After years of lagging behind the United States on performance and earnings, European stocks are starting to close the gap. The economic environment in Europe has been improving for some time, feeding through to strong earnings growth. But after the run-up in the strength of the euro over the summer, are these companies still well-positioned? It’s time to take a closer look at the potential attractiveness of European stocks.
Market expectations for earnings per share (EPS) growth for European stocks remain quite strong, building on the excellent delivery in the first two quarters of the year. In both quarters, earnings upgrades were broad-based instead of concentrated in particular sectors. Since October 2016, trailing 12-month EPS for European stocks are up double digits, and since July of last year, 12-month forward EPS expectations are up by a similar amount. That’s thanks to the rebound in commodities and global growth pickup, and would likely be higher if not for the stronger euro.
Since April of this year, the euro-U.S. dollar exchange rate went on a tear from 1.06 to 1.20 before weakening again in recent weeks. A stronger euro is good news for European tourists who want to shop overseas, but not helpful to European companies whose international revenues suddenly become worth fewer euros. As a result, consensus earnings growth assumptions have taken a hit for next year, with analysts expecting lower EPS growth than before. The good news is, the stronger euro is now reflected in analyst expectations—removing some potential for disappointment.
On the valuation front, European stocks also look attractive relative to domestic stocks (and particularly cheap relative to bonds). The valuation premium that U.S. stocks enjoy has been persistent through time, but looks particularly high now. On a forward earnings basis, European stocks have gotten cheaper continually since 2015, and comparing price/book value (P/BV) for the two regions shows European names trading at a multi-year discount (see below chart).
European stocks have persistently traded at a discount to U.S. stocks
This persistent discount largely comes down to the difference in return on equity (ROE) between the two regions. Return on equity is a way to measure a company’s fundamental performance: how well did they use investments to generate growth? Before the financial crisis in 2008, European companies improved their performance and began to close the ROE gap relative to the U.S., and the valuation gap also started to close. But since that period, ROEs have diverged sharply again. U.S. companies have done a better job of bringing net profit margins back up to pre-crisis levels (or even higher). Flexible labor markets and less regulation have helped, and U.S. companies have also taken better advantage of lower interest rates to refinance debt. U.S. companies have cut their interest costs by about 30%, but European companies have only cut theirs by about 13%.
How can European companies close this valuation gap? Largely by continuing their solid recent performance. Structural reforms take time, but by delivering on earnings, European companies can continue to catch up to U.S. stocks fundamentally and in stock performance. Our CIO specialists remain constructive on the region, and currently rate it an overweight.