Ultimate contrarian – should you invest in Europe now?

European equities have been laggards since the financial crisis.

One only has to read the news headlines to understand that the weight of the region’s debt hangs heavy around its neck and the inability of its political leaders to get a grip on this debt crisis has compounded the problem. Investors, lacking confidence in a successful outcome, have avoided European equities. This year has, however, kicked off with more optimism, as indicated by the recent stronger performance of European equities.

Though risks remain: corporate margins are high relative to history and may come under pressure again as European economies face more austerity. There is, in extremis, still the risk of a disorderly disintegration of the eurozone. I believe, however, that the eurozone will stay together, as the cost of exit will be too great both for those who leave and for those who stay.

Austerity, and muddling through, is the lesser of two evils. As an equity investor, I am putting money into European companies not governments or economies. European companies are not, of course, restricted to doing business in the countries in which they are listed. Many of the companies I own are large, multinational enterprises whose fortunes are tied to the global economy rather than just the eurozone area.

European companies have, in fact, continued to grow their earnings and dividends, during this sovereign crisis, such that valuations ended last year at a historic extreme with an aggregate dividend yield approaching 5% which is a full 50% above the longer-term average for Europe over the last few decades.

This level of yield also appears very attractive when compared to ten year government bond yields of two percent, or less, in Germany or the UK. This suggests, to me, that much of the bad news is already priced in to European markets. Dividends may fall if economies falter and those high corporate margins come under pressure. They would, however, have to fall almost a third for the aggregate dividend yield on European equities to return to the long-term, multi-decade average.

During the financial crisis, when many banks reduced dividends from generous levels to nothing, aggregate dividends fell about a third cumulatively. This could happen again, of course, but I think it unlikely, especially when you consider that many large banks are still paying very little in dividends so there is not much left to cut! Yes, there are risks to forecasts but, in my view, these are discounted and so I believe there is fundamental value in European shares.

As always, risk and reward are common bed-fellows and the biggest rewards often come when risk appears to be high. From an investment point of view the key question is: what to do now?

Selecting cash-generative companies which have sound balance sheets, good business prospects and therefore the potential to deliver consistent dividend growth is a proven way to make money for investors. That a company is able to reward shareholders with a consistent and growing dividend is a sign of its good health and such companies are the bedrock of my investment philosophy because they deliver a consistent track record of outperformance. These sorts of companies may not sparkle in a sharp rally but they will deliver superior returns over any sensible investment horizon.

Take Hugo Boss, for example. This brand is well developed in European markets, particularly in its home market of Germany, but it has not been exploited to its full potential elsewhere. A newish management team, who were put in place a few years ago by majority owners Permira, are now delivering on this having done a good job in improving the basic operations of the company. Sales and margins are showing evidence of this improvement. Hugo Boss has low levels of debt and a high level of free cash flow, most of which it pays out in dividends so investors are enjoying a generous level of dividend and double-digit dividend growth.

Another example of this sort of company is Schibsted, traditionally a Norwegian newspaper firm but increasingly moving on-line with, in particular, some well-known on-line classified advertising sites in Scandinavia, France and elsewhere. Many of these on-line sites are number one in their national market and this is a business where the winner takes all, as evidenced by high margins and strong growth.

Schibsted generates cash, despite funding a high level of investment into its on-line business. It also has a strong balance sheet. The valuation is reasonable, particularly compared to on-line peers, and investors receive a reasonable dividend yield that is growing at a very attractive rate. These companies illustrate that there are ample opportunities for discerning European equity investors. The European economy is troubled but many European companies are in much better shape.

Investing in European equities is not the same as investing in the European economy and as a consequence, there are many good opportunities to be found across the continent. There are, of course, risks involved in investing in Europe, but risk and reward go hand in hand.

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