It’s no secret that US equities have gotten ahead of earnings – even most bulls will concede that there is a good chance of a pullback before year’s end, and with so much skepticism about emerging markets many value investors have been looking for deals in Europe. With a healthy discount to the US market and PE dispersion at one of the highest levels in thirty years, it could be the perfect time for a value-oriented stock picking strategy.
Europe set to grow, but not evenly
“Restructuring, re-rating, and European revenue growth in 2014 is still a valid proposition,” said RWC head of European equity team Ajay Gambhir in an April 10 presentation. “It’s really the combination of a still cheap European equity market and earnings growth at the same time that makes European equities an interesting proposition.”
Gambhir points to the steadily rising European PMI as evidence that we should expect the market to grow, but earnings surprise is now neutral, indicative of mixed results across the market.
Unlike the S&P 500, when an investor could have almost thrown money around at random and made double digit returns, European growth will likely be uneven. First, there are still plenty of global headwinds, so you wouldn’t expect companies or sectors with different exposures to grow at the same pace. Second, even though Europe’s equity valuations are well below US levels, there are individual stocks that look expensive and could stand to come down this year. The volatility that we’ve already seen so far in 2014 also indicates that an index strategy may not get the best returns.
PE dispersion falling, but still high
Europe’s PE dispersion is falling, but it’s falling from the second highest point in thirty years (February 2000 dwarfs everything else) and is still well above the long-term average. As value investors move into the European market, PE dispersion will contract further as it did in the US (though maybe not to the historic lows we saw here) and this opportunity will dry up.
Until that happens Gambhir thinks investors should consider taking long positions on cheap sectors and short the more expensive ones, as a multi-year strategy (not a surprising recommendation from someone at a long/short Europe’s equity fund). Predicting that value stocks are about to play catch-up with their US counterparts seems reasonable. Whether expensive stocks will also fall, or short investors will get punished in Europe just like they did in the US last year, is something we will have to wait and find out.