It's easy to get excited about a particular market when everyone else seems to be piling in, and the headlines are screaming of new record highs. That has certainly been the case with U.S. equities of late. While many investors are paddling to catch the wave before it crests, it takes a great degree of fortitude and patience to wait for the next one to form in places that don't look particularly thrilling right now. Where is the next wave forming? We are searching for equity values across the pond in Europe, where many investors don't dare dip their toes.
Growth in the euro area has been bleak. The International Monetary Fund recently updated its forecast for real GDP growth to contract about 0.25% this year, noting a recovery could be slower than expected because of adjustment fatigue, weak balance sheets, broken credit channels in the periphery, and insufficient progress toward stronger economic and monetary union. However, our stock selection process boils down to a long-term perspective, a contrarian approach, and value—of which Europe is providing plenty of right now.
There is a lot of reticence about Europe because of fiscal austerity, weak GDP growth, and a general sense of malaise among investors and the European electorate. However, eventually these economies will reach a bottom from which they can begin to reaccelerate. The most exciting time for stocks is the reacceleration period. If, during a crisis period, we can identify companies that we think have good businesses and the financial strength and fiscal flexibility to weather the downturn, then we hold our nose and buy because it's the rebound potential that drives returns.
We believe investors are generally looking at near-term economic prospects in Europe and thinking companies there are going to struggle to make money. Yet, remember that Europe's economy has been relatively anemic for the better part of two years, and many companies have been able to generate strong earnings and good cash flow from their global businesses. Investors are not giving European companies a look because of their zip [postal] code, but Europe is home to some of the world's most successful multinationals and corporate revenues in the region are truly global in nature. High free cash flow yields are evidence of the lack of attention those cash flows are getting from investors, and we believe that presents an opportunity.
Another part of the Europe story, which the macro-fixated market is ignoring, is the structural reforms that are starting to be discussed, which we think should increase the competitiveness of European companies, combined with company specific attention to cost cutting and capital allocation.
We focus on long-term normalized earnings potential, or trend earnings, which incorporates the secular growth potential of a company and anticipates its total return potential over a five-year investment horizon. With so many investors focused on the short term, our differentiated time horizon allows us to buy when others are not yet interested, and sell when that potential is eventually recognized.
European pharmaceutical developers, in our view, are a great example of truly global companies whose valuations do not reflect their diversified revenue streams (many European drug-makers now get 20-30% of revenues from emerging markets as growing middle classes demand increasing levels of healthcare). Nor do we believe they reflect the
consolidation and restructuring these companies have undergone over the past several years, or their increased exposure to biotechnology, which should provide more sustainable revenues going forward. Even after their recent run, European many pharma companies (and many of their U.S. counterparts), still trade on undemanding valuations and offer 3-4%
dividend yields.
Some European industrial companies feature similar levels of revenue diversification as pharmaceuticals, yet trade on the GDP growth expectations of their domestic countries. With European growth expectations at anemic levels, it is not surprising that we are able to identify industrial conglomerates at compelling valuations that should sustain consistent, long-term earnings growth from global power generation needs and clean energy transitions, automation, and other growth areas. With Templeton's longer term view, an eventual turn in the European economy can provide an additional tailwind.
Many investors are starting to feel Japan may be bottoming as it attempts to escape a multi-decade deflationary spiral with experimental new policy measures. The initial market response has been dramatic, with Japanese equities delivering their best six-month rally in 60 years. We are taking a cautious stance here, both in light of the country's structural challenges, which include the developed world's highest official debt burden and most rapidly aging population, as well as an inefficient corporate culture that has long depressed capital returns. Despite such headwinds, though, we are finding select opportunities as we pull apart individual companies and look at their potential to compete globally and drive earnings growth.
We have found a lot of value in autos, and selectively across various other industries, but we have not broadly jumped in with two feet. A lot of the strength we've seen in Japan has been very much a macro rally in response to monetary policy. It remains to be seen whether this will merely lead to asset bubbles or if policy changes will actually help facilitate the structural reforms necessary for Japan to regain competitiveness. We continue to monitor the region, but for now it remains a stock-picker's market and not a source of wholesale value, in our opinion.
From Europe to Japan, success lies in avoiding a “black-box” approach. It is about looking at a myriad of valuations across equities and fixed income and comparing the opportunity sets in each of the asset classes. We assess which asset class has better potential to drive total return, measure the relative risk and volatility, consider the yield potential of both asset classes, and make an allocation decision. We allocate assets on a bottom-up basis based on the opportunities and risks perceived in each asset class.
Lisa Myers is an executive vice president, portfolio manager and research analyst with Templeton Global Equity Group. She is a co-manager of Templeton Global Balanced Fund.
