Investment Perspective

Dean Tenerelli, Portfolio Manager, Europe Equity Strategy.

EXECUTIVE SUMMARY

We believe Europe, the second-largest market in the global asset management industry, offers better value than is commonly realized. The recovery is still intact and many high-quality companies that are well positioned for an upturn are being unjustly overlooked.

In this Price Points, Dean Tenerelli, portfolio manager for T. Rowe Price’s European equity strategy, explains why he is constructive on the outlook for the region going into 2015 and gives insights into the types of companies he favours.

Europe is a diverse continent bedeviled by oversimplifications. It is seen as a homogeneous market that is uncompetitive, riddled with debt, and unable to grow. This view fails to capture the complex realities of a region that not only includes the eurozone, but also the UK, Switzerland, Sweden, and numerous Eastern European countries.

In fact, Europe has six of the world’s 10 most competitive economies (as assessed by the World Economic Forum); its share of developed market exports has increased; and the current account is in surplus for the eurozone in aggregate and most individual member states. Country debt levels are still high, as in many parts of the world, but quoted companies have virtually halved their debt burdens since the financial crisis and are now in a fundamentally strong position.

Indeed, recent company performance has been resilient. The earnings season just passed was the best since at least 2011. Efforts by companies to restructure and reduce costs are bearing fruit. Powerful financial forces are also helping them. The headwinds of a strong currency and high energy costs have become tailwinds after a steep decline in the euro against the dollar and a plunge in oil prices to five-year lows. The pattern of harsh fiscal austerity across the eurozone in recent years has passed, and the overall budgetary stance is actually now becoming modestly expansionary.

Encouraging signs

While the Continent’s economy remains subdued, there are encouraging signs of an early pickup in activity. The eurozone’s composite purchasing managers’ index, a leading indicator of growth, remains above the key 50-level that signals economic expansion, monetary indicators are improving, and there are some early signs that both the supply of and demand for credit could be recovering.

The European Central Bank has clearly become more proactive in its effort to support a recovery and ensure that deflation expectations do not become entrenched, and there is still very considerable scope for it to intervene more and to encourage banks to extend credit into the real economy. The sharp decline in the euro and the plunge in oil prices should also play a role in shoring up activity and heartening consumers.

So we believe the pessimism about Europe’s prospects is overdone and that there is scope for improvements in sentiment and the underlying economic performance.

Overlooked opportunities

Investors have generally favored more defensive sectors of the market in 2014, and this has presented us with many attractively valued opportunities across the continent that should do well when growth picks up. In the rotation this year, investors have overlooked high-quality companies that are domestically oriented, while some global franchises de-rated amid emerging market growth concerns.

Banks and utilities were good bets for us earlier in the year, particularly Spanish ones. We took profits on them as share prices recovered and bought stocks in the telecoms and consumer discretionary sectors, which we favor.

Telecoms consolidation

Regulation of telecoms in Europe is now less harsh and there is more appetite for consolidation to improve returns and create stronger European companies. Our focus is now on ensuring that any consolidation moves are on favorable terms to shareholders. In some markets, such as Germany, the reduction in the number of players means there is considerable scope for shareholders to benefit from cost savings over the medium term.

Within consumer discretionary there are many opportunities in media, luxury goods, retailers, and automotive suppliers. These are high-quality companies that are financially strong and well managed, with competitive positions and consistent strategies. They are still earning decent returns even in a challenging environment, and many have been unjustly penalized by the market.

Spain and Italy attractive

We construct our portfolios from the bottom up, selecting those good-quality companies that we can find at attractive valuations across Europe. We have been overweight Spain and Italy for the past two years as we were able to find many attractive stocks in these two countries.

Spain has diverged from the overall European macroeconomic picture. The country is benefiting from meaningful reforms that have spurred competitiveness and economic growth. Consumers are becoming more confident again, as are parts of the property market. In Italy, economic performance is subdued, and much still needs to be done. Our holdings are spread across a range of industries, some of them exposed to the domestic economy. However, we believe we are being more than adequately compensated for this in the attractive prices we have paid for these stocks.

Undervalued market

Some investors in the markets argue that European shares are looking overvalued after a decent performance over the past three years or so. A better argument is that they are reasonably valued, as a simple price-earnings ratio based on expected earnings for the next 12 months shows company valuations are now close to their long-term averages.

However, this picture changes when one applies a 10-year cyclically adjusted P/E ratio, reflecting the scope for earnings to recover over the medium term. This shows values are still low not only compared to historical levels but also against other markets. On this measure, the European market is currently 15 times earnings versus a longer-term average of closer to 20 times. Japan and the U.S. trade at over 24 times.

In our view, a sustained recovery in earnings could be well rewarded by the market. We are well positioned to benefit from renewed momentum.

Well-positioned companies offer rewards

Many of the stocks that we have identified are attractive opportunities because investors have been reluctant to assume that they will enjoy any real recovery given their skew towards their domestic economies. We believe conditions are gradually improving and will show that these companies have strong competitive positions. We believe their pricing power will enable them to achieve a marked improvement in returns.

When inflation is rising, it is not hard for many companies to raise prices even when offering relatively undifferentiated products and services. In more challenging times, it is only those with compelling products and services proposition and facing limited competition that will be able to price confidently. These are the types of companies that have underpinned our performance, and which continue to be a hallmark of our strategy.

IMPORTANT INFORMATION

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. Past performance is not indicative of future results. The views contained herein are as of December 16, 2014 and may have changed since that time.