European Equities: In Challenging Times, Think Like a Business Owner

What should equity investors think about when they invest in European stocks today?

Tawhid Ali, CIO European Equities at AllianceBernstein (AB): Europe presents an attractive yet challenging landscape for investors today. Economic growth looks solid across the region, which is supporting a strong earnings outlook. Equity valuations are attractive when compared with other developed markets—especially the US. But there’s also plenty of uncertainty, from political risk related to Italy or Brexit and the potential for rising interest rates. All these variables argue for an investing approach that puts individual company fundamentals at the heart of stock selection. When it’s done right, we think investors can capture the attractive long-term potential that European stocks offer without being held hostage to macroeconomic or political uncertainty.

How is your approach to investing in European stocks different from peers?

Tawhid: When we search across Europe for portfolio candidates, we apply the mindset of a business owner—not an equity investor. In practice, this means we vet companies like private equity investors in three ways. First, we study the industries that the companies operate in to learn how those industries will evolve over time. Second, we focus on the cash flows that the companies will generate over the next several years. And third, we take a long-term view and think about the return’s potential over a multi-year horizon. This allows us to maintain conviction in our positions, even when markets face short-term volatility.

Why are cash flows so important in your search for investments?

Andrew Birse, Portfolio Manager—European Equities at AB: Cash flows are, in our opinion, the best way to measure what a company does and the value it creates. Many investors focus purely on accounting measures—like profit and loss sheets. But accounting measures are flawed. They can be skewed by different rules. And quite frankly, management teams can easily manipulate accounting measures to show a rosier picture that masks underlying problems in the business. By focusing on cashflows you can eliminate all that noise and gain a clear view of what truly matters.

But what if European markets hit a rough patch? Won’t that affect the outcome?

Tawhid: Actually, our approach is designed to identify companies that can deliver returns without an expansion of stock market multiples. It’s based on internal rates of return (IRRs), a tool typically used by private equity investors. Our analyst forecasts are used to derive an annualized return rate from the cash flows that we expect the investments to throw off—both from dividends and expected proceeds—over five years. We assume a conservative exit multiple, either equal to—or lower than—the current multiple. In other words, we use IRRs to show the return potential from investing in a company based on its forecasted cash flows, without the benefit of any expansion of its stock market multiple or a market re-rating of the stocks. We think this approach offers a good margin of safety in a very uncertain world.

Does geopolitical uncertainty affect the types of stocks you choose?

Andrew: Not really. Of course, investors should always be aware of the geopolitical environment but it shouldn’t cloud your view when searching for stocks. Companies that are turning around poorly performing businesses or which have sustainable competitive advantages should do well even if economic conditionsget tougher. Other companies are positively exposed to a global trend that has little to do with the global economic environment.

Can you provide an example?

Tawhid: For example, look at Valeo, the French auto parts maker. This is a company that’s able to grow much faster than the global auto market because its business is focused on sophisticated components and technologies that are making up an increasing share of the content used in cars and trucks today. This trend should continue no matter how the global macro environment changes.

How do you find companies like these?

Tawhid: One key advantage that we bring to the European market is our globally integrated research footprint. We study European stocks from a global perspective, which often allows us to find research answers that are different than a regionally oriented person might uncover.

Andrew: What’s more, most of our investment professionals have a background either in industry or as industry consultants. So they bring a view of working inside the companies and develop quite a different perspective from your more traditional investment approach. It allows us to really understand what's going on behind the scenes in companies.

When you find companies like these, how do you assemble your portfolio?

Andrew: Our guiding principle is to be benchmark agnostic. That allows us to find interesting opportunities that may be outside the benchmark, including smaller cap companies that aren’t on most investors horizons. And our research gives us the confidence to take large, high-conviction positions in companies that pass our rigorous selection requirements. You end up with a much different construction than you would see in a diversified benchmark sensitive portfolio. An unconstrained portfolio like this enables investors to profit from investing in undervalued stocks with a smoother pattern of returns than you might get in style-focused equity portfolios.

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European Equities

In Challenging Times, Think Like a Business Owner

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