Disparities in European equity stock valuations lead to a great opportunity

Market movements have created significant disparities in European equity stock valuations leading to a great opportunity for fundamental investors.

European equity markets have always offered investors diverse investment opportunities across multiple industries, countries and company sizes. The market disruption that has been experienced during 2018 has resulted in valuation multiples available in some European companies today that make this a particularly compelling area to research and invest in.

The movements in the markets during 2018 have been partially driven by sector rotation, with growth companies generally outperforming value companies on a year to date basis, as investor sentiment moved from being excessively bullish in January, to excessively bearish at present. As a result of this, the disparity in stock valuations has now reached extreme levels. Some value stocks in Europe have been de-rated to levels seen in the immediate aftermath of the Brexit vote, at a time when European economic data surprises are turning more favourable. Moreover, EPS upgrades continue to be widespread. Therefore, barring a further escalation in trade rhetoric, there may be a swift rotation back into Value stocks, similar to the latter half of 2016 in the team’s opinion. Fundamental players that are willing to do the necessary work may be better placed to take advantage of this dislocation as normality returns to European markets.

The team believe that the European small and mid cap universe is an amazing opportunity set of companies that are off the beaten track, with management happy to provide access for investors taking an interest in their companies. There are indeed nuances in working across so many sectors and countries, but equally the smaller companies are sometimes less driven by short term shareholder targets as opposed to longer term investment opportunities in the businesses that they have nurtured.

Given the diversity of this market segment, small-cap index products can struggle to delve deeper than broad sector exposure into sub-sector exposure, not helped by smaller companies sometimes being miscategorised by data providers. Delving into sub-sector exposures provides greater granularity and therefore diversification within a portfolio, which ultimately spreads risk for investors.

Repeatable and disciplined investment processes over the past 16 years

Bertrand Faure’s team have been successfully managing money with their investment process in this strategy for the past 16 years. Their method of combining 360 degree private equity style fundamental analysis with a disciplined investment style has proved very successful. Since the strategy launched just over three years ago with EI Sturdza it has returned 27% to investors through to the end of August.

Bertrand’s team are looking for something special in each of the companies that make it into the portfolio, a standard that is possible to adhere to given the breadth of the European small cap universe. The team seek to invest in businesses that have defendable market share and pricing power, significant free cash flow and strong management. Management really is key; Bertrand believes you should not invest in smaller companies without meeting them first. In addition, the team meet with competitors and suppliers, and when appropriate they also do site visits.

The team’s investment process is disciplined. They have built up a very large database of proprietary financial models over the past 16 years, and consistently update each of them. This is indeed a significant commitment but opportunities can be short lived. You need to be ready to go when the opportunity presents itself, not start doing the work then because it can often be too late at that point.

The fundamental analysis is combined with risk management, looking at the downside as well as the upside associated with a position, to arrive at the entry and exit levels for each stock prior to it being established, while weightings ensure that investors capital is put to work where there is most to gain and the least to lose.

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The views and statements contained herein are those of Pascal Investment Advisers SA in their capacity as Investment Adviser to the Fund as of 25/09/18 and are based on internal research and modelling.

 

Further insights

October 2018

Higher yields - Not necessarily bad for equities

Data reports for the period were solid, showing no particular signs of an economic slowdown. As expected, the Federal Open Market Committee increased the federal funds rate by 25 basis points (to 2-2.25%) after its September meeting.