Several successive years of no earnings growth for European corporates could finally be at an end, according to Argonaut’s Olly Russ, despite tail risks such as the fallout from the Volkswagen emissions scandal.
The manager of the £173m Argonaut European Income fund noted European corporate earnings have been lagging those of the US over the past five years, with Europe still 30 per cent below its last earnings-per-share peak, whereas US earnings are at an all-time high.
He said the rise in European price/earnings (P/E) ratios from 10x to 14x seen in the past five years was almost entirely due to the market-friendly policies of European Central Bank president Mario Draghi.
“That reduction in macro risk is very correlated to eurozone CDS [credit default swap] spreads; in other words, the risk of default in the eurozone,” said Mr Russ.
“The lower that is, the higher P/E people will pay – there is [an inverse correlation] between macro risk and P/Es in Europe. That explains what has happened up to this year. But for those wanting to invest in Europe now, you have to believe there will be some earnings growth this year, having seen none for the past four years.”
Mr Russ suggested the drivers behind an earnings recovery are a much weaker euro, which is helping exporters, and an improvement in the domestic economy due to rising consumer spending. He holds clothing retailers H&M and Inditex, the parent company of Zara, to take advantage of this trend, although he has begun selling down the latter on valuation concerns.
But the manager acknowledged his theory was subject to revision.
“One big risk is what Volkswagen [and its emissions scandal] has done at headline level. That in itself is manageable, of course, but what impact does that have on the wider German… and European economies? We haven’t really seen [that] yet, but that is the sort of thing that could impact European earnings.”
The slowdown in China, which has triggered recent market swings, might also affect Europe’s exporters – Mr Russ pointed to the latest results from Jaguar Land Rover in which the carmaker reported a 29 per cent fall in sales in China year to date.
Elsewhere in the portfolio, the manager is focusing on defensive names such as utility companies and telcos. He has held “all-time favourite stock” Terna, an Italian electricity provider, since the fund launched a decade ago.
At the sector level, the fund is overweight financials, where insurers such as Finland’s Sampo Group have been strong contributors to the portfolio’s 4 per cent yield.
Mr Russ said he is still waiting for banks to look more attractive before he increases his exposure to this sector. For now he is happy to hold institutions that look “like Lloyds [Bank] if it had not merged with HBOS”. By this he means a conservatively managed, cash-generative business that behaves more like a utility than a bank, such as Sweden’s Swedbank, the fund’s largest holding at 4 per cent (as at 31 August).