Newspaper headlines about Europe rarely make for happy reading. Rising unemployment rates, wavering economic growth, sovereign debt crises and political drama sound like a shopping list of negatives – hardly the sort of backdrop that makes for a favourable investment.

Yet, amid the tough economic environment the European equity market has done remarkably well. So well in fact, that the FTSE World Europe ex UK Total Return Index rose 17.8%¹ in 2012 in sterling terms. Not bad for a region that has spent much of the past few years reeling from one crisis to another.

Why are European equities doing so much better than the economy? First, it reflects the market taking some comfort from the pledge made in July 2012 by Mario Draghi, President of the European Central Bank (ECB), that the ECB would do “whatever it takes to preserve the euro”.  This was quickly followed up by the creation of Outright Monetary Transactions (OMT), a programme that effectively backstops eurozone governments by buying their short-term debt so long as they agree to stringent fiscal conditions.  

OMT’s existence alone has helped reduce one of the biggest tail risks facing European investors – denomination risk.  Investors have become less fearful that an investment in the troubled periphery will be repaid in devalued lire or pesetas, rather than euros.

It is perhaps no coincidence that just as the existential fears surrounding the eurozone have faded, the spotlight has fallen on the US and the wrangling over how to resolve the US federal budget deficit. Investors are quickly appreciating that Europe is not alone in needing to bring government spending under control.

Second, there is a gradual recognition that a domestic economy and the stock market are not always connected.  Several emerging markets, such as Indonesia and Russia, enjoyed strong economic growth last year but it did not follow that their stock markets were all winners. Taking this analogy further, just because a company is domiciled in a country does not mean its performance need reflect the local economy.

With careful stock selection it is possible to avoid the worst of the local economic headwinds and benefit from growing niche industries and more dynamic economies outside Europe. Those European companies with a global footprint mean that even if the local economy is not firing on all cylinders, it is likely that the economies of other countries in which it operates may pick up the slack. For example, Swatch Group, the watch and jewellery company that counts Omega and Longines amongst its many brands, has less than 37% of its sales in Europe, with the fast-growing Asian region accounting for just over half its sales. With brands straddling different price brackets as well as countries, the company benefits from a diversified customer base.

Other European companies are operating in industries that are enjoying secular growth that is largely independent of the economic cycle. A good example is the fragrance and flavourings business, which is consolidated into the hands of a few players. Two European companies, Symrise of Germany and Givaudan of Switzerland, are at the forefront of this industry, creating the ingredients that improve the taste of food and providing the fragrance in cosmetics, perfumes and humbler personal care products. With consumers becoming increasingly demanding in terms of quality and developing markets wanting the same products as those used in rich nations, the only real constraint on this market is the size of the world’s population, which is expected to grow by two billion over the next three decades.

One of the advantages of European companies is that they can provide exposure to fast-growing areas of the world but with the reassurance that comes from being listed on a well-regulated, established stock exchange and the good corporate governance that entails. In fact, companies such as Bureau Veritas, the French testing and inspection group, make a virtue of their European roots and the quality and trust it engenders.

Similarly, Kone, the Finnish lift manufacturer, receives orders because customers trust the quality of its product: it is simply not worth the risk of installing an inferior lift in a building when reliability and safety are paramount. Through maintenance and service contracts Kone is able to enjoy recurrent earnings from an installed base of more than 850,000 lifts and escalators that help reduce the cyclicality from its original equipment manufacturing business.

There is no denying that the last few years have been challenging for European companies but, in many cases, this backdrop has hastened reforms and efficiencies meaning that those European companies that remain are generally in strong financial shape.  At the aggregate level, therefore, European equities look attractive, although, in our view, a selective approach can help isolate those companies with even stronger prospects.

¹Source: Datastream, at 31.12.12

There has been a remarkable swing in sentiment on European shares, which have recouped a fair amount of the previous underperformance against the US market and also against bonds. I am sure many are asking whether this trend can continue – so here is my view as a European fund manager.

I will restrict my comments to Europe – with the one exception that the excellent weekly publication ‘The Economist’ made recently regarding the USA turning European. The point is that the USA is now having to face up to the same issues about debt levels as the Europeans have been wrestling with for the last five years, and the postponement of the Fiscal Cliff/debt ceiling debate by two months means the issue will be topical again very soon.

But in the meantime, there is clear evidence that European economies have at least stopped getting worse, and may perhaps begin to look a little better later in 2013. During Mario Draghi’s most recent press conference he pointed to a number of positive developments; namely, “Bond yields and countries’ credit default swaps (CDSs) are much lower, stock markets have increased and volatility is at an historic low”. He went on to highlight some of the lesser known improvements – “We are seeing strong capital inflows to the euro area. The deposits in periphery banks have gone up. TARGET2 balances have gone down. The size of the European Central Bank’s balance sheet, which is often considered as a source of risk, continues to shrink. So, all in all, we have signs that fragmentation is being gradually repaired.”

The picture is still far from euphoric however, with greater stability yet to filter through to the real economy – unemployment is still high and with growth likely to remain low, debt reduction will take years to achieve. The recent small improvement in sentiment indicators could lead to a self-fuelling virtuous circle of better growth as companies utilise some of the large cash piles they have available, and take advantage of historically low funding rates. An example of this is SAP – whose management looks like it will announce a good order book for their new systems as companies realise they need the best software to operate most effectively. Recent stimulus plans by China and Japan also show that Asia may trigger better growth. So, all in all, I think we can be reasonably confident at this early stage that global growth will be slightly better in 2013 than it has been in previous years.

This means that earnings should be able to make a small advance in most European companies this year. So while the performance of last year was totally due to the excessively over sold and cheap level of European equities (as we discussed many times with mostly sceptical clients), this year should see markets progress due to better earnings. Any further expansion of ratings of European markets would need a quite enthusiastic switch away from more expensive areas such as the US equity market. More likely is that we will see a switch from bonds – where the large flow of money in recent years has resulted in a number of ‘bubble’ characteristics. We have maintained for over a year now that in the view of us European equity managers, many European bonds look way too expensive, and that a switch from bonds to equities was justified.

It could be that there has started to be very early agreement in this argument, and if that is the case, the flow back towards equities could be large and last some time. This reinforces our view that European equities look attractive still at current levels, and since a consolidation is entirely likely after such a rapid rise, any weakness is likely to be met by renewed buying interest.

For much of the last few years Europe has been viewed warily by investors as the sovereign debt crisis and a mixed economic picture have weighed on sentiment. In fact, it has become something of a badge of honour to avoid the continent. Crises, however, have a habit of encouraging transformative change and Europe is gradually reshaping itself.

The end of 2012 was interesting because for the first time in three years Europe avoided the spotlight. Instead, it was the turn of the US to be in the public glare as politicians frantically scrabbled to secure a deal that prevented the US economy falling off the so-called ‘fiscal cliff’. In echoes of earlier eurozone debates only a partial solution was agreed, with the budget decisions and debt ceiling talks delayed to the end of February.

For Europeans looking across the Atlantic they might be forgiven a wry smile and a sense of déjà vu. After all, whilst the US is only starting to face up to its structural problems, Europe has already been having these debates – in public – for the better part of three years.

Structural reform is underway

For all its faults, the straitjacket of the euro forced issues to a head, most notably the need for structural reforms. For countries such as Ireland and Greece, therefore, austerity programmes are well advanced. A cursory glance at the bond markets highlights this. Only two years ago Ireland was a pariah nation but now it is able to borrow in the open market at rates only a few percentage points above Germany, whilst its banking sector is fast rehabilitating.

It might seem Machiavellian but European companies, particularly the more globally-facing multinationals, have used the crisis in Europe to their advantage. One of the French electronics firms that we hold confessed to us that in ordinary circumstances they would never have been able to drive through the restructuring and plant consolidation they wanted to do were it not for the crisis dissuading politicians from blocking reforms. The result: European companies have been able to get fit quickly, focusing their operations on their more profitable businesses and culling the underperforming areas.

The carousel of eurozone crisis summits and market volatility was draining, but it led to incremental improvements and engendered greater political consensus. This was evidenced in the summer of 2012 when the eurozone was priced for an existential crisis. Politicians were spurred into action and the pragmatic approach taken by Mario Draghi, the European Central Bank president, particularly his pledge to preserve the euro helped to deter some of the more destabilising speculation, allowing markets to focus more on fundamentals and valuations.

Eurozone aggregate numbers attractive

As the hysteria surrounding a possible break-up of the eurozone faded, commentators have begun to look more objectively at the region. Europe combines net goods exporting countries such as Germany with net importers such as Spain. At the consolidated level, therefore, the eurozone is broadly in trade balance, unlike the US which runs a constant trade deficit or Japan which is reliant on exports. Similarly, the media has focused on the fiscal sinners but many European countries have their spending house in order and have relatively low levels of national debt. At the aggregate level, therefore, Eurozone net government borrowing in 2012 as a percentage of gross domestic product is forecast to come in at 3.3%, well below the 8.7% level of the US and 10.0% level of Japan.

Source: International Monetary Fund, World Economic Outlook Database, 2012 estimates, October 2012

When presented with such facts, it becomes far easier to comprehend why European equity markets performed well in the second half of 2012.  The FTSE World Europe ex UK Total Return Index rose 15.3% in sterling terms in the final half of 2012, outperforming the equity markets of the UK, Japan and the US.

That said, I tend to become wary when a market does well, as it is more vulnerable to a correction or profit-taking. Neither of these should be ruled out over the coming months, particularly as global economic concerns and political hurdles, such as the Italian elections, are never far away, but for investors with a meaningful investment time horizon, Europe remains attractive. It is a region replete with quality cash-generative companies, many of which are household names with a global footprint, such as Adidas, the sportswear company, Roche, the pharmaceutical, Nestle, the food group, and BMW, the car manufacturer.

Whilst it might be argued that the better quality companies in Europe have already enjoyed something of a re-rating, they are generally still inexpensive relative to their peers in other regions. What is more, whole swathes of Europe have largely been shunned by investors. This is why we are tentatively identifying opportunities in peripheral areas of Europe such as Spanish domestic banks, encouraged by low valuations and a regulatory environment that is becoming less onerous.

Europe is beginning to emerge from the shadow of the crisis. For those investors who are prepared to look more deeply, they will discover a region that may be building towards a starring role in an investment portfolio.