Investorinsights.MorganStanley.com Evidence is increasing that economic conditions in Europe are improving, according to Stephen Peak, portfolio manager of the Henderson European Focus Fund. “There’s a much better feel about Europe,” he explains. “People can see the macro developments,” which Peak believes is helping to reverse the flow of assets. What’s more, those buyers who are returning to the region are finding opportunities to own stocks at more reasonable valuations—especially in economically sensitive sectors. Peak recently discussed his outlook with Morgan Stanley Wealth Management’s Tara Kalwarski. The following is an edited version of their conversation. TARA KALWARSKI (TK): What is your outlook for European stocks? STEPHEN PEAK (SP): One thing that seems certain is: Things are “less worse.” If you want to spin that another way, you can say they’re getting better. We’ve been through a period in which people, including American investors broadly, have sort of given up on Europe. They saw the headlines: Greek crisis, turbulence in the Euro Zone, etc. We’re all human; we see these things and it gives us a natural aversion. What we’ve seen in the last few years is that investors have either sold down their European positions or, in some cases, sold out completely. They felt that Europe was unsuitable for investment and they couldn’t possibly have any money there. “It’s over. Let’s go somewhere else.” That is in the process of changing. I think the change has been triggered by the headlines changing from crisis to recovery. Europe is still a big market. It’s two-thirds of the international market by capitalization. Investors are now starting to scratch their heads and say: “You know what? We’ve been out of this market. We’ve been low in this market. We had really good US returns during the last few years, with the market reaching all-time highs. Maybe we should go back and think about Europe again.” Things are past the worst. European markets are nowhere near their highs. If you look at index levels, European stocks would need to rise approximately 30% to get back to their all-time highs. That doesn’t mean they will, but it’s an interesting contrast to the US. TK: What do valuations currently look like versus US stocks? SP: Price/earnings ratios (P/Es) in Europe are lower, but you need to adjust for the economic cycle. The cycle in the US has been more extended, while Europe is in a depressed state. You need to adjust for that in terms of your earnings prognosis. We think the US is trading roughly at, or just above, its long-term average in cyclically adjusted P/Es. Pretty much all the markets in Europe are trading at distinct discounts to their long-term P/Es. If you map them relative to the average US P/E of the past 30 years, the line goes from top left to bottom right, so we are trading in heavily discounted territory. Based on the ratio of price to book value, broadly speaking, it’s the same shape of curve. Go back 30 years and the chart in relative price to book values, in Europe versus the US, goes from top left to bottom right. That doesn’t mean the line will go up, but this should give investors some comfort. They’re not paying top dollar. They’re getting something at a discount, with the potential for the discount to narrow. In terms of the risk/reward dynamic, you’re not buying something that’s just traveled and been world’s best. You’re buying something that’s moved off its low but whose valuation metrics offer appeal and should have a margin of safety. The other factor that I think is relevant is the asset flows, or the process of people reassessing their portfolios and looking at Europe and saying that it has become suitable for investment again. People have been underweight or absent, and they’re starting to rectify that. We see that in our business and we think the process is not complete. There is more to come. We think the flows into Europe mutual funds are likely to continue. On a demand/supply basis, that probably adds fuel to the potential upside of the markets. TK: Can you discuss your strategy and how you go about identifying attractive opportunities? SP: I’m very much a bottom-up investor, and I’m agnostic about style and market capitalization. When I’m looking at stocks, I’m looking to paint a picture of potential upside. I’m looking for an outlook for business that I believe in, that I think is mispriced, whether it’s on a multiple basis or a growth basis or whatever it may be. I’m looking to imagine and work out the potential in the stock over the next 12 to 24 months. If there’s sufficient upside in which I have conviction, then that company’s a clear candidate for the fund. TK: Can you tell me about your current positioning? SP: There are no deliberate concentrations in particular sectors or regions, but if you do a snapshot of our holdings right now, the biggest allocation is to the UK. That doesn’t mean that I think the UK economy has the best outlook, just that most of the best ideas that I can find are companies listed in London. Second up is Germany. Third up is Spain right now. It’s quite a diverse mix. I’m looking to have a range of exposures geographically rather than having all my eggs in one basket. I think what people tend to struggle with sometimes is that they think that if they’re investing in a Europe fund, they’re investing in European gross domestic product. That is clearly not the case. We’re investing in the shares of European companies, which may be exposed to a number of European markets or to global markets—particularly in the example of multinationals. TK: What sectors look appealing, and which are you avoiding? SP: I have been building up exposure to the financial sector over the last 12 months. We think that European recovery has started and will gradually get stronger and more stable. As happened in the US, the European financial sector is recuperating. It’s going through a healing process. In tandem with a better macro outlook, it seems likely that the financial sector is going to respond. Another area that I like is consumer discretionary, which is also a play on recovery as, perhaps, employment prospects get better across the region. Areas that I don’t like, which is just as important to consider, include consumer staples, a sector that has done well in the last few years, primarily because some of the bigger companies have very little to do with Europe. They have exposure to emerging markets, which have grown faster, but conditions there have become more difficult, and some of the consumer staples companies are finding it more difficult to grow their earnings; their multiples have expanded and they look expensive to me. I’m very light in that area and prefer companies elsewhere. I’ve probably tilted the portfolio in the last six to nine months to focus more on the European economy in the expectation that companies exposed to Europe will have a slightly better time of things, certainly versus recent history. We’ve been adding industrials and financials in Europe, but also companies that may be global but have a predominant emphasis on Europe. TK: What developments might indicate that your thesis about European recovery is incorrect? SP: I believe that we’re starting to see pockets of recovery, but if that’s wrong and Europe stagnates and slips back into recession, the argument of financial recuperation would be damaged. That would be one thing I would watch very closely. The other thing we need to watch very closely is best described as regulatory risk. Regulators around the world have been demanding that banks have more of a buffer and improve their capital ratios. If they make further demands for banks to be better capitalized and then even more capitalized beyond that, that’s got some potential negative ramifications because it means they need to issue equity, and that’s dilutive. The bad combination would be we’re wrong on economic progress and regulators are more harsh and demanding and companies need to issue more paper. TK: What do you think could surprise on the upside? SP: The big surprise could be at the corporate level. We don’t buy GDP, we buy shares of companies. My suspicion is that Europe’s GDP is not going to boom; it’s just going to get better. If that’s right, in terms of the earnings prognosis for companies, you’ll have that specter of operating leverage coming through. In other words, if a company can grow its top line by 1%, then earnings per share will grow by more than 1%. Generally speaking, I think analysts tend to underestimate the inflection point and they tend to underestimate the potential for earnings per share because they misconstrue or are overly conservative on operating leverage. That would mean the earnings prognosis for Europe at the company level is actually better than we currently think. We don’t think it will be very dramatic over all, but in certain instances it will be. That’s one of the things that I’m looking at in terms of my stock selection: companies with operating leverage. Stephen Peak is not an employee of Morgan Stanley Wealth Management. Opinions expressed by him are solely his own and may not necessarily reflect those of Morgan Stanley Wealth Management or its affiliates.