Euro coin being squeezed in a vice

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With European growth at 0.2% and inflation well above target at 7.5%, Europe is bracing for the kind of stagflation it hasn’t seen in 50 years, says Sean Kenzie, head of equities with Dublin-based Setanta Asset Management.

Kenzie said challenging economic conditions dictate the need for careful analysis and new investment strategies.

“It’s the first time since the 1970s that we’ve had to really worry about stagflation,” he said. “Fortunately, we can learn from Warren Buffett, who has written extensively on the topic.”

Using logic borrowed from the Oracle of Omaha, Kenzie pointed out that inflation does not spare capital costs like investments in plants, machinery, inventory and receivables.

“So, it takes more capital per dollar of revenue and that, combined then with a lower margin, gives you a lower return on capital and lower equity returns.”

In times like this, he said, “You really need to focus on companies with competitive advantages and pricing power; companies that are price makers, not price takers.”

Stagflation is often described as an economic condition in which “growth is down and inflation is up.” But Kenzie prefers the definition offered by Kristalina Georgieva, managing director of the International Monetary Fund. She puts a more human face on stagflation by describing it as a time when “incomes are down and hardship is up.”

“In Europe, you have a dramatic squeeze on household budgets,” he said. “J.P. Morgan estimates that 40% of the U.K. population will spend 30% of their income on food and fuel. And after lodging, that doesn’t really leave a lot for discretionary spending,” he said.

The source of the inflation, he said, is correctly identified as the Russian war on Ukraine, but is amplified by other factors, including ongoing concerns about Covid-19, a tightening labour market and stubborn global supply chain issues.

“Supply chain shortages are something that we feel are temporary in nature. Capitalism has a history of solving these sorts of problems,” he said. “But working against that assumption is this ongoing splintering and regionalization of supply chains, and the blurring of lines between economics and geopolitics, where countries want to be sure of the security around the data, their communications, their technology and their supply chains.”

He said the current Russian aggression has spelled the end of Siberian oil and gas in Europe, and will speed the transition to alternative forms of energy on the continent.

“Germany, for example, already had a target to get to about 80% of electricity from new renewable resources — which is about double where it was in 2021 — and this will likely ramp that up,” he said. “Energy transition is now not just about climate crisis arguments. Now it’s about energy security as well.”

Ideological polarization also remains a threat to European unity and economic health.

“The political instability in Europe is a bigger call-out. It seems to be a little bit more vulnerable to political risks, with some protectionist elements,” he said. “That is always a backdrop in Europe.”

France’s recent national election, for example, only narrowly avoided an upset from far-right candidate Marine Le Pen. Italians are set to go to the polls within a year, with some predicting similar divisions.

But long-term, an even bigger consideration for Europe, Kenzie suggested, is simple demographics.

“Canada is expected to add 10 million people off a base of 38 million people by 2050. The U.S. will have 100 million more people by 2050. But the population of the E.U. 27 is expected to remain flat over the same time horizon,” he said. “And if you think about population growth then in terms of demand for construction — people need homes to live in, places to go to work, infrastructure to connect all of that, roads, bridges, airports, etc., — and all the multiplier effects that go with that, that is a structural headwind to European growth.”

With all of these factors, Kenzie suggested a new approach to eking out gains.

“Investors should have lower expectations for returns from equities in this environment of tighter financial conditions and decelerating growth, and stubbornly high energy prices and inflation,” he said. “And if these high energy costs and higher wages persist, it’s the companies with pricing power and operational leverage that are able to capitalize.”

Among the European companies poised to do well is France-based EssilorLuxottica SA, the product of a 2018 merger between the Italian sunglasses and frame maker Luxottica, and global lens maker Essilor.

In addition to having industry-leading brands and processes, the company purchased the network of Sunglasses Hut stores, and is partnering with opticians to efficiently capture prescription, retail and online sales. Kenzie also pointed out the demand for corrective eyewear is growing structurally, not only because populations are aging but because the increased use of screens is leading to a step change in eye degradation and a need for more corrective eyewear.

“Essilor is at the leading edge,” he said. “It is spending far more in R&D than anyone else in the industry, and it’s a really strong leader in innovation and lens coatings and so should do quite well.”

Another attractive opportunity is Ireland-based CRH plc. This provider of building materials has taken an integrated approach to infrastructure construction work that differentiates it from competitors.

“As management say, they like to sell the road, not the rocks. They have moved away from commodity products and commodity pricing to much higher-value solutions,” Kenzie said. “They pay a cash dividend yield at the moment of 3% and a buy-back yield of 4%. So that’s a return to shareholders of 7% per annum.”

The bottom line for investors, he said, is focusing on the ability of companies to control input costs and pricing in a time of high inflation and low growth.

“Once you identify these factors, then it’s just being really careful that you don’t overpay and expose yourself to multiples compression,” he said. “If these companies with those attributes can translate these advantages into higher free cash flow conversion and rising dividend yields, and returns to shareholder, they should do well.”


This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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