InvestmentsNov 12 2020

The hunt for defensive European equities

Supported by
Columbia Threadneedle Investments
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Supported by
Columbia Threadneedle Investments
The hunt for defensive European equities

Niall Gallagher, European equity fund manager at GAM, says the market he invests in will always be more vulnerable to the performance of the global economic cycle than other markets.

He says this is because of the historic make-up of the market, with companies involved in sectors such as energy, car-making, and industrial companies.

But Mr Gallagher says the market has evolved in recent years, and is now more internationally-focused, with companies earning a greater proportion of their revenue from outside Europe.

If a company is relying on growing its earnings from within the European economy and doesn’t have international earnings, then that is a problem Niall Gallagher, GAM

Focusing on companies with significant international earnings is one of the ways Mr Gallagher believes he can add defensive exposure to his funds. 

He says: “If a company is relying on growing its earnings from within the European economy and doesn’t have international earnings, then that is a problem.”

Traditional defensives

Ben Richie, head of European equities at Aberdeen Standard Investments, says while eurozone-listed companies generate revenue from across the world, negative sentiment towards European equities tends to be correlated with the performance of the wider economy, with outflows from European equity funds tending to be larger in the immediate aftermath of negative economic data. 

He says that in addition to the traditional defensive equities in the consumer area, there are also financial companies, which are defensive as they benefit from higher volumes of trading of investments when markets are volatile.  

Key Points

  • European markets will always be more vulnerable to the performance of the global economic cycle
  • Some financial stocks count as defensive
  • Some consumer staple stocks are affected more by bond yields than economic growth

James Sym, European equities fund manager at River and Mercantile, says that in the event of a significant downturn in the eurozone or global economy, “the stock that the market traditionally views as defensive will once again be viewed as defensive. Some of those stocks might actually look quite expensive now, but they wouldn’t look so expensive if there is a downturn”.

He cites pharmaceutical stocks and consumer staples companies as examples of traditional defensives. But while he is optimistic about the prospects for such businesses in the event of a downturn, Mr Sym is reluctant to invest in most of those businesses at this time.

He says at current valuation levels, with the possibility that a downturn does not occur, investing in some of the lavishly-priced consumer staple companies would offer such meagre returns relative to the risks involved as to be akin to “trying to pick pennies up from in front of a steamroller”.

Many consumer staple stocks – companies that include Unilever and Nestle – have performed strongly over the past decade, almost regardless of the growth rate of the wider economy, due to bond yields being very low.

Low bond yields benefit these companies, which have an income that is low compared with that offered by some other equities, but is higher than offered by bonds, and viewed as equally as secure as the income from a bond.

So when bond yields are low or falling, those equities often rise in value.

In the event of an economic downturn, one of the likely policy responses from governments would be to cut interest rates, which would typically lead to bond yields falling, and so increases the attractiveness of the income from those consumer durable equities, because while that income is low, it is higher than that offered by bonds and viewed by the market as almost as safe. 

Mr Sym says: “Some of those types of companies did very well during the sell-off in March, but the question you have to ask is, ‘what about the valuation?’.” 

Hugh Cuthbert, European equity fund manager at SVM, says German residential property shares have defensive characteristics and high yields, so he regards those as likely to perform well in the event of a wider downturn. 

John Surplice, head of European equities at Invesco, says it’s not a “naturally defensive market” and that the consumer staple companies’ share prices would suffer quite severely if the next major theme in markets is higher inflation.

“The typical policy response to higher inflation is to put interest rates up, which causes bond yields to rise, and makes the income generated by consumer staple shares relatively less attractive.” 

Fahad Hassan, chief investment officer at discretionary fund house Albemarle Street Partners, says the consumer goods companies listed in Europe, such as L’Oreal, Nestle and Roche, are “among the most defensive in the world”. 

Impact of coronavirus

Duncan Goodwin, manager of Premier Global Alpha Growth fund, says investing defensively is very different in a world experiencing radical change than would be the case normally.

He says the companies benefiting from those changes are growing in a way that is not particularly impacted by the performance of the wider economy. 

Mr Goodwin says structural growth areas best accessed by investing in Europe include alternative energy and food safety.    

Mr Cuthbert says: “Technology companies are defensive investments now, though they are often not viewed as that. The fallout from the pandemic has shown us that in tough economic times, demand for technology has risen, not fallen, which is the definition of a defensive investment.”  

Michael Crawford, chief investment officer at Chawton, says the biggest long-term challenge facing the European economy is its ageing population.

Structural growth in economies happens only via growth in the working age population, or via technological advancements.

Mr Crawford says the relative lack of venture capital in Europe makes it more difficult for innovation to happen, and this hurts the long-term growth prospects for the economy, but he favours the defensive businesses, of which the European market has many. 

He says: “One of our criteria for selecting companies for investment is reduced exposure to economic cycles as we believe this provides the opportunity for greater compounding over time, increases predictability and reduces shorter term volatility – the best of all worlds.

“The staples and healthcare companies described above have these attributes. We also find that the high-quality industrials we research aim for reduced economic sensitivity through being asset-light and seeking ancillary recurring revenues such as long-term maintenance contracts. As such, we believe European companies are perhaps the greatest source of defensive stability.”   

Sam Morse, who runs the Fidelity European Values investment trust, says: “While the European equity market lacks the high-octane growth companies that have driven the US market over recent years (that is, large consumer technology stocks), many of Europe’s largest companies boast very attractive attributes of low volatility growth, stable balance sheets and good dividend yields.

“As the rise of the US equity market has been led over the past decade by the technology sector, we have similarly seen the composition of the European equity market change. Where the region may lack the volume of technology leaders that the US has (although there are some), healthcare and consumer stocks have come to dominate, while the traditional heavyweights of oil and telecommunications have reduced in prominence in the index.

“The shift from highly cyclical sectors towards more stable growth has been a function of the low growth, low interest rate environment. As earnings growth has proven harder to find post-GFC, companies offering solid growth have been rewarded.

“As we look across the market today there are many global, best-in-class companies that are headquartered or listed in Europe, benefiting from the regulatory quality and liquidity the region affords.

“As we think about those factors that offer defensive characteristics in a crisis, it is likely to be names with stable balance sheets, strong franchises and resilient earnings profiles than can weather the storms and emerge stronger.”

David Thorpe is special projects editor at Financial Adviser and FTAdviser