Opportunities for long-term investors with solid stomachs

ANALYSIS:EUROPEAN STOCK markets have rallied in the last fortnight but many indices nevertheless remain firmly entrenched in bear market territory, having lost a quarter or more of their value since the spring. With valuations at levels unseen in 30 years, long-term investors will be "amply rewarded" by buying into market weakness.

That’s the view of Niels Jensen, a strategist with London-based investment firm Absolute Return Partners. Jensen has been “structurally bearish” since 2002 but, like other high-profile bears such as Jeremy Grantham and David Rosenberg, he believes that current valuations more than compensate investors for the likely challenges facing Europe.

Jensen’s latest letter to clients accepts that the “unprecedented” challenges facing Europe include “prolonged recession, possibly even depression” and the possible disintegration of the euro zone itself. Nevertheless, a Greek default and European recession is now fully discounted, he reckons.

The extent of pessimism towards Europe can be gleaned from Bloomberg’s most recent quarterly survey of investors. It found that 75 per cent expect a European recession within 12 months, with 51 per cent believing the euro zone faces eventual collapse.

Less than 20 per cent expect the best investment opportunities to come from Europe over the next year, while 53 per cent caution that Europe will offer the worst opportunities globally.

Jensen’s argument is echoed by Rory Gillen, formerly of Merrion Capital and founder of InvestRcentre.com. He notes the Euro Stoxx 50 index declined by more than 20 per cent relative to its 30-week moving average in August. That “capitulation signal” has occurred in Europe on only nine occasions since 1970. The average one-year return is 17 per cent, three-year returns 23 per cent and five-year returns 53 per cent. The signal failed to deliver in 2001 and 2002, but markets were grossly overvalued then, Gillen says. Today, they trade on single-digit price-to-earnings ratios and 4-5 per cent dividend yields.

To Jensen, multiple valuation methods suggest European equities are cheap. The Euro Stoxx 50 has a book value of 1 and a dividend yield of over 5 per cent. It trades on 9.4 times last year’s earnings and 7.6 times next year’s earnings.

Earnings are hugely volatile, of course, which is why many long-term investors prefer to use a cyclically-adjusted PE ratio (Cape) that looks at average earnings over a 10-year period. Cape irons out earnings volatility over the business cycles, and successfully identified the great market peaks and troughs of the last century.

It shows, says Jensen, valuation levels unseen “since the dark days of 1981-1982, just before we embarked on the 1982-2000 bull market – the biggest of all time”.

Twenty-year returns have averaged 13.4 per cent per annum for investors who bought when PE levels were at their lowest, he notes. Investors who bought in bullish climes, when PE levels were at their highest, had to settle for a measly 3.2 per cent per annum.

Current valuations augur well for future pension fund performance.

It’s a different story in the US. While one-year PE ratios imply the market is cheap, the Cape ratio for the SP 500 is almost 20, which remains above its long-term average (16). That may stun some investors, given that the index is trading at 1998 levels, but it merely reflects just how frothy markets were at the tail end of the secular bull market that ended in 2000.

The SP 500’s book value, at 1.89, is almost twice that of the Euro Stoxx 50, while its dividend yield is less than half that available in Europe.

It wasn’t always thus. European valuations were higher than in the US less than two decades ago. That changed during the dotcom bubble and has never reversed. Why? Jensen blames the so-called Greenspan (now Bernanke) put – the common belief that the Federal Reserve “will not allow a wholesale fall in asset prices”, a perception “which provides an invisible hand under US financial markets”. Such views do not prevail in Europe, he adds.

Valuation aside, Jensen suggests a European recession will only have a limited effect on many of the continent’s biggest companies, given that their earnings are increasingly global. While European economies may not be competitive, many European companies are.

Nevertheless, there are reasons why Europe is trading at a serious discount to other markets. For one, financials account for 24 per cent of the Euro Stoxx 50 compared to just 14 per cent of the SP 500. European indices could be “badly impacted” by a worsening of the current crisis and further bank bailouts, Jensen admits. While Absolute Return Partners is increasing European equity exposure “for the first time in years”, it is avoiding the financials. He cautions that investors buying today need a “solid stomach and some patience”, with volatility likely to “plague markets for some time to come”.

Still, the ability to snap up equities trading at 1982 valuations “ought to make everyone sit up and listen”, he adds.

Back then, the business media was busy proclaiming the death of equities and investors were steering clear. Eighteen years later, when earnings multiples were at all-time highs, everyone wanted to buy.

“Guess who had the last laugh,” asks Jensen.