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The 2014 All-Europe Research Team
Bank of America Merrill Lynch displaces Deutsche Bank atop our annual ranking of the region's best equity analysts.
From Locked ranking
Fund managers are finding much to celebrate in Europe these days. Many of the region’s stock markets logged their best gains in years in 2013, led by Greece (up 39.9 percent), Finland (35.5 percent), Ireland (32.9 percent) and the Netherlands (23 percent). Overall, European stocks shot up more than 18 percent last year, and there are strong indications that the surge won’t end anytime soon.
“We believe that 2014 will be another good year for stocks — growth is coming back in Europe as fiscal drag is fading and financing conditions are improving,” observes Paul Huxford, who directs coverage of European equities at J.P. Morgan Cazenove in London. “Peripheral sovereign spreads keep narrowing, banks are seeing more favorable funding costs, and private demand has fallen to low levels. The region offers strong earnings growth potential, which will likely drive the equities market this year.”
Investors affirmed this optimistic view last month when they allocated the lion’s share of money pulled from volatile emerging markets — roughly $4 billion of a total $6.5 billion in the third week of January alone — to European equity funds, according to EPFR Global, a fund-tracking service headquartered in Cambridge, Massachusetts. Also last month the International Monetary Fund raised its 2014 forecast for real gross domestic product growth across the euro zone, to 1 percent, while noting that the recovery is uneven, deflation remains a regional threat, and Southern Europe is still “the more worrisome part of the world economy,” as the Washington-based organization’s chief economist, Olivier Blanchard, put it.
Simon Greenwell, who in June became director of research for Europe, the Middle East and Africa at Bank of America Merrill Lynch in London, shares similar concerns. “The key issue for us is growth — or rather the lack of it,” he says. His firm is also forecasting GDP expansion of 1 percent in the euro zone this year, but that top-line figure obscures wide fluctuations. His economists project that output will increase by 2.7 percent this year in the U.K. and 1.6 percent in Germany, but just 0.8 percent in Spain.
“We’re more cautious than some commentators on Spain,” Greenwell admits. “It’s the market most exposed to global growth, in both a positive and negative way. If you’re concerned about growth, then Spain is a market where we’re not as constructive.”
The crew at J.P. Morgan Cazenove holds an opposite view. “The region is projected to accelerate from the 0.4 percent growth rate of last year to a pace of 1 percent this year, and we think that peripheral markets — Italy and Spain — will outperform,” Huxford says. “Their valuations still offer significant investment potential, and further tightening in peripheral spreads could drive a rerating relative to core countries. Our economists forecast Italy and Spain to deliver the biggest swings in GDP growth, which will help a strong rebound in earnings.”
Deutsche Bank researchers are similarly upbeat. “We expect to see far greater economic stability, with clear signs of recovery in Southern Europe — especially Spain,” reports Jonathan Jayarajan, associate director of EMEA equity research in London. “Deflation remains a significant threat. However, we believe the European Central Bank will be prepared to engage in quantitative easing and negative deposit rates if that looks likely to materialize.”
One issue on which just about everyone can agree is that 2014 will be volatile. Slowing growth in China remains a worry, as does the stability of many emerging-markets economies. Last month’s announcement from the Bureau of Economic Analysis that U.S. output increased at a rate of 3.2 percent in the fourth quarter has triggered fears that the Federal Reserve Board will accelerate the pace at which it exits its program of quantitative easing; such speculation sparked sell-offs in emerging markets several times last year.
Many investors rely on guidance from the sell side to help them assess each new development and position their portfolios appropriately, and they say the firm whose analysts provide the most helpful insights is BofA Merrill, which leaps two places to lead the 2014 All-Europe Research Team, Institutional Investor’s 29th annual ranking of the region’s best sell-side equity analysts. The firm captures 32 total team positions, an increase of five over last year. Deutsche Bank, which topped the roster from 2011 through 2013, drops only one notch even though it loses ten positions, leaving it with 28. Close behind is J.P. Morgan Cazenove, which returns to the top three for the first time since 2010. Its total increases by two, to 27.
Holding steady in fourth place despite a loss of three positions is Morgan Stanley, with a new total of 23. UBS, which came in second overall in 2013, plunges to fifth place after its total plummets from 33 to 20.
These results reflect the opinions of some 2,200 money managers at roughly 800 institutions that collectively oversee an estimated $6 trillion in European equities.
As the euro zone has been progressing toward economic stability, the research needs of money managers have been changing. “Country investing became very important to investors through the sovereign crisis. The systemic risk associated with a potential debt default and/or the breakup of the currency area would have had large and variable costs across countries,” explains Vincent Laurencin, London-based head of research at Exane BNP Paribas, this year’s biggest upward mover among the top firms. It bolts from ninth place to sixth after picking up four positions, for a total of 15. “The banking sector would obviously be at the center of such concerns, but the broader impact on economic activity and domestic government policy made it impossible for investors to ignore ‘country of domicile’ when such systemic risk was perceived to be relevant.”
Since policymakers have taken the necessary steps to reduce country-specific risks, he adds, “the pendulum has swung back in favor of sector-based research.”
That’s certainly true with regard to consumer stocks, affirms Richard Chamberlain, who took charge of BofA Merrill’s Retailing/General team in 2012 and this year guides it up one level to No. 1. “We have seen more interest in our sector over the past 12 months, owing to an improved consumer outlook in the U.K. driven by employment and housing, as the sector is steadily globalizing and as investors have been attracted to stocks with a strong online growth story,” he says.
The London-based analyst and his associates have identified ten key themes for 2014, including more robust sales of hardlines in the U.K., stronger domestic consumption in Germany and increased traffic at discount retailers throughout the region. Rising disposable income and an uptick in investment should propel consumer spending in Germany, Chamberlain believes. Companies likely to benefit from these trends include apparel retailers Gerry Weber International, a domestic concern, and Sweden’s Hennes & Mauritz, where roughly 60 percent of annual sales are attributable to German shoppers.
“We favor H&M for an improved offer, exposure to an improving German consumer, likely gross-margin upside from stronger full-price sales and the strong euro, and e-commerce catch-up,” he explains. “In the U.K. we like [clothing retailer] Next for online momentum, upward pressure on space guidance and more competitive pricing.”
When it comes to high-end retail, however, demand is diminishing, according to Luca Solca, who pilots the Exane BNP Paribas team to No. 1 for the first time in Luxury Goods. “I am seeing lower investor interest in my sector in the past few weeks,” the London-based researcher reports. “After ten years of outperformance, luxury goods stocks have been lagging for a couple of months, on the back of market concerns on discretionary demand in China. I am urging investors to expect greater pergence in the sector and to pick companies that have better structural prospects and higher probability to increase return on invested capital in the midterm.” His current recommendations include Switzerland-based jewelry and watchmakers Cie. Financière Richemont and Swatch Group.
Many companies in his coverage universe need to reconsider their business strategies. “The era of easy growth from opening new stores in China is over for most brands, at least for the moment,” Solca says. “Luxury players can no longer ignore growth opportunities like online, be cavalier about integrating franchisees and shop-in-shop into direct retail or tolerate underperforming businesses in their portfolios.”
Contrasts in company performance is also a theme in the Leisure & Hotels sector, according to Victoria Lee, who guides the Barclays crew from second place to claim its first appearance atop the roster. “We are seeing a huge amount of interest in the sector today. I think investors on the whole want to position themselves for recovery, and leisure is a really great sector for that, given the cyclical exposure and high gearing of many of these companies,” she explains. “Our preference is to play the hotel names for this theme.” Favored stocks include Accor, a hotel operator headquartered in France, and U.K.-based hospitality services provider Whitbread.
The uneven pace of recovery across the region informs her team’s choices, the London-based analyst adds. “There’s a real variation within Europe,” Lee points out. “I’m extremely excited about the U.K., especially the business-investment-led recovery, which is key for hotels, whereas I have a more modest expectation for France, for example.”
Robert Plant, leader of the J.P. Morgan Cazenove team in London that rockets from runner-up all the way to first place in Business & Employment Services, also stresses that the performance of companies in his sector will vary widely by their exposure to particular markets. “We are seeing a lot of interest in public sector–related stocks as investors look to benefit from government attempts to introduce greater efficiency to cut spending,” he says. Beneficiaries of this new focus are likely to include such U.K.-based outfits as Capita, which provides back-office administration and business-processing services, and Serco Group, an operator of detention centers, prisons and schools.
“A lot of public sector functions are being outsourced to the private sector for the first time,” he adds. “For example, the U.K. government recently outsourced the training for the civil service to the private sector and is also in the process of outsourcing probation services.”
Geographic factors also influence the recommendations of Mark Troman’s group at BofA Merrill, which climbs one rung to lead the lineup in Capital Goods for the first time since 2010. “The engineering sector has generated a lot of investor interest for a number of years, probably because the bulk of companies tend to add value through the economic cycle,” says Troman, who works out of London. “Most investor questions are centered on end markets — that is, where are the best growth trends? As growth is expected to be still quite low by historical standards, we think companies that can restructure effectively or have options to use their balance sheets may do better.” Siemens has been a team favorite since last March, in large part because of the German engineering company’s robust earnings growth and management’s commitment to improving margins.
Troman and his teammates see cause for optimism in the year ahead. “There are some encouraging signs that European industrial output should improve, most notably OECD lead indicators and purchasing manager’s indexes,” he points out.
Oswald Clint, who shepherds the Sanford C. Bernstein team to its first appearance in the winner’s circle in Oil & Gas Exploration & Production, is equally sanguine about his sector. “I watch Europe from an energy-demand perspective, which is a strong indicator of economic growth,” he says. Regional demand for natural gas rose year-over-year in 2013, while appetite for oil products was flat. These developments “stand in sharp contrast to the double-digit declines we have experienced since 2009, and I do see a path to stability at the very least.”
Money managers are paying attention, the London-based crew captain insists, even if many aren’t ready to invest just yet, owing to perceived risks to commodities prices and thus corporate revenues. “I’m urging investors to look at changes in signaling and actions of integrated oil companies over the last 12 to 18 months, which I think are encouraging, such as a better focus on short-term performance measures, less focus on long-dated volume targets and better allocation of their hefty capital budgets toward the best return projects,” he says. BG Group, a U.K.-based provider of natural gas, is among the team’s current favorites.
Investors have been keeping tabs on developments in the financial services sector ever since the global crisis began, but not all segments of the industry have been affected equally, observes Bruce Hamilton, whose Morgan Stanley squad is celebrating its second straight appearance at No. 1 in Specialty & Other Finance. “The persified financials sector has probably suffered less but also perhaps seen less reengagement relative to the European banking sector, given the latter’s greater sensitivity to regulations, sovereign stresses and so on,” says Hamilton, who is based in London. “At the margin I would say I’ve seen more investor interest, given the sector’s gearing to improved cyclical dynamics.”
Forthcoming regulatory changes will also affect the companies this team covers. An update of the European Union’s Markets in Financial Instruments Directive II is in the process of being finalized, with implications for investors in over-the-counter derivatives as well as those that engage in electronic and high frequency trading, among other issues. Plus, the EU’s European Market Infrastructure Regulation, which also deals with OTC derivatives as well as counterparties, should be implemented in full late next year or early in 2015. “We expect that will benefit the London Stock Exchange [Group], which has been our top pick in the space since last summer, given the requirement for clearing of OTC trades,” he says.
Increased regulation may further reduce investor anxiety and thus spur greater exposure to equities, but a number of variables still could stop recovery in its tracks, market observers point out.
“The U.S. economic recovery warrants and will likely get a higher cost of capital via rising Treasury yields at a time when economic conditions in large parts of the globe do not warrant a rise in ‘the global cost of capital,’” says Exane’s Laurencin, who leads teams that finish first for coverage of France and runner-up for reporting on Iberia. “The channels through which this risk may be crystallized are many. But whether it’s capital repatriation from emerging markets forcing tighter monetary policy onto the current-account deficit economies, or even a drain in global liquidity that challenges the benign conditions in Europe’s peripheral bond markets, the consequences have the potential of causing significant economic and market damage at some point this year. We have to recognize we are on the verge of exiting from a period of extreme monetary policy stimulus — and that process is fraught with execution pitfalls for global policymakers.”
Despite some regional success stories, world markets are still very intertwined, adds Huxford, of J.P. Morgan Cazenove, who also leads a team that secures a runner-up spot for U.K. coverage. “This year we believe that market movements will be determined by whether solid global growth is able to promote healing,” he says. “Healing in the developed-market economies depends crucially on whether stronger demand growth will elicit stronger supply — as manifested in faster gains in investment, productivity and labor supply — allowing utilization rates to normalize in a low-inflation environment.”
Richard Smith, co-head of global equity research at Deutsche Bank in London, believes it will. “A turn in the credit cycle and continued low rates should benefit the regional economies, driving higher-than-expected demand and at least a stabilization in earnings-per-share forecasts,” he says. “That should drive greater investor faith that the improving macro picture is being felt at a bottom-up level and could perhaps even drive some upgrades through 2014.”