The European equity market may not have returned to pre-financial crisis levels of earnings growth, but certain sectors, and companies, have performed well and should continue to do so.
Investing in Europe is not fashionable these days but investors are missing out. Pessimism hangs in the air over the ‘old continent’, with talks of stalling growth, soaring energy prices, and a scarcity of innovation. Yet, beneath the gloom, there lies opportunity.
This bleak perspective is outwardly supported by the track record of the European equity market, which has struggled since the 2008 global financial crisis. Earnings growth has still not reached the level it peaked at in 2008 – that’s 15 years of negative earnings growth, made more alarming when compared to the S&P500 and MSCI World Indexes, which have seen significant earnings growth.
The prevailing explanation for this is that the European market is ‘over-indexed’ on sectors that have experienced significant structural headwinds (think financials, utilities and materials), and ‘under-indexed’ on sectors which have seen significant tailwinds (such as information technology).
Take financials, for instance. Right before Lehman Brothers shook the world in September 2008, Europe had an outsized financials sector (about 5 percentage points more than the MSCI World). When the crisis hit, it shook Europe hard, especially with continuously declining interest rates taking a toll on every bank's bottom line. The weight of this extra-large financials sector wore down Europe's market performance.
Other relatively larger exposures in the European market, like utilities and materials, did not fare much better in the post-crisis, lower-growth world. These sectors witnessed negative earnings growth over 15 years, a performance significantly worse than the MSCI World’s average. To add insult to injury, Europe ‘under indexed’ exactly on the very sector – information technology – which in the years after 2009 delivered particularly strong earnings growth.
Attractive pockets
So, is Europea just not as cutting edge? Not really. Significant subsets of the European market have excelled over the last two decades and appear poised to continue to do so. Indeed, the European equity market is, in fact, becoming more attractive, with many areas of strength becoming more important for the overall market.
Tech is one such area of strength and opportunity. While Europe isn’t identical to the US, the ‘old continent’ does have many world-leading companies benefitting from strong structural tailwinds, particularly in the semiconductor industry where companies such as Infineon and ASML are market leaders, driving growth in ‘sexier’ areas. These giants are well-placed to continue their dominance in the long-term because they invest large amounts in R&D (both companies invested more than €1 bn in 2022), allowing them to stay several steps ahead of their competitors.
Semiconductor strengths
Artificial intelligence provides us with a case in point. While the limelight often shines on US capabilities in this field, there are many European semiconductor companies that are inexorably tied to the rise of AI, without which none of the optimistic forecasts that were recently making the rounds would be achievable. As it happens, many of the most critical aspects of the industry’s value chain are housed in Europe. Staying true to Europe’s long tradition around equipment manufacturing excellence, it is semiconductor equipment from the Netherlands and Germany which has emerged as the lynchpin of the entire industry.
Europe is also firmly established as global leader in the luxury industry, boasting brands that have heritages near impossible to surmount, including Moncler, LVMH and L’Oréal. These companies have a high degree of pricing power. They also think and stay ahead, allowing for long-term maintenance of growth. L’Oréal, for example, has posted double-digit earnings growth for the past 40 years. This innovative prowess and entrepreneurial spirit have not only driven growth in the past, but positions these companies to grow in the long-term.
It is crucial to emphasise there is no one-size-fits-all approach when it comes to Europe. It is important to differentiate and to be selective. Sectors already provide a useful classification here.
As a recent analysis from Goldman Sachs illustrates, stark differences exist between sectors in their investment levels. Healthcare and tech companies in Europe invest substantial proportions of their cashflows into growth and R&D, whereas energy and basic resources companies invest minimal amounts.
Over the long term, these investments are poised to be key drivers of profit growth and business success, which is why we tend to focus on sectors that show such levels of investment. The exception proves the rule, which in this case, is the utilities sector. The high investment rate in this sector is mainly driven by renewables. However, we believe there are few renewables businesses with really attractive competitive positions and are thus sceptical as to how high the returns will be on those investments.
However, even more rewarding than picking the right sectors is identifying the right companies. This is particularly true in Europe. Even over a time period that saw Europe underperforming, it would have been possible to deliver highly attractive returns from investing there. A focus on great businesses, boosted by attractive growth tailwinds, would have yielded such results. We believe this will also hold true in future.
Matthias Born, head of Investments and CIO Equities, Berenberg
