Which are the most attractively valued European-domiciled companies that possess sustainable competitive advantages? Morningstar equity analysts have compiled a list, revealing the Consumer Cyclical, Energy, and Utilities sectors trade at the steepest uncertainty-adjusted discounts to our estimate of their firms’ intrinsic values.
Compiled monthly, the latest list saw a small amount of turnover as trading level fluctuations caused two firms in our coverage universe to edge out some of our February picks on an uncertainty adjusted price/fair value basis. Firms that left our list this month included Tenaris (TEN) and Vallourec (VK), Lloyds Banking Group (LLOY), and Rolls-Royce Holdings (RR.).
The FTSE 100 appreciated 3% in February, trailing considerable gains captured by major U.S. indexes. In aggregate, our European coverage universe now trades at a 9% premium to our fair value estimates, though there are some bargains in the space.
Though we removed Lloyds from the list to make room for a more undervalued European bank, its discount to our fair value estimate still looks attractive at current trading levels. The company recently declared its first dividend since 2008, which analyst Erin Davis believes will pave the way for a more material dividend for 2015 and a forward yield of around 4%. Lloyd’s narrow moat is a result of its scale in its strong U.K. retail business, where it is able to attract more low-cost deposits than competitors – it has a 25% market share in current accounts.
The company also keeps operating costs low with a banking cost/income ratio near 50%, which Davis expects to fall further as interest rates rise. We also removed Rolls-Royce from the list following Jeffrey Vonk’s recent downgrade, which reflects a normalized long-term real rate environment in his forward projections. Nevertheless, Vonk believes the business still exhibits a narrow economic moat, as the company’s significant installed base produces a stream of predictable aftermarket services.
Further, the industry’s high barriers to entry, attributed to technical knowledge required to design and manufacture a jet engine, should discourage new competitors in this highly cyclical and capital-intensive business. New entrants to the list this month are Holcim (HOLN) and Lafarge (LG), HSBC Holdings (HSBA), and Schneider Electric (SU), as they represent the cheapest European names on an uncertainty-adjusted price/fair value basis.
London-based HSBC is one of the world’s five largest banks, operating large business and retail banks in the U.K. as well as the largest bank in Hong Kong. Though analyst Erin Davis contends that regulatory costs will remain at permanently higher levels, as evidenced by the firm’s bevy of legal costs incurred in the fourth quarter, the firm’s narrow moat is intact. Davis believes the value of HSBC’s broad reach has been clearly demonstrated by its performance in the ongoing credit-market turmoil, during which HSBC has suffered considerably less damage than most of its competitors.
Excepting the global financial crisis and other unusual items, HSBC consistently earns returns above its estimated 12% cost of equity despite employing significantly lower leverage than most global banks.
