European equities are a complex market. We have a broadly declining working population, slow productivity, structurally high unemployment, high debt levels and more recently the risk of EU dissolution. This is not exactly a recipe for success.
However, an investor that disregards European equities on this basis alone is a first-level thinker. The real question is how much of the bad news is already priced in, which admittedly, requires assumptions to be made on the future status of the European Union.
Our analysis shows that under most plausible scenarios, Europe is more attractive than the United States on a 10-year view. There appears to be two standout opportunities from a valuation perspective; namely European energy and European emerging market exposure.
These markets offer 10-year valuation-implied returns of 7% and 8.4% respectively, which look very healthy in light of a poor overall backdrop that is offering 3.5%. The real issue is whether these are value traps, and whether we can realistically expect mean-reversion under an environment of potential structural stress.
This is where a margin of safety is desirable, and something we believe is available at the current time. For instance, the dividend yield of European energy is currently 6.4%; considerably higher than the 20-year average of 3.8%. Even emerging market Europe, which isn’t known for its strong dividend profile, is offering 3.9% versus a 20-year average of 2.4%. The same valuation appeal is apparent for earnings, book values and cash-flow.
What is in a Valuation?
Valuations remain the core driver of Morningstar’s portfolio decisions, and a framework of absolute value, relative value, fundamental risk and contrarian sentiment form a basis for selection criteria. This involves meticulous ongoing calculations around return-on-equity, book values and profit margins; among others; to identify pockets of opportunity and risk in the equity market spectrum.
Most markets continue to offer positive real valuation-implied returns, as would be expected from an asset class that entails higher risk.
Apart from a few selected “unappreciated markets”, a large percentage of countries appear to offer relatively weak return profiles, with more than 50% of the universe offering less than 4% over the next 10 years from a valuation-implied perspective. The United States is generally unattractive as it sits at the lower-end on a relative basis, offering a small real return profile over the next 10-years. The UK and Japan are balanced.
Emerging markets are generally attractive, with the highest valuation-implied returns coming from many in the Europe, middle-east, Africa (EMEA) region.
