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Promotional material published by Metzler Asset Management GmbH - 11.7.2019 - Edgar-Walk

Good prospects for European equities – especially for European small caps

To better assess the attractiveness of a financial investment, a comparison with the dominant financial investment in the respective market segment often helps. The US equity market is undoubtedly the benchmark for all equity markets worldwide. Since 1970, we have seen that, although European and US equities perform differently in individual market phases, they seem to share a common trend, and thus sometimes it’s European equities and other times it’s US equities that are in the lead.

European equities have recently fallen behind US equities
Total return index in USD (31.1.1970 = 100)

Sources: Thomson Reuters Datastream, Metzler; as of May 31, 2019

At the moment, however, US equities have an unusually large performance advantage of more than 30%. If the historical pattern were to continue into the future, either a rise of European equities to the level of US equities or a fall of US equities to the European level would be expected. However, the pattern observed in the past is not a law of nature, but is based on the relative performance of corporate earnings. The chart below shows the development of corporate earnings in local currency and not in US dollars as in the chart above. Otherwise, the development of European corporate earnings would appear very volatile.

Since 2012, corporate earnings have developed better in the USA than in Europe
Earnings per share before interest and tax in local currency (31.1.1970 = 100)

Sources: Thomson Reuters Datastream, Metzler; as of May 31, 2019

US stocks have performed better in recent years because, since 2012, profits have risen much faster in the USA than in Europe. This is mostly because US companies have bought back their own shares to a considerable extent financed by debt. According to calculations by BofA Merrill Lynch, the volume of share buybacks since 2009 totals USD 5.4 trillion and the issuing volume of US corporate bonds even totals USD 15 trillion. When companies buy back their shares, earnings per share automatically increase for the remaining shareholders. According to JP Morgan estimates, if US companies had not bought back shares starting in 2009, earnings per share would be more than 15% lower today. However, it’s virtually impossible to directly measure the extent to which share buybacks have been debt financed, as a company could always have used its own cash flow for an investment instead of financing it with debt. In Europe, share buybacks have played only a minor role so far. The effect of debt-financed share buybacks can be measured indirectly by looking at the net debt of a company in relation to its profits. According to calculations by Unicredit, the indebtedness of US companies is close to historical highs while it’s close to historical lows in Europe.

European companies are less in debt than their US counterparts
Median net indebtedness of companies in the S&P 500 and STOXX 600 vs. EBITDA

Source: Unicredit; as of Q1 2019

There are also several other reasons for the better profit performance of companies listed in the USA. Firstly, economic growth in the USA has been higher on average in this timeframe. Secondly, the US technology sector is highly profitable and there aren’t any comparable tech companies of this size in Europe. Thirdly, European banks and utilities are characterized by structurally somewhat low profitability with a share of around 15% in the total market. Fourthly, the tax reform in the USA led to a leap in profits in 2018. 

The question now is whether European companies can catch up with the price advantage of US equities. Factors in favor include the fact that further US tax reform is unlikely and there is even a small but steadily growing political movement for tax increases in the USA. In addition, the high profit margins of US companies are coming more and more into the political spotlight. The concern here is that monopoly power may have been created that needs to be fought politically. 

Profit margins of US companies at record highs
Profit margins according to I/B/E/S estimates for sales and earnings in %

Sources: Thomson Reuters Datastream, Metzler; as of May 31, 2019

Moreover, we expect economic growth to be about the same in both economic areas in the years to come. It is unlikely that European companies will soon buy back their own shares on a large scale financed by debt. However, due to the high indebtedness of US companies, the rate of share buybacks in the USA could decline in the future.

Against this background, it’s interesting to look at analysts' average earnings forecasts. Analysts revised their earnings growth forecast for European equities in 2018 downwards from 11.2% in the first survey in December of 2015 to 7.1% in February of 2019. In the USA, the forecast for earnings growth was raised from 10.3% in December of 2015 to 21.7% in February of 2019 – likely due mainly to the US tax reform. However, a survey of analysts in May of 2019 revealed a different picture for earnings forecasts for the 2019 calendar year; analysts now expect earnings growth of 5.5% for European companies and only 3.2% for US companies this year.

For 2019, consensus expectations point to higher equity earnings growth in Europe than in the US
MSCI USA and MSCI Europe, earnings per share in % y-o-y

Earnings estimates for 2018

Sources: FactSet, Metzler; as of May 2019

Earnings estimates for 2019

Sources: FactSet, Metzler; as of May 2019

This could be the first indication that European companies are starting to catch up. In addition, restructuring efforts and high costs for investments and R&D are currently dampening the earnings of several European companies, especially in the auto industry, but they are also laying the foundation for higher profit growth in the future. However, the success of these efforts will depend on the European economy achieving a turnaround and establishing a trend towards more dynamic growth. Economic data has weakened steadily since the beginning of 2018, but first signs of economic stabilization have been seen in recent months. If there are no more major political shocks, such as another escalation of the trade dispute, a hard Brexit or a military conflict in the Middle East, there is a good chance that a very loose monetary policy combined with a moderately expansionary fiscal policy can accelerate growth in the second half of the year. The profits of European companies could therefore slowly come close to US profits again.

European small caps in the fast lane

European small caps have consistently outperformed large caps since 1999, with an average annual return of 6.6% since October of 1999 while large caps have averaged 3.1% per year. The question now is whether this outperformance can be sustained on into the future. A glance at how the valuation of small caps has developed since 2004 shows that the price/earnings ratio has tended more or less sideways. We are therefore not seeing any exaggerated euphoria.

Small caps – outperforming large caps in the long term
Long-term indexed performance compared to large caps
Source: Bloomberg; As of May 31, 2019, indexed 10/1999 = 100

Outperformance is achieved through high profit growth and acquisitions. Due to the low starting point, it is usually easy for smaller companies to achieve high growth rates in their product niches over an extended period of time. However, in most cases they have to build up a completely new market segment for their innovative products and/or open up new markets abroad. Often, the following process can be observed in the small-cap segment: a new, young, innovative company goes public, achieves high profit growth and, after a few successful years, is either taken over by a large cap company at a premium on the current share price, or it is added to a mid-cap index. Of course, there are always companies that fail and go bankrupt, but overall, the successful companies predominate, so that a constant process of renewal can take place in an economy.

This renewal process is important for investors because the composition of the large-cap index hardly changes over time, while the small-cap index changes constantly due to the addition of new companies with high profit growth or the departure of older companies due to bankruptcy, takeovers or a switch to the mid-cap index. It is therefore possible for the small-cap index to show a structurally higher profit growth than the large-cap index and thus also structurally better performance. 

Especially now, there are numerous opportunities for investors to get involved with young innovative companies. The large utilities are struggling with low profitability while several alternative energy companies with new business models (solar energy, hydrogen, smart grids, etc.) are entering the stock market. Furthermore, the large telecoms companies currently have only limited growth prospects while numerous new companies that supply the large telecoms companies with innovative products in the areas of semiconductors, equipment, etc. have great potential. The same is true in the banking sector where fintechs are heightening competition. Structural areas such as medical technology and digitization also have great growth potential.   

Especially for small caps, active management offers good opportunities for additional earnings through stock picking. Investors have almost 1,200 European small-cap stocks to choose from, some of which are assessed by only a few analysts and some of which are not analyzed at all. This can result in large information shortfalls that can be corrected by active management.

Overall, the European equity market currently offers good earnings prospects. In our view, small caps are looking more attractive than large caps.

Edgar Walk, Chefvolkswirt Metzler Asset Management
Edgar Walk

Chief Economist , Metzler Asset Management

Edgar Walk joined Metzler in 2000. As Chief Economist in the asset management division, he is responsible for formulating our global economic outlook. Due to his close cooperation with the portfolio management, he focuses on capital market themes as well as on global economic analyses. Mr. Walk holds a master’s degree in economics from the University of Tübingen in Germany and spent a semester at the University of Doshisha in Kyoto, Japan. In addition, he completed the program “Advanced Studies in International Economic Policy Research“ at the Institute of World Economy in Kiel, Germany.

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