It risks trivializing Europe's travails to say that its rolling, multiyear crisis amounts to noise. But that view is still worth considering. For active equity managers, that noise has posed challenges in the search for real returns in Europe. In that circumstance, the conventional approach to finding opportunities in Europe seems all the more conventional. The pursuit of alpha among European equities requires new thinking.
The optimal approach for uncovering names with the greatest potential for real returns uses both quantitative and qualitative equity analytics in a balanced way. The key to this balancing is to minimize the bias that can creep into both approaches – and to maximize the strengths each can deliver. The goal is to provide alpha in a high conviction, yet risk-controlled manner.
Why the 'noise' obscures opportunity
Every country or region experiences crises in its own way and Europe is no different. The current economic and political challenges facing the region are varied and complex. No one can predict the exact outcome of this current situation. The U.S. experience here, however, is instructive.
While the U.S. equity market has had its own experiences with volatility, particularly between 2008 and 2011, it has still moved higher albeit through numerous ups and downs. Since the lows of March 2009, the market has staged an impressive rally, and is up more than 100% in U.S. dollar terms. Similarly, for 2012, U.S. equity markets have appreciated 16% on a total return basis for the S&P.
We see the basis for a similar result in Europe. Investors are recognizing the progress being made on the political front and have begun to slowly come back to European equities, which are up more than 30% in U.S. dollar terms from the lows of this past June. Although this rally has been impressive, we still see considerable value in European stocks, which have lagged U.S. market returns by 50% since the lows in 2009. From a valuation perspective, Europe is compelling. As of December 31, 2012, the Euro Stoxx 50 trades at a 2012 p/e ratio and dividend yield of 12.3x and 4.53% compared to 14.2x and 2.24% for the S&P 500.
The proper focus
Certainly one legacy of the financial crisis is that it has become increasingly difficult for active managers to consistently produce alpha. Part of this problem is simply that the universe of potential investments, globally, has become so large, and the data and related "information" (including the "noise") about them so abundant and deafening. In that environment it's hard to focus, confidently, on the right ideas.
There is no black box that will magically uncover the ideas worth the most attention. But we do believe there is a quantitatively driven systematic discipline for narrowing the larger universe to a manageable number of companies worth focusing on and then further evaluating them through a technical and fundamental analytical process.
A quantitative approach has important strengths that need to be harnessed. Quant models can achieve a greater discipline in the analytical process because they are unemotional and always apply a consistent framework. This can remove a measure of behavioral-based subjectivity that can lead to bias in investment decision-making: a bias often expressed as an overly bullish or bearish sentiment. Quant models have no memory and no subjectivity, only a focus on the underlying data.
But quant is only optimized when it's combined with the discipline of qualitative analysis, that is, when it's balanced with human experience and judgment. This is particularly useful when identifying opportunity in situations where market “noise” can obscure alpha. The model can cut through the noise but qualitative analysis helps confirm what the model is telling you.
Quant forces a level of conviction, focuses attention and creates awareness of risks within a portfolio and within the overall investment universe.
Of course, even this approach needs further checks and balances. Too pure a focus on fundamentals can create an environment where you fail to see problems developing quickly enough. No matter how confident you are with a quantitatively and qualitatively balanced investment decision if the market disagrees with you it's important to understand why. A layer of technical analysis does that. It lends an element of risk awareness and all-important stability to the process as a whole.
The right ideas
Last year, our analysis found specific opportunities in the defensive sectors in Europe, including consumer staples. More recently, we're focusing on securities in the more cyclical sectors of the market, including financials, consumer discretionary, technology and certain materials.
This approach of using a quant model to cut through the "noise" and pinpoint interesting investment ideas is demonstrated through two specific examples. The woes of Europe's financial sector names are well known and hardly a day goes by without some other negative news headline. But consider Germany's Allianz, Europe's largest insurer by market capitalization and the world's largest property and casualty insurer. Its global footprint is key but more than two-thirds of its revenues are generated within Europe.
Despite Allianz's strong business model, many worry about its balance sheet risk, specifically the high level of exposure to European sovereign bonds. We take a different view, and after examining the company's balance sheet are comfortable with the quality and end market exposures of the bond portfolio. We also take comfort in the underlying sector dynamics, and Allianz's performance of generating strong returns and cash flows. We believe valuation is also compelling: Allianz trades at a p-e of 8x, a price to book ratio of 0.9x and offers a dividend yield of 5%.
Similarly, the Spanish information technology sector is not necessarily an obvious choice for finding opportunity now, we like Spain's Amadeus IT Holdings. It is a leader in information technology systems and services to the global airline industry. In one of its two main business lines, global distribution services, Amadeus aggregates flight information and supplies it to travel agents. Within the GDS market, Amadeus commands approximately a 40% global market share. Its second line of business is outsourced IT solutions for the airline industry. Amadeus believes it has a technology edge over competitors, a lead it continues to invest in through R&D.
Amadeus' fundamentals also appear to be strong. It has a highly cash generative business and a strong growth profile. Dividend payouts are expected to increase as net debt is paid down. It also trades at an attractive p-e and a discount to its peers globally.
Of course, in both cases there are risks. Among the risks for Allianz would be a substantial deterioration in European government bonds. With Amadeu,s the risks include macroeconomic events impacting global airline passenger volumes, or a shift by consumers moving to direct bookings by airlines and bypassing GDS.
Only fundamental analysis can verify the trust any manager puts into his or her way of narrowing the investible universe to find the most worthwhile ideas. We believe that this "trust the model, but verify" philosophy is key to finding value in Europe.
Spencer Mellish is a senior portfolio manager for AGF Investments/Highstreet's non-Canadian equity mandates; international, global and U.S. equities.