Europe the place to go for equity value

For some years, many investors felt that the succession of financial and sovereign debt crises would overwhelm Europe, leading to talk about country defaults, a collapse of the single currency, and even the breakup of the European Union (EU). More recently, though, conditions appear to have improved. There is now a great deal of interest in European equities; it's evident that flows into European equities have been pretty strong recently, which helps to explain the strength of the euro. Even so, it appears to us that many investors may still not be as invested in the region as they have been in the past. In June, the European Central Bank (ECB) gave compelling new reasons for investors to take an active interest in Europe. The package of measures was extensive and included not only a further reduction in its main interest rate for lending to banks, but the first-ever negative deposit rate to be implemented by a major central bank. This negative rate, designed to discourage banks from sitting on their cash, would apply to commercial bank funds held with the ECB that are in excess of the reserve requirement. The ECB also introduced plans for a series of Targeted Longer-Term Refinancing Operations (TLTROs) at very low fixed rates as a new measure to help boost bank lending to the non-financial private sector over the next two years, and said it would intensify preparations for the outright purchase of certain asset-backed securities (ABS). ECB President Mario Draghi also indicated that he could announce further measures to support lending and boost Europe's recovery, including so-called quantitative easing. GOOD SIGNALS These are very good signals to send investors and very good measures to implement. On the whole, the package was not as extensive as hoped, but it was clearly better than most had expected. From a liquidity and lending standpoint it has been very positive because the TLTRO program for up to €400 billion should help small- and mid-sized companies invest in growth. This is particularly true for the southern part of the eurozone region, which has been hardest hit by the fallout of the 2007-2008 financial crisis. The TLTROs are likely to help a lot of banks, particularly in Italy, to fund themselves at cheaper rates. They should allow the banks to increase their net interest margins and therefore their earnings. At the same time, the TLTRO facility will potentially enable them to make very profitable loans to precisely those companies in regions that need it the most. This is very important to investors in European equities because current valuations do not appear to take into account any earnings improvements among those European companies that have large exposures within Europe. Companies that are in a position to benefit from their exposure to a recovery in the hardest hit regions of the Eurozone are particularly attractive. Many of these companies have been actively reducing their costs throughout the economic recession. They are now lean and mean, and this improves operating leverage, so that even a modest improvement in the economy could potentially produce a direct, positive impact on their earnings. RISKY STRATEGY When markets experience frequent bouts of volatility, many investors would prefer to invest in defensive sectors such as food, healthcare and telecoms, which tend to perform well in uncertain markets because they generally provide stable earnings and often a dividend. This approach can work well when the economic outlook is weak, as it has been in recent years. But continuing to rely on defensive stocks in Europe is a risky strategy now because these stocks are trading at unattractive levels. Moreover, many of these companies have enjoyed several quarters of rising earnings and are now close to the top of the cycle, so they could potentially face earnings deceleration going forward. A better strategy for investing in a market in the early stages of a recovery is to stay focused on equity fundamentals and wait for earnings to respond to the improving economy. Any volatility we come across is likely temporary. At times like these, it's more important than ever to do your homework as an investor — stick to your fundamental research and try to look beyond a short-term investment horizon. Philippe Brugere-Trelat is executive vice president and portfolio manager, Franklin Mutual Series.