Nadine Wojakovski finds the opportunities among the chaos in European equity market

The current Euro crisis has made many investors cautious about the prospects of the European equity market. The lack of political consistency to create a sustainable plan to solve the debt situation and the fear that the crisis could spread further have created panic. The long term uncertainty has caused many investors to be fearful about being too exposed to European equities. On the other hand, it has also presented an opportunity to those who think the asset class offers good value in these turbulent times.

In a traditional portfolio a large proportion of UK pension funds have, on average, a 50 per cent strategic allocation to equities and about 20 per cent of this is allocated to continental European equities, which equates to 10 per cent of the total fund. Many of these funds are currently underweight Europe, so in practice the average actual exposure to European equities is below 10 per cent, notes Cardano UK CEO Kerrin Rosenberg. Indeed he believes it makes sense to continue to be underweight as the current risks associated with Europe are "extremely high". He argues that if there is a disorderly default in Greece and widespread contagion to Italy and Spain, the consequence could be far worse than the Lehmans default, namely that Europe would fall into a severe recession and all risky assets would suffer. "The impact on financial markets would not be limited to Europe, so US and Asian equities would fall as well, but probably not by as much as European equities."

However, if or when they can see a credible political solution to the European fiscal problem, then European equities are quite attractively valued. The question, he says, will be how quickly they appreciate off the back of a credible policy announcement and whether funds can up their exposure quick enough.

Specialist investment consultant firm bfinance has seen evidence of waning interest in equities with European equities low down the list. Its July 2011 survey showed that there had been more reduced equity exposure in the first six months than had been anticipated. It also showed that this trend would continue with more reduction in the second half of 2011. Senior associate Ian Shea and managing director Olivier Cassin say that clients are looking to increase diversification in their portfolios by adding some more alternatives. These include absolute return type strategies as well as some inflation hedging strategies such as property or infrastructure. In terms of the equity searches it has conducted it continues to see higher numbers of global searches, accounting for 41 per cent of searches for the year to June 2011. This is closely followed by emerging market equity accounting for 36 per cent, whilst just 10 per cent of the manager searches were for European equity managers.

"There is a big divide in opinion on Europe," say Shea and Cassin, as they identify that different managers are looking for different things and the current spike in volatility makes it difficult to identify stable trends. For instance, bottom-up stock pickers may look through the macro uncertainty and focus on the solid earnings of some of Europe's listed companies particularly those that sell to the emerging markets. "Most managers have been overweight Northern Europe and underweight Southern Europe (Portugal, Italy, Greece, Spain - the PIGS).

However, we also saw those managers with some top-down aspect to their process move the portfolio around a bit more and they have benefited from the market rally in the PIG markets at the start of the year only to go more defensive again now."

In contrast to the many detractors on Europe, Henderson Global Investors director of institutional business David Morley is rather upbeat about the prospects ahead. He has seen a renewed interest and search activity in European equities, with a "healthy interest" in the small cap area. In fact, he says the current situation is not as extreme as the liquidity squeeze of 2008. "In spite of a great deal of uncertainty the investment place supports investment into Europe," he says. Compared to 2008 he finds companies are in better shape. They have been deleveraging which makes them generally stronger.

Furthermore, daily news flows which often include much doom and gloom do not appear to be affecting pension funds' strategic long term asset allocation plans. They are aware of the risks and volatility but are in it for the long term. "We think Europe is relatively cheap compared to other equity markets and cheap compared to historical levels and other asset classes, in particular bonds." He has also seen evidence of some pension funds re-risking their total portfolio by moving assets from bonds into equities. "Markets have been very weak. We think there is a good buying opportunity in Europe for the long term investor."

In a similar vein, Geneva-based Reyl Asset Management senior fund manager in equities Emmanuel Hauptmann says that following a period of strong underperformance, European markets have reached valuation levels that make these equities trade at a discount to both their US and emerging markets peers on an earnings perspective. "Our feeling is that most institutional investors are very cautious about investing in Europe relative to other regions at present.

They are underweight Europe in their equity allocation to the benefit of either US or emerging markets equities." He says the rationale behind that is the fact that the old developed economies are entering a period of slow growth. The current Euro crisis is exacerbating this position and making a lot of investors even more cautious than they would have been. "This relative disaffection of European markets in favour of US and emerging markets might be worth revisiting," he offers. The current year estimated price to earnings ratio of the DJ Stoxx 600 (the broad benchmark of pan European shares) is now well below 10 (the average level in the last 10 years being around 13) against 12 for the S&P 500.

"This relative under-valuation of European equities at the moment makes investing in Europe relatively attractive against other regions in the world," he explains. Looking for instance at European companies that have a high level of exports to emerging markets, typically industrials, he observes that many trade at a significant discount relative to their US or emerging markets peers. The other issue about emerging markets' overweight positions is the fact these markets seem to have, as in the first half of 2008, benefited again from large flows justified by the "decoupling" story.

Emerging markets growth, he concedes, is still far from immune to the troubles encountered by their developed peers given its high dependency on exports. Says Hauptmann: "We believe that despite the current focus on the Euro-crisis, valuation levels and downside risks make it difficult to argue for emerging markets or US overweight positions at the expense of European equities, and that the latter might surprise positively in the next months from a relative standpoint."

Allianz RCM Europe equity growth lead fund manager Thorsten Winkelmann acknowledges it has been a challenging period for investors, but he says bad headlines can often overshadow positive trends at the corporate, micro or stock level. As in the last high volatility market environment post Lehman Brothers, careful stock selection focusing on high quality business models remains key. "We believe that there is a silver lining to periods of market weakness which investors should not miss; selected attractive investment opportunities across Europe in strong European companies with the ability to deliver excellent long-term returns in our opinion despite a difficult macroeconomic background in both the US and Europe at the moment."

Written by Nadine Wojakovski, a freelance journalist

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