Janus Henderson: European equities - sensitive to a cyclical recovery?

European equities have enjoyed a positive 2019 thus far, supported by hopes that European economies may have turned a corner and amid more dovish signs from the European Central Bank (ECB) and the US Federal Reserve. Sentiment was bolstered by the ECB’s plan to issue new long-term loans for banks from September 2019, which will likely mean interest rates will remain at their ultra-low level for at least the remainder of the year. The volatility that undermined sentiment towards equity markets in the latter stages of 2018 seems to have eased, and the backdrop for equities in Europe now seems more supportive, although political news continues to dominate the headlines.

Whatever the macro-economic and political background, our investment decisions are always going to be based around the analysis of return on capital. This analysis requires that we get the simple stuff right, and ask the right questions. Does a business have an ongoing reason to exist? Does it have barriers to entry that enable its return profile to stay high? Does it have pricing power on its products or services? Does it offer an attractive and sustainable margin structure? These are the questions we are constantly asking ourselves when we look at businesses.

Brexit and the investment landscape

A lot of recent concern has been focused on what has been a protracted and distracting Brexit process. We do not look at the UK and decide we do not want to buy it on the basis of Brexit or any other political development. What is far more important to us is not the area of a company’s listing, but the quality of the business and quality of the investment opportunity. At a fundamental level, the UK stock market is populated with companies operating across the globe, especially in the FTSE 100 Index.

We currently invest in eight UK-listed stocks that we see as having very attractive business models on a long-term view. Some are classic compounders in nature – companies that align well with our investment philosophy and which we believe can deliver above-index performance over time. Prudential is one example – a UK-listed but truly international insurance business. We also invest in some UK businesses that we believe can improve their return profile over time, such as BP or Shell. These are big oil companies where operational cost discipline and capital expenditure discipline has improved and we expect the return profile to follow over time.

Europe’s inherent cyclicality

Europe offers a broad investment landscape, but one populated with a lot of banks and a lot of energy and commodity-related businesses. Recognition of this inherent cyclicality can give us some indication of how the market might behave at different times. For example, if we see a period of economic weakness, such as that witnessed at the end of 2018, then Europe is likely to underperform other markets. But if we see a cyclical recovery – either aided by monetary or new fiscal stimulus measures globally, or the tailwind of a recovery in Chinese money supply as it feeds through into the real economy – then Europe will be a good place to be.

Our strategy has some inherent biases, reflecting certain sectors where we find businesses that can consistently generate high levels of return on capital. Within healthcare, for example, we have a reasonable exposure to pharmaceutical businesses and some healthcare services providers. We like big companies with high barriers to entry, mainly based around scientific knowledge and research prowess. Information technology is another area that we are exposed to, and in particular software, where we have found cash-generative businesses with a high return on capital, reflecting their low-cost structure and strong pricing power.

There are also some sectors where we generally struggle to find attractively, good quality investment opportunities. Telecommunications, for example, is an area where we see highly regulated, price-taking companies, exposed to high competition. As another example, the mining sector is skewed by unpredictable supply and demand dynamics and we struggle to see any significant pricing power for companies.

Our view at the end of 2018 was that European equities were more cheaply valued than they were 12 months earlier, with valuations suggesting some level of earnings weakness had already been priced in. We will never claim to be able to predict market direction, but we believe that our disciplined and systematic strategy is well positioned to identify attractive opportunities in the European equities space as the year progresses.