European stocks are rising: 3 to buy now

Writing in The MoneyLetter between the first round and final run-off French elections, portfolio manager John Stephenson admires the strong economic recovery underway in Europe. He picks two financial stocks and a cash-rich airline as current ‘buys’ to benefit from a new round of Europe rising.

European markets finished their best week this year following the first round of the French presidential vote, as investors poured money into the region at the fastest pace since 2015. The Euro has also been on the rise, soaring 1.6 per cent against the U.S. dollar in the last week of April.

All this comes as investors look beyond the political risks, to the strong economic recovery on the continent. In the week following the French vote, Germany’s DAX index reached a record while the Euro Stoxx 50 index of blue-chip euro-zone stocks climbed 3.5 per cent, with banking stocks leading the charge. In U.S. dollar terms, the Euro Stoxx 50 index is up almost 12 per cent this year, nearly double that of the S&P 500’s gains.

The fortunes for the eurozone appear brighter after the solid election victory of the Dutch political establishment in March, and April’s first round of the French presidential election, when pro-European centrist Emmanuel Macron won the most votes.

Investing by the numbers

Instead of politics, investors are focusing on earnings and economics. Unlike in prior years, analysts have continued to raise their forecasts for earnings per share growth in the eurozone. First-quarter earnings in the Stoxx Europe 600 are expected to increase 5.5 per cent from the first quarter in 2016, according to Thomson Reuters data.

Good signals from the economy are helping to buoy investor appetite for all-things Europe.  Business confidence and gauges of activity in the eurozone’s manufacturing and services sectors rose to six-year highs in April, despite the uncertainty surrounding the French vote.

The consensus of bank analysts is for European corporate earnings this year to be 18 percent ahead of what was reported in 2016, thanks in large part to dramatic rebounds in the profits of bank stocks and mining stocks. For the first time in six years, global growth and profit expectations have been revised upwards and earnings revisions have been stronger outside of the United States.

In a re-accelerating global economy, Europe is well-positioned to capitalize, with European stock markets overweight financials, industrials and material sectors, the three most cyclical sectors. But this cyclical nature of European bourses relative to the S&P 500 is even more pronounced within sectors.  For example, non-U.S. consumer discretionary contains 37 per cent autos. This compares with heavier weights within the S&P 500 of the less economically sensitive media and internet retail sectors.

Not only do European bourses have greater cyclicality, but the constituent companies have greater operating leverage than their North American peers. While higher fixed costs and lower margins hurt European companies in periods of modest or slowing output, it helps when GDP is accelerating—such as the current environment. This increase in leverage in a growing economic environment translates into superior earnings growth, a boon for investors.

European equity funds have been enjoying the ride with their strongest inflows since December 2015, with inflows of $2.4 billion in the week to April 26.

Risks persist

Risks in the region continue to persist and they could quickly dampen the mood. There is a small chance that Ms. Le Pen, who pledged to take France out of the euro, could win the final run-off presidential election on May 7. Euro-skeptic parties have a decent chance of winning the Italian elections that will come next year at the latest, and Italy and France continue to be mired in sluggish economic growth.

Since the financial crisis, the U.S. has been the default destination for global investors, because it offered low risks and growth when there was very little available worldwide, at least until now.

But with U.S. stocks markets hitting fresh highs and worries about whether or not the Trump administration can actually get any of its ambitious agenda passed into law, the near-twenty percent discount in valuation that European stocks offer is attractive.

What I recommend

Europe has finally begun to catch on fire after being an investment laggard for the better part of the last decade. Suddenly, Europe is hot and with good reason. The continent is home to top global financial stocks, cutting edge manufacturing stocks and global leaders in the resources business. With the political risks to the continent increasingly fading into the rear-view mirror, now is the time for investors to start diversifying beyond North America’s shores to Europe.

One company that I really like is financial stock Allianz SE (XETRA—ALV), the world’s largest property and casualty insurer and the world’s third largest life insurer. Allianz is also top five global asset manager and a world leader in the management of fixed income investments through its PIMCO unit. The company serves about 76 million customers in some 70 countries, with Europe accounting for half of its profits, with Germany, Italy and France being its most important markets.

The life insurance business is performing well and I believe that Allianz can meet its targets for EPS growth of five per cent compounded annually. As well, the company is buying back shares and offers a dividend yield of 4.31 per cent. I have a ‘buy’ rating and a twelve-month price target of €195 per share for Allianz SE.

Ryanair Holdings plc (LON—RYA; NASDAQ—RYAAY) is an ultra-low-cost-airline stock operating primarily out of Dublin and London and flying mostly to secondary airports. The company offers very low fares if booked well in advance of travel, often with a very low base fare, and a number of add-on charges, for things such as web check-in, baggage, reserved seating, priority boarding, and administration charges.

The company delivers very strong staff productivity, low operating unit cost of aircraft and cheaper airport hubs, all of which remain strong differentiating factors for Ryanair. The company is generating large amounts of cash, which paves the way for a potential future capital return to investors. I have a ‘buy’ rating and a twelve-month price target of €18.25 per share.

Another name that I really like is Lloyds Banking Group (LSE—LLOY), a large UK-based financial stock. Lloyds is a leading provider of banking services to both the personal and corporate sector in the UK. Through its Scottish Widows division, it is also a leading provider of insurance and pensions. The company has been a very strong generator of capital, has a high dividend-paying capacity, expanding margins and a very attractive valuation. I have a ‘buy’ rating and a twelve-month price target of 90 pence sterling per share on Lloyds Banking Group.

Stock markets around the world have been moving higher of late, with some of the greatest gains coming from the European bourses. Despite persistent talk of a ‘Trump Bump’ the reality is that these gains are occurring not because of a changing political landscape but rather because of improving global conditions. Purchasing Managers Indices are up across all developed markets, highlighting the breadth of the growth.

The departure from extraordinarily low inflation expectations and interest rates (the lowest in over 50 years) has set the stage for positive equity prices in the months ahead. European bourses trade at a forward price/earnings ratio of 14.9 times versus 17.6 times for the S&P 500, a substantial discount in valuation that is just too attractive for savvy investors to pass up. With the political risks on the wane in Europe, the biggest headwind to investing in the continent has been swept away, creating a unique and compelling opportunity for investors.

John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse.” He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or jstephenson@stephenson-co.com.

This is an edited version of an article that was originally published for subscribers in the May 2017/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846