sheets compared to European investors.

In the chart below, note that consumer discretionary, utilities and telecom sectors have the highest debt-to-equity ratios.

3-leverage

“This reluctance to buy areas of the market with leverage runs counter to the exuberance in European credit markets,” says the note, highlighting that corporate yields in Europe have declined to levels below those in the US – a sea change from the troubled days of the European crisis in 2011 and 2012.

How falling yields will affect leveraged companies

Barclays point out that the ratio of interest expense to total debt for the European market has plummeted by half since the late 90s.

“In addition, current bond market yields are exerting downward pressure on companies’ interest cost and this presents a refinancing opportunity for corporates,” say the analysts. “This could have a significant impact on companies’ cost of capital and is particularly beneficial for sectors carrying higher leverage such as the utilities sector.”

This is reflected nicely in the under noted chart.

4-refinancing

How the utilities sector will benefit

Barclays point out that because utilities sector companies spend a high proportion of their income – about 52% – to service their debt, they could benefit from the refinancing opportunities opening up on falling credit yields. “Even small reductions in the actual interest cost can have a significant positive impact on EPS,” say the analysts.

The analysts have accordingly upgraded the European utilities sector from an Equal Weight rating to Overweight.