Compelling investment opportunities in Europe as earnings stay below peak

Europe’s economy is picking up the pace and the outlook has improved considerably. A synchronised global economic recovery combined with strengthening internal demand is lending support to European earnings. With second quarter reporting season behind us, equity analysts predict that European earnings will grow double digits this year. After several years of no top line or earnings growth, 2017 marks an exciting inflection point in Europe’s corporate prospects. Europe is starting from a low base and earnings remain 20 per cent below the previous peak, in stark contrast to US corporate profits which are close to record highs. This dispersion provides compelling investment opportunities.

Europe can benefit from both a cyclical and structural recovery, in our opinion. Cyclical headwinds are changing direction. European firms derive a high proportion of revenues from both the commodity sector and emerging markets, where fundamentals are finally on an improving trajectory. Meanwhile, the European domestic economy is demonstrating increasingly robust growth. The fortunes of financial firms may also be turning; capital concerns have been mostly addressed and institutions could benefit from a shift in the direction of interest rates and steeper yield curves.

We are increasingly evidencing of a structural shift in corporate behaviour with European companies re-emphasising shareholder value. Such a shift will help the investment community to gain confidence that firms are able to sustain a profit revival over the longer term. We believe a greater focus on simplifying corporate structure, addressing underperforming businesses, tighter benchmarking and wider sharing of best practices could boost European margins significantly.

Businesses in Europe may have overemphasised debt reduction, especially given the low interest rate environment. As confidence in the economic outlook grows, right-sizing balance sheets can also enhance shareholder value, facilitating higher dividends and share buybacks. Spare capital could also be deployed in strategic acquisitions. Many industries in Europe remain extremely fragmented and M&A is likely to feature as companies seek to sharpen focus and deepen market penetration. When markets consolidate, there is typically an improvement in financial returns for the whole industry.

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Growing revenue momentum in Europe, combined with cyclical and structural tailwinds, mean we are likely to see significant operating leverage. When margins are at low levels, operating leverage can be substantial, meaning modest top-line growth can generate large bottom-line growth. At the start of a new profit cycle, operating leverage can act as a large multiplier to earnings and its impact is often underestimated.

Interestingly, many companies in Europe have embraced research and development, technology and innovation to drive premium positioning with a quality product, and customer service to match. Motivated by tighter labour laws, automation is often seen as essential to increasing productivity, while bringing down costs. These trends have been especially evident among smaller companies. It is likely that the financial benefit of these investments has been hidden so far by the weak top-line environment. With inflation returning, premium products should be able to command greater pricing power. Price rises tend to fall straight to the bottom line and enhance operating leverage.

Each additional percentage point of revenue growth feeds through to profits at a higher rate in continental Europe than other regions. We believe investors may be underappreciating this factor. Furthermore, restructuring already undertaken by businesses through the downturn means this operating leverage may be higher than in previous cycles.

The stage is set in Europe for a cyclical recovery. In addition, as the focus of European executives shifts towards a renewed desire to address the structural drag on profitability, a sustainable recovery may be at hand. As home to many leading international businesses, Europe offers a rich source of attractive investment opportunities. The key is to identify those companies that are well managed and have the competitive position and vision to grow their earnings well into the future.

Grace Peters is the executive director - equities at JP Morgan Private Bank