Seek undervalued quality

WHICHEVER way you look at it, the Eurozone is not going to enjoy rampant economic growth in the years to come. The International Monetary Fund (IMF) only estimates GDP growth of around 1.8 per cent in both 2012 and 2013, hardly a storming pace of expansion. And the financial markets have been quick to price in subdued economic growth in Europe – on 2011 forecast price-to-earnings (p/e) estimates the UK and Europe lag behind every region except Central Eastern Europe, Middle East & Africa – see chart.

But do all European stocks deserve such low valuations? This is unlikely, for three reasons. First, European firms’ return on equity is roughly in line with the rest of the world – suggesting that they are not suffering from poor profitability. Second, the low valuation has been overly influenced by the underperformance of the mega caps and third, many are international and are not solely dependent on the health of the European economy.

However, firms will certainly need to adapt to this more sluggish pace of economic growth. No longer will they be able to rest on their laurels and expect GDP expansion to drive both the performance and the share price upwards. Companies that can deliver organic growth despite the weak economic backdrop will do well and their share prices should reflect this.

There is still plenty of global demand for the products and services produced by European companies but there is little demand for European equities.

But how can spread betters pick the companies that are currently undervalued simply because they are listed in Europe? According to Citigroup strategists, led by Adrian Cattley, firms with an international focus and a strong balance sheet will be key in determining outperformance.

“International bias is a simple way of looking for organic growth as the emerging markets have, in particular, faster volume growth due to real GDP growth being faster than Europe. There is also the potentially illusory benefit of higher inflation,” they write in a note.

They add: “Strong balance sheets offer companies the opportunity to be much more in control of their own destiny. These companies can invest for organic growth or look to acquire growth, potentially by hoovering up weak competitors which are struggling to get access to credit or grow.”

Fundamental methods of valuation such as return on equity and positive earnings momentum throw up stocks such as Nestle, Antofagasta, ARM, Inditex and Novo Nordisk. These are quality, internationally-oriented stocks with a strong positive reputation. Make the most of their cheap valuations now to pick up some quality winners.