The fourth quarter of 2018 was tough on investors in European equities, and uncertainty appears to be rising as we enter 2019. But, the Invesco International and Global Growth team believes that environments like these can result in great prices for attractive businesses. In fact, we haven’t seen valuations in Europe this low since 2013. So, what is our outlook for Europe, and where are we finding opportunity?
Uncertainty is the theme for Europe
The MSCI Europe Index declined 13% in the fourth quarter, and European investor sentiment deteriorated — investor survey data from Bank of America Merrill Lynch show the lowest levels of sentiment in Europe that we’ve seen in six years, and near the lowest we’ve seen since 1999.1
As for valuations — in the recent past, stock market valuations were unattractive relative to our team’s criteria, but this is changing. The price-to-earnings ratio for the MSCI Europe Index fell to less than 12x from over 15x at the beginning of 2018.2 We haven’t seen valuations this low since 2013, and on a relative basis, we’re back to record discount valuations for Europe relative to the US.3
What are the main sources of uncertainty for Europe?
- Brexit. The UK is due to leave the European Union on March 29. Parliament recently voted down Prime Minister Theresa May’s Brexit withdrawal plan, but voted to keep her in Downing Street. At the risk of stating the obvious, the situation is highly complex and uncertain. The most important thing is that a smooth execution of Brexit requires a lot of improbable things to go right. A volatile outcome only needs a few likely things to go wrong.
Bottom line: Our UK-based holdings are predominantly multi-national businesses with minimal domestic exposure. Invesco International Growth Fund has less than 4% domestic UK exposure while Invesco European Growth Fund has roughly 12%. We continue to cautiously monitor the situation.
- Italy. The Populist Coalition government made some very expensive promises to their supporters, leading to disappointment and rising spreads on Italian bond yields as the market digested the situation. Initially, the coalition targeted a budget deficit of 2.4% while the European Commission’s deficit target was 0.8%. But last month, after a bit of spirited debate, the European Commission rubber-stamped a plan for a 2% deficit.4
Bottom line: Our funds’ exposure to Italy is just over 3%.5
- US-China trade war. Over the past few months, the scale of US tariffs on Chinese goods climbed dramatically. While the US and China are the primary players in this drama, European companies generate over half of their revenues overseas. The rise of protectionist measures creates earnings uncertainty, and we continue to monitor this closely.
Bottom line: Invesco International Growth Fund and Invesco European Growth Fund have no auto company exposure, an area particularly impacted by this issue. More broadly, we have limited exposure to areas impacted by the trade war.
- Rates are rising. The markets are losing their tailwind from quantitative easing. There is uncertainty regarding the timing of federal bank rate hikes, but the tailwind removal is a near certainty. Widening spreads indicated the bond markets are showing tangible signs of distress above and beyond the weakness we’ve seen in equity markets.
Bottom line: Our funds have generated higher cash flow return on invested capital (CFROIC) than their broad benchmarks, with less financial leverage.6 We believe this combination of higher CFROIC and low leverage indicate a greater resilience to uncertainty and rising rates.
Where have we added exposure?
We evaluate opportunities using our Earnings, Quality, Valuation (EQV) philosophy. We prefer high-quality businesses with strong long-term growth outlooks. It is a challenge to buy these businesses at attractive prices when markets are confident. When the market environment is volatile, we have increased odds of finding a great business at an attractive price.
Italy’s FinecoBank is an example of our team is finding opportunity in the midst of uncertainty. FinecoBank is a high-growth, high-quality digital leader in the Italian wealth management market. We believe FinecoBank is a structural winner because they offer a convenient, digital experience at a lower cost to customers than competitors. The high levels of concern in Italy provided an attractive opportunity to buy this stock. We established a position in FinecoBank in the third quarter and increased our position in the fourth quarter as Italian concerns rose. (0.99% of Invesco International Growth Fund and 1.27% of Invesco European Growth Fund as of Dec. 31, 2018).
1 Source: Bank of America Merrill Lynch, Dec. 31, 2018
2 Source: Bloomberg, L.P., as of Dec. 31, 2018
3 Sources: Bloomberg, L.P., and Invesco. Europe defined by the MSCI Europe Index, and the US defined by the MSCI USA Index.
4 Source: BBC, “Italy budget deal struck with Europe after months-long row,” Dec. 18, 2019
5 Invesco International Growth Fund had a 3.40% allocation to Italian companies as of Dec. 31, 2018, and Invesco European Growth Fund had 4.98%.
6 Source: Invesco, as of Dec. 31, 2018. Invesco International Growth Fund had a 5-year average CFROIC of 11.8x and leverage (net debt/EBITDA) of 0.3x, compared to the MSCI AC World ex USA Growth Index, which had 5-year average CFROIC of 5.4x and net debt/EBITDA of 0.8x. Invesco European Growth Fund had a 5-year average CFROIC of 9.6x and leverage (net debt/EBITDA) of 0.6x, compared to the MSCI Europe Growth Index, which had 5-year average CFROIC of 7.3x and net debt/EBITDA of 0.9x.
Blog header image: Bartfai/istockphoto.com
The MSCI All Country World ex-USA Growth Index is an unmanaged index considered representative of growth stocks across developed and emerging markets, excluding the United States. The index is computed using the net return, which withholds applicable taxes for nonresident investors.
The MSCI Europe Index is an unmanaged index considered representative of European stocks. The index is computed using the net return, which withholds applicable taxes for non-resident investors.
The MSCI Europe Growth Index is an unmanaged index considered representative of European growth stocks.
The price-to-earnings (P/E) ratio measures a stock’s valuation by dividing its share price by its earnings per share.
Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.
Credit spread (bonds) is the difference in yield between bonds of similar maturity but with different credit quality.
Cash flow return on invested capital (CFROIC) measures how much cash flow a company has generated on its invested capital.
Financial leverage refers to the use of debt to acquire additional assets.
EBITDA is the acronym for earnings before interest, taxes, depreciation and amortization. Net debt/EBITDA is a comparison of debt levels to earnings.
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Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
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