In the wake of the sub-prime crisis, Andrew Sheen examines European equities and finds that - the financial sector aside - large cap is the safest place to invest
Burnett said: "Unfortunately, European financial institutions really picked up the worst of the structured finance assets. In 2006, the big increased purchasing of structured products actually came from European institutions - they picked up the most toxic stuff of all."
Robert Quinn, European equities strategist at S&P Equities Research, said total exposure to sub-prime securitised debt amounted to as much as US$150bn. He added that disclosed sub-prime related losses were in the region of $30bn to $50bn, meaning there could be worse to come.
Kevin Liley, manager of the Royal London European Growth Trust, said while Europe had been negatively impacted by the poor summer's trading, the banking sector had been underperforming even before August. "It was the suspension of two funds by BNP Paribas in early August, through inability to price, that sparked off the crisis," he said. "The impact on stock prices has been felt across the market, but the almost indiscriminate mark-down of the banking sector has been the most pronounced."
David Moss, director of European equities at F&C, agreed: "The market has been pretty much indiscriminate as a lot of them have been tarred with the same brush - there are opportunities in individual banks." As an example, Allied Irish was caught up in the storm and its shares lost approximately a third of their value, despite the bank having no exposure to sub-prime assets.
However, Moss added: "We don't generally look at things by sector on the basis that you'll often find the constituents within it aren't actually that homogenous anyway." The banking sector, for instance, which comprises over 20% of the market, ranges from the likes of purely investment banking operations like Deutsche Bank to pure retail.
Moss said European growth expectations were slightly lower in 2008 than 2007 - 2% down from about 2.5% - but that he still considered the continent an attractive option on the basis of strong expected corporate performances. "Corporate balance sheets are generally strong, dividend yields are around 3% or more [in 2007] and forecasted at 3% to 3.3% [for 2008] so there will be decent returns."
Liley agreed the outlook was generally positive, with strong opportunities for a robust bounce-back, as although Europe was unlikely to pursue aggressive interest rate policies similar to those seen in the US, strong business relations with high growth regions (Eastern Europe, China, India and Latin America) should support profit growth.
Khuram Chaudhry, chief European quantitative strategist at Merill Lynch, commented: "The perception is that Europe is still a good place because valuations are still attractive compared to other parts of the world."
Burnett said the sectors he felt to be the most promising in 2008 were the 'classic' defensive sectors - utilities, consumer staples and pharmaceuticals. He said because of the size of these sectors within the market, they should have the strength to offset weaker performances in other sectors.
He added: "In terms of equity market returns, there has been incredible performance. European equity market returns have done pretty well [in 2007], even though they've been hit by pretty material weakness in the financial sector."
Chaudhry said: "My suspicion over the next 12 months [is that] closely benchmarked passive funds are likely to give better returns than active managers. The macro economic backdrop is changing, my personal view is that everything that has underperformed massively since 2003 will start to look more appealing."
The rise of Eastern Europe has been well-documented, with the accession of ten new nations to the European Union in 2004 and Romania and Bulgaria in 2007. The economic development of many of these nations has been rapid, benefiting directly from generous EU development grants and foreign investment. However, Quinn urged caution when it came to investment in the region: "There's obviously more growth in Eastern Europe thanks to the higher GDP growth and earnings growth in the markets. However, a lot of these economies are overheating - particularly the Balkan states."
Liley said he thought the highest EU growth in 2008 would come from the East thanks to the 'catch up' in terms of development. However, he added that it was not yet clear which region - East or West - would deliver the best returns in the medium term.
He qualified this statement, adding: "I think that the best returns will come from those Western European companies which have large exposure to Eastern Europe." A combination of local market growth and corporate restructuring to benefit from the lower production costs that were available in the East would be good for businesses, he said.
Moss said it was often quite difficult to invest directly in Eastern Europe as there were regulatory barriers and a large number of the more attractive propositions had already been acquired by western companies. He added that the banking sector, as an example, was already largely controlled outright by western banks with limited free-floats available to investors.
Chaudhry compared East and West: "Eastern Europe has done extremely well since 2003. It's also a similar trade to industrial cyclicals, China and commodities - it's done well because of liquidity, so as liquidity starts to slow, it may be more vulnerable. But in Europe there's still scope for more economic and political reform.
"In Western Europe, especially Germany, the stock market has lots of industrial companies - chemical, engineering, automotive companies - those have done well, but that's where the weakness comes over the next couple of years."
While he said there were potential opportunities in Eastern Europe, Burnett thought Western Europe was preferable at the moment.
In fact, Burnett said on aggregate most of the opportunities in Eastern Europe had been played out already: "A few years ago, it was a bit of a frontier and now it has been largely combed over about a million times and as a result there aren't so many 'hidden gems' in those markets anymore."
Small, mid or large cap?
Many have predicted the end of the strong small and mid cap outperformance that has lasted for a number of years. However, as Liley commented, the right manager should still be able to find suitable small cap companies with the potential for high growth.
"On a selective basis, the returns that can be achieved are far higher, reflecting their earlier stage [of growth]," he said.
The slowdown in mid and small cap performance has come as a direct result of the credit crunch and the ensuing lack of cheap credit. Banks have become more selective about which companies they will extend credit terms to, heralding the end of easy finance.
Burnett said: "Small caps have been outperforming for a long time and all good things must come to an end. The catalyst for this is the timing of the credit crisis itself and the consideration now is that because smaller companies have slightly higher debt and less diversified lines of business, they need or benefit more from relaxed lending standards from banks."
Quinn said: "Small and mid caps have really outperformed the large caps in this bull market and bull cycle - I think the FTSE 250 has more than doubled [in value] over the past five years, and that's true of most [European small/mid cap] markets."
Liley and Quinn were both of the opinion that the spate of private equity takeovers had contributed to a bid premium excess, with mid cap companies particularly affected.
Quinn also pointed out the poor results of the financial sector had depressed large cap results across the board: "If you took the banking sector out of the large caps, I'm pretty sure the large cap companies in other sectors would have outperformed their peers."
Burnett said large caps were looking attractive because of their relative cheapness when compared to other sectors.
"Growth expectations are being revised down, so as a result it's going to be more difficult for smaller companies. Large cap is definitely the place to be in terms of swimming with the tide."
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