02.11.2017 — EUROPEAN EQUITIES: PROFIT GROWTH CONTINUES TO DRIVE THE RALLY
In his European equity funds Berenberg European Focus Fund and Berenberg Eurozone Focus Fund, which were launched in early October 2017, fund manager Matthias Born focuses on enterprises with stable profit growth. And so naturally he is delighted that corporate profits in Europe rose strongly again in 2017, for the first time in a long time. He also expects strong profit growth in the coming year. Especially cyclical sectors are posting big gains. Technology, cyclical consumer goods, industry, and healthcare are currently preferred sectors for the fund. However, this weighting results from the selection of individual stocks and is not controlled by macroeconomic trends.
The profits of many European enterprises showed no growth in the last few years, but now they are gushing again. "2017 is the first year in a long time when enterprises are earning solid profits. Profits have risen at a double-digit rate," said Berenberg fund manager Matthias Born. As equity prices have risen in the last years, valuation indicators such as the price-earnings ratio have widened. "Now the equity markets rally has gone from being valuation-driven to being profit-driven. That is a very healthy development", Born said.
He also expects good economic conditions in Europe next year, so that nothing stands in the way of further profit growth. The sentiment is very positive and sentiment indicators have reached multi-year highs. "It is true that sentiment in equity markets can always turn on a dime, especially considering that the recent substantial price gains could lead to profit-taking. However, the underlying fundamental profit trend remains intact for now", Born said, and recommended using potential dips as an opportunity for increasing investments in European equities.
Catalonia and Brexit do not scare the equity markets
Born sees the development of the euro as the only possible brake on profit growth. "For the first time in many years, the euro has appreciated against many currencies, including the US dollar, pound sterling, and the Chinese renminbi. Further appreciation could be detrimental to profit growth", Born warned. On the other hand, he does not regard political flash points such as the situation in Catalonia and the Brexit negotiations as a threat to the European equity market overall. At most, he expects only short-term, sentiment-driven declines to result from these developments. "However, the only thing that could stop the market in its tracks would be a profit recession, and we don't see that at the present time", Born explained.
On the other hand, local markets are most certainly affected by political issues. "Spanish equities will probably continue to be volatile for now", Born said. In the United Kingdom, the coming Brexit is causing uncertainty among enterprises, which are holding back on capital spending, and is dampening consumer sentiment. "In the United Kingdom, we are seeing relatively numerous profit warnings from enterprises that are locally oriented, such as enterprises in the consumer goods sector", Born explained. "In our fund, however, political developments and currency fluctuations play no role. Diversification across many different end markets reduces concentration risk; furthermore, it has been shown again and again that one should not be irritated by such temporary disturbances. What counts in the medium to long term are company-specific drivers of revenues and profits."
Favourable valuations support the case for European equities
Another argument in favour of European equities is valuation. European stocks are still inexpensive, especially compared with US stocks. "The valuation discount has remained at the same level this year. The US equity market has once again turned in a better performance than the European market", Born said. The economy is also doing very well in the United States and the weaker dollar is helping a lot of companies. This works in favour of Born's strategy. While it is true that his Berenberg European Focus Fund invests in Europe and his Berenberg Eurozone Focus Fund invests in the Eurozone, both funds are focused on globally active enterprises. Therefore, a globally good economy is just as advantageous for him as an upswing in Europe.
"We are convinced that equity prices are driven by profit growth in the long term. Therefore, we look for enterprises with stable profit growth", Born said. To achieve this goal, they must have a robust business model with high barriers to entry. In Europe, he finds this kind of company mainly in Germany, France, Scandinavia, the United Kingdom, and Switzerland. In terms of sectors, this kind of company is mainly found in technology, consumer goods, healthcare, and industry. This preferred type of enterprise for him is not as well represented among banks, utilities, and telecom companies. "Especially in Europe, only very few banks can grow their business structurally", Born said. Furthermore, utilities and telecoms are very homogeneous sectors. The enterprises are hardly different from each other and have similar drivers. As a stock picker, he prefers sectors like industry, consumer goods, and technology. In these sectors, many enterprises stand out through innovation, brands, or special business models. "Europe is still a region where you can find strong global players and hidden champions, which can protect their profit growth over the long term with high barriers to entry."
Luxury goods are preferable to car makers, specialist pharmaceuticals preferable to big pharma
In the sector of cyclical consumer goods, Born avoids car makers and gives preference to luxury goods producers instead. "The growing regulation related to cutting CO2 emissions and the trend towards electric vehicles mean big investments for car makers. That inhibits profit growth. And they are facing more competition from new competitors in the segment of electric cars", Born explained. After going through a rough patch in the last two years, luxury goods have returned to their long-term growth course, which is fundamentally supported by increased global prosperity. In addition, many enterprises in this sector can protect their position over the long term with strong brands.
He has also removed big pharma from his shopping list. "The big pharmaceutical companies are under constant pressure due to expiring patents and the price pressure exerted by healthcare systems", Born warned. Consequently, he prefers specialist pharmaceutical and medical engineering firms that are somewhat better insulated from these trends.
Defensive consumer goods companies increasingly have to contend with more local competition, especially in emerging-market countries, for which reason Born is very selective in this sector. Furthermore, this industry is being adversely impacted by the disruptive shift towards online sales channels.
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Status: November 2017