The earnings profiles of many value stocks in Europe are improving, either because their operating environments are improving, or through self-help, or both.
Banks present investors with the biggest opportunity. At trough margins and near trough earnings, banks are one of the few sectors that could experience both strong earnings growth and a re-rating as the cost of capital rises. Many European banks pay dividends of 5 per cent, trading on price-to-book multiples of 0.8-0.9 times, with price-to-earnings ratios of 10 times. BNP or Intesa are key holdings.
Materials are also standout areas of value. Miners such as Rio Tinto and steel giant ArcelorMittal have done an excellent job at repairing their balance sheets and are now in a position to grow their earnings and dividends.
They remain cheap with extremely high cash flow yields. Years of crisis have changed the strategic goals of management in these companies. Balance sheet strength and capital conservation are now key. The risks associated with investing in these companies are falling sharply.
While quality growth companies have low earnings risk, high valuations mean many of these companies have high price risk. Sometimes only slight earnings disappointments are required for share prices to fall heavily. The recent falls in the tobacco sector – often seen as the ultimate safe haven – illustrates this point. Nestlé’s price-to-earnings ratio has climbed from 14x six years ago to 24x today. This is a historic high despite its growth outlook deteriorating.
It is understandable that investors remain wary of value strategies given the degree of underperformance in recent years. But this long bear market is providing the entry point. The conditions are in place for value to resume its long history of outperformance.
Rob Burnett is manager of the Neptune European Opportunities Fund