While US industry big-wigs Warren Buffett and Robert Shiller have recently been banging the drum for Europe amid renewed investor enthusiasm for the long under-loved region, Ian Ormiston, manager of the Old Mutual Europe (ex UK) Smaller Companies Fund, is remaining cautious. But while he is at pains not to oversell the European recovery, he believes certain domestic-focused areas of the market are well set to thrive.
Let’s not get too overexcited.Yes, economic conditions in Europe seem to be improving; yes, the latest Greek can-kicking exercise shows some valuable policy lessons have been learned from the blunders of 2010 and 2011; and yes, it’s nice to see outsiders finally banging the European equity drum. But that’s just the good news.
Truth be told, although European growth may well be better in 2015 and 2016, it is still likely to lag that of its peers. Meanwhile, the whole ‘Europe is cheaper’ argument is a bit of a red herring given the circular and relative nature of valuation discussions. What’s more, from a European smaller company perspective, the Euromoney Smaller Europe (ex UK) Index now trades at 16.7x forward earnings which, in a very unusual cycle, suggests it is above mid cycle. Cheap? I’m not so sure.
Of course, the smaller market cap companies in which we invest are more attractively valued but my general enthusiasm is more idiosyncratic in nature. I’m excited about the Irish economy growing sustainably at around 4% a year, about Spain playing a successful game of catch-up and the exciting dynamic of re-discovered internal competition in Europe. Above all, I’m excited about domestic demand.
Indeed, the underlying composition of the region’s growth should be in greater focus. Employment growth and real wage growth are doing much to bolster domestic demand for a region long used to relying upon the wants of outsiders. Areas such as the European auto industry should prosper.
Elsewhere, year-on-year bank lending is finally turning positive across much of the region – for the first time since 2008 – as the painful processes of balance sheet repair and capital ratio rebuilding start to pay off. Areas such as commercial and residential construction are the likely beneficiaries. The European construction industry has moved from trough levels through to nascent recovery but is unlikely to hit boom levels due to the effects of new regulation – including maximum loan-to-value restrictions – and it pays very attractive yields.
And on the topic of construction, we like building materials too. We own producers that, as a result of being in an industry using around 60% of its capacity, should see huge operational gearing in any upturn.
On a broader footing, we also expect to see the improvements in European disposable income drip through to those secular growth stories – we like online gambling companies and niche retailers.
The big story as far as we are concerned is not one of regional economic recovery or of relative value versus the US; instead, it is one of domestic demand and of domestic recovery stories, many of which can’t be accessed through larger companies.We remain happy to focus on those smaller companies that have not only survived the past few years but have thrived in them.
And on that basis, I’ll happily admit there’s some cause for optimism.