Disintegrating euro

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Prices of European equities don’t reflect their recent outperformance against U.S. equities, says Sean Kenzie, head of equities with Dublin-based Setanta Asset Management.

He said while European equities have long had weaker earnings than their U.S. counterparts, that underperformance ended in recent years.

“Indeed, Europe has outperformed the U.S. from an earnings context since 2020,” he said. “However, the price performance of European equities has not inflected. That’s why this very, very large valuation gap has opened.”

Kenzie said Europe historically traded at a 15% to 20% price-to-earnings discount to the U.S. Now it trades at a “massive” 35% P/E discount.

On a like-for-like basis — comparing European companies with the same growth rate as U.S. companies — U.S. companies tend to trade on much higher multiples, he said.

“A company growing at 10% in the U.S. will trade over 30 times earnings while the same company in Europe will only trade in the low 20s,” he pointed out. “That has always been the case. But the point is now we’re at an extreme 35% valuation, versus a long-term median of 15%. We believe that very much offers opportunity for investors.”

Kenzie said the dislocation stems from lower demand for European equities due to geopolitical concerns — particularly Russia’s invasion of Ukraine.

“Since 2022, you’ve had outflows in European equities, [and] no inflows at all over that time frame,” he said.

Low valuations have led some European corporations to buy back their shares.

“They’re using their strong balance sheets in shareholder-accretive ways,” he said. “That has the effect of improving their return on equity.”

Names he likes

Kenzie said conditions have been particularly favourable for a couple of Dublin-based companies: the low-cost airline Ryanair and the international sales and marketing conglomerate DCC plc.

He said Ryanair has embraced cost control in a way that no other European airline has, often offering flights for a third of the cost of their competitors.

“They’re extremely capital disciplined in terms of how they buy planes at low points in the cycle,” he said. “In 2009 and in 2020, they ordered massively from Boeing, when Boeing needed the orders, and they could negotiate really interesting prices.”

He said they also fly into lower-cost regional airports, rather than larger hubs.

“These sort of strategic and cultural aspects of the business means that they make margins of 15% to 18% and return on capital employed of 20%, in contrast to the industry that only just covers its cost of capital,” he said.

DCC, meanwhile, operates in the health care, technology and energy arenas, cultivating stable demand for its products, and enabling scaled expansion with directed capital investments in storage facilities, transport vehicles, bulk tanks and distribution network infrastructure.

“DCC have been very successful at bolting on acquisitions to expand their presence in different geographies and different markets,” he said. “That has the effect of them being able to make really interesting levels of return on capital employed, despite the fact that they’re continuously growing.”

Kenzie said between the discount available for European stocks and the market crowding of U.S. stocks, there are attractive opportunities for investors.

“We believe that from a risk/return point of view, there’s far more interesting opportunities outside of the U.S. and particularly in Europe,” he said. “If you focus on companies with high return on capital, good free cash flow, strong balance sheets that are run by competent shareholder- and stakeholder-friendly management, and on lower multiples, the odds are very much in your favour of doing quite well from here.”


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

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