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10 reasons to consider investing in Europe: a special report

The eurozone crisis may not be over but Henderson fund managers John Bennett and Stephen Thariyan explain why now is a good time to invest there. 

by John Bennett, Stephen Thariyan on Sep 25, 2012 at 13:55

Is now a good time to invest in Europe?

Debate is raging whether now is a good time in Europe. Optimists argue that this month's launch by the European Central Bank of its OMT (outright monetary transactions) programme is an important turning point and shows that the authorities are finally getting to grips with the eurozone crisis.

However, with the global economy slowing down rapidly, we are not out of the woods yet and the recovery in Europe is unlikely to be even.

Nevertheless, investing ahead of the crowd when things are still uncertain is often the best way to get the best returns.

In the following pages European fund managers John Bennett and Stephen Thariyan explain how the turmoil in the eurozone has left the shares and bonds in many European companies looking good value. Although the finances of many European countries are stretched the corporate sector is in good shape.

Both Bennett and Thariyan are currently rated by Citywire for their investment performance.

Bennett has a Citywire 'A' rating for the three-year returns on the Henderson European Focus and Henderson European Selected Opportunities funds that he runs. Both funds invest in shares or equities.

Thariyan is a bond specialist. He currently has a top Citywire 'AAA' rating for his track record on the Luxembourg-based Henderson HF Europ Corporate Bond fund. He also runs the Henderson Sterling Bond fund.

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Next: Companies are in strong financial health

1. Companies are in strong financial health

European companies have rarely been in such good corporate health. Having spent the past few years improving their balance sheets, their finances put to shame most governments. Cash on corporate balance sheets is near record levels (see chart 1), whilst borrowing (net debt) has steadily reduced (see chart 2). Such strong balance sheets mean that companies are able to finance growth internally, creating less pressure for rights issues, in which companies issue new shares to raise money from investors but dilute the value of their shareholders' existing holdings. It also means there is a significant capital cushion should the economic environment deteriorate.

2. Valuations at 30-year low

Profits at European companies have been robust, although the pace of earnings growth has moderated given the weak macroeconomic background. Share prices have failed to reflect the higher earnings and strong cash flow. As a result, European shares are trading well below their long-term historical average in terms of price to earnings (P/E) multiples, as shown in the chart below. The table below the chart also demonstrates that on a 12-month forward price to earnings multiple, Europe is the cheapest of the major developed equity regions, offering the potential for a re-rating.

P/E ratios are an important measure for analysing shares. Read our Smart Investor guide to understanding P/E ratios if you want to find out more.

3. Higher income from dividends than from government bonds

European equities (or shares) also appear attractive in terms of income. Equities are currently in the rare position of offering investors a higher income than the corresponding government debt (or bonds). Unlike fixed bond payments, which remain static, company dividends offer the potential for growth as earnings improve. In the year to 31 May 2012, 63% of companies making up the MSCI Europe Index increased their dividend. (Source: Datastream).

4. Global exposure

European companies are proving particularly successful in acting as a gateway to the world. Famous names such as Nestlé, the Swiss food group, and car makers such as BMW have a global footprint, with overseas operations that dwarf their domestic business. Many of these companies have successfully increased their global exposure over the past five years and are still expanding outside their domestic markets.

European companies are among the principal beneficiaries of growing wealth in emerging markets, as European engineering products from consumer to individual as well as healthcare respectively cater to an expanding global middle class and infrastructure projects. A key advantage of European companies is that they enable an investor to play themes across the world, from commodities to emerging market growth, but with the strong corporate governance that comes from a developed market listing.

5. Diversity within sectors

With an entire continent to choose from, Europe offers considerable investment choice. The MSCI Europe Index alone has 450 constituents, with a broad spread across the different sectors.

Thousands more can be included by moving down the scale to smaller companies. As this snapshot of the MSCI Europe shows, many of these Europe-headquartered companies are household names and world leaders in their fields.


6. Bid activity could propel share prices higher

In recent years, merger and acquisition (M&A) activity has been muted as companies have preferred to concentrate on strengthening their balance sheets. With this process now mature, chief executives are becoming increasingly comfortable about the financial state of their businesses and many companies have amassed considerable firepower for capital expenditure or M&A activity. As a result companies are scouting opportunities to expand market share or consolidate rivals. The first few months of 2012 saw confidence returning with a number of takeovers/mergers being announced with European participants across a variety of sectors. These included:

  • Glencore/Xstrata (Commodities)
  • GDF Suez/International Power (Utilities)
  • DS Smith/SCA (Paper)
  • UPS/TNT Express (Logistics)
  • ABB/T&B (Engineering)

7. Shares in European property companies: stable income on attractive yields

Property as a 'real asset' offers protection against inflation, with rents tending to increase as economic growth and inflation increases. Investors considering Europe today may be concerned about the medium-term impact of central banks’ recent money printing initiatives, such as the ECB's OMT programme. This, however, has fuelled investors’ interest towards real assets and against this backdrop as an asset class property should benefit.

Quoted property companies tend to have long-term leases to large corporate tenants, thus generating a reliable ‘bond like’ income stream. The UK property market represents around 40% of the European index and is as such the single largest market. This chart shows the weighted average lease length of selected UK property stocks, which highlights this income security. You can get an idea of the level of income coming off these shares by looking at the dividend yield. This measures the amount of income or dividend you get when buying the current share price. In other words, it is either the historic or forecast dividend per share divided by today's share price. The current dividend yield for the pan-European property sector is 4.6%.

8. Corporate bond yields are also attractive

The yields on the government bonds of 'core' countries such as Germany are near all-time lows. At the same time, European companies have reduced their debt levels and there has been a renewed emphasis on cash generation, which increases the capital cushion of a company and means that coupon payments [the regular fixed interest paid by bonds] are more likely to be met. Whilst the stronger financial position of companies has been partly reflected in higher bond prices (lower yields), ongoing nervousness surrounding the sovereign debt crisis means that corporate bond yields remain at attractive levels.

9. Corporte bonds still look good value and don't fully reflecting improvement

It is not just that yields on corporate bonds appear high relative to core sovereign bonds, they are also generous compared to what has historically been paid in relation to the financial strength of a company. The scatter chart plots net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation) to give a measure of a company’s indebtedness on the horizontal axis. The vertical axis shows the margin (or spread) of a company’s corporate bond yield over the corresponding government bond.

As might be expected, the higher the debts of a company, the greater the yield spread demanded by investors to compensate them for higher risk. We can draw a line of best fit that shows the slope across the sample. The red dot indicates where the average pan-European company currently lies. This shows that, on average, the corporate bonds of European companies are yielding considerably more (approximately 145 basis points) than would be expected given a net debt/EBITDA ratio of 1.85.


10. Defaults expected to remain low

The underlying financial strength of companies means that default rates among European corporate bonds have remained low. In fact, the default rate on European investment grade rated bonds for the 12 months to May 2012 was 0%. For European corporate bonds rated below investment grade, the default rate covering the 12 months to May 2012 was 2.7%, which was down from 2.8% in April. Moody’s, the credit ratings agency, predicts that the default rate on sub-investment grade bonds will rise slightly to 3.3% by May 2013, but this is still historically low and is an indication of how companies have been adept at repairing their balance sheets and securing financing. If such low levels of defaults are maintained investors will be able to retain a high proportion of the generous yields provided by corporate bonds.

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