Core vs periphery trade is dead says GAM's Gallagher

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Niall Gallagher, manager of the GAM Star European Equity and GAM Star Continental European Equity EUR AccGAM Star Continental European Equity funds reveals what worked for him in 2012 and his strategy for 2013.

At the beginning of 2012 many commentators predicted an inevitable eurozone break- up. This lazy consensus ignored a number of important factors.

It ignored the likelihood of a policy response, which duly came in the form of ECB action from the President Mario Draghi. It did not consider the continued strong profit growth of high quality European consumer, industrial, technology and healthcare companies, many of which are world leaders in their respective sectors. It also didn’t take into account the attractive valuations attached to these shares.

We are reaching the end of 2012 and the eurozone is still intact. Whilst European equities have performed well over the course of this year – confounding many of the euro doomsters – this reflected an extraordinarily low level of equity valuations at the end of 2011, combined with a continuation of attractive profit growth.

Into 2013

Looking into 2013, the prospects are fundamentally positive. Valuations for European equities have improved from early 2012, but are still below the median values of the last 30 years – even when excluding the financial sector where we see continued headwinds.

Europe is also still trading at close a record discount to the US of approximately 33% based on the Shiller Cyclically Adjusted Price Earnings (CAPE) ratio as calculated by Morgan Stanley. 

Also notable is the valuation gap between equities and corporate bonds in Europe where dividend yield to corporate bond yield ratios are at record highs. This is best illustrated by the fact that cash-rich companies – including some we hold in our portfolio – are taking advantage of record-low yields to issue debt and use the proceeds of their bond issuance activity to fund buy-backs of their own shares. 

Rethink on periphery

For bottom-up investors a choice between northern and peripheral Europe is not a logical question; many of the companies we own in Europe from Germany to the peripheral markets, are global businesses where profits are driven by success or failure in the global markets where they compete. 

The prospects for appreciation of the shares of such companies will depend on the continued success or failure of commercial strategies in those markets. We have been persistently 'overweight' the periphery over the last few years for this reason  as we find numerous world class companies in these countries such as Inditex and Saipem. 

Structuring an investment portfolio with respect to country weights does not make sense in today’s global market where many companies are far more global than the countries their shares are listed in.

If we were to reframe the question and ask: 'do stocks domiciled in peripheral European economies (and listed on peripheral European stock exchanges), suffer a country discount?', then our answer would be no. 

This may have been the case at the beginning of 2012 but given the share price performances of peripheral listed companies such as Inditex, Paddy Power, Ryanair, Kingspan, Saipem and Amadeus, this no longer holds true.  Businesses that have done well this year have largely seen it reflected in their share prices, irrespective of which European market they are listed. This will remain the case into 2013. 

Time for a catch-up?

Peripheral European economies are going to experience very difficult economic conditions for some time, with the current euro exchange rate for them being too high and requiring a painful and deflationary adjustment in the real economy to improve competitiveness.   

Stocks in those markets that have performed badly  are largely the domestically-oriented sectors such as utilities, telecoms, and banks  and we expect them to continue to perform badly.  

We are particularly sceptical on peripheral European banks where profitability remains low and asset quality very poor.

One exception to this and an area of the southern and peripheral Europe where we do see an excessive level of unwarranted valuation discount is in the Spanish utility sector and we have bought a position in Gas Natural.  While we do not expect to see much growth from the Spanish part of the business, the Latin American operations will continue to grow and Gas Natural also possesses a very attractive global gas trading business.  Gas natural delivers a high level of free cash flow and is trading on a very attractive valuation.

No need to trade safety for growth

Our fund’s positions are focussed on companies with good growth prospects, earning a high return on capital employed, with robust balance sheets and generating high free cash-flows.  

We make no trade-off between safety and growth, as the companies in general combine attractive returns with the ability to re-invest those returns into the expansion of their businesses.

While we have a larger bias towards companies exposed to faster growing geographies, that is not exclusively so: We own a number of outstanding companies whose businesses are almost entirely oriented towards Europe and the OECD and still provide the inherent characteristics we look for. Good examples are Paddy Power, Ryanair and Fresenius.   Also we do not seek a defensive bias and own many quality companies that have more cyclicality embedded in their operations such as BASF, Continental, Nokian Tyres, SKF, Volvo and Atlas Copco.  

Our focus on the underlying value of the stocks we buy means that we do not seek to target or restrict sector and country weights. Nevertheless, the portfolio composition shows that our preferences lead to a large proportion of the fund’s net asset value continuing to be invested in consumer, industrial, healthcare and technology stocks.

Formerly of T. Rowe Price, Gallagher took the helm of both GAM funds following the departure of John Bennett to Gartmore (now Henderson) in 2009. Over the past three years Gallagher has returned 35.2% in the Equity Europe ex UK sector covered by Citywire's analysis. This compares to the average manager return of 21.6%.