Most major developed European equity indices are lagging their US peers this year. While the S&P 500 is in the positive territory year-to-date major European benchmarks are in the red as shown below:

UK’s FTSE 100:  12.1%
France’s CAC 40: -3.4%
Germany’s DAX Index:  -1.6%
Spain’s IBEX35 Index: -8.2%
Stoxx Europe 600: -6.3%

Source: WSJ

Though investors’s current fears about European stocks are understandable Credit Suisse is actually bullish on them. From a CS article:

Investors, however, seem to be misreading the tea leaves, and have of late been selling European stocks in droves. Year-to-date outflows as a proportion of assets under management are at their highest level in a decade. Given the pessimistic mood, the market-implied rate of GDP growth in the Eurozone currently stands at zero, but Credit Suisse believes the European economy will actually grow 1.5 percent in 2017.

Another reason for optimism? European companies are more exposed to emerging markets than either Japanese or American firms, with developing countries accounting for one-fourth of European sales and 11 percent of Eurozone GDP. That hasn’t been an advantage in recent years, as the steep decline in commodity prices and sluggish global growth sent many emerging markets reeling, but it will be going forward. Currencies in the developing world are stabilizing, and growth is accelerating. So Euro zone stocks are worth a look. And here is what you’ll find: European stocks are much cheaper than U.S. equities, trading on a 19 percent discount on a 12-month forward price-to-earnings discount, or 7 percent after adjusting for sector differences. Continental Europe is one of only two regions in which the Global Markets equity strategists recommend an overweight position.

Source: Unshakeable Europe, The Financialist, Credit Suisse

I have written many times that some of the large-cap firms the continent have strong presence in emerging markets, For example, Europe-based consumer goods multinationals are big players in emerging markets due to historical ties of operating in those markets.

For investors looking to consider stocks from the continent, here are some options:

Consumer Staples: Unilever NV (UN), Nestle SA (NSRGY), Unilever PLC (UL)

Household goods: Henkel AG & Co KGaA (HENKY), Reckitt Benckiser Group plc (RBGLY)

Consumer discretionary:b Heineken NV (HEINY), British American Tobacco PLC (BTI), Anheuser-Busch InBev SA/NV (BUD), Diageo PLC (DEO)

Pharma: Novartis AG (NVS), Roche Holding AG (RHHBY), Novo Nordisk A/S (NVO)

Disclosure: Long RBGLY

Stocks usually tend to outperform cash and other asset types over the long-term measured in 5 years or more. The performance gap between stocks and cash over decades is even more wider due to the effect of compounding returns due to dividend reinvestment.

While holding cash in a savings account offers safety and peace of mind, cash is not the best vehicle to build wealth. The following chart from Fidelity UK shows the 30 year returns of stocks vs. cash:

Click to enlarge

Source: Why long-term investing works: How putting £10K into the stock market would have earned you £90K more than cash savings over three decades, This is Money

An initial investment of  £10,000 in 1986 in the benchmark FTSE 100 would have grown to £126,867 based on total return which includes dividend reinvestment. The same amount in FTSE 100 would be worth £121,466. An investment of the same 10K in the FTSE 250 would have grown to £265,035 in the past 30 years.

Had an investor stashed the cash in a savings account, the investment would have grown to only £28,196.

Hence they key to success equity investing is to hold high-quality stocks for many years and do not panic and sell when markets turn volatile. Selling out during panics such as the recent Brexit drama is not a wise move.

Stocks in the consumer staples sector have elevated P/E ratios today relative to the market. This is because investors looking for safety and reliable income stream have piled into these stocks over the past few years. Market volatility and ultra-low interest rates only added more fuel to the solid rise of consumer staples stocks. Companies in the sector have rewarded investors year over year with decent dividend growth. However such raises may be unsustainable in the future according to David Jane of Milton Asset Management of UK.

From a recent article at Citywire, UK:

As the table below shows, over the past five years these companies have delivered nearly 10% annual dividend growth.

That looked impressive, said Jane, but had not been driven by rising sales in emerging markets, as many investors believed, because sales growth has been near zero for most of the groups.

Nor had higher dividends been driven by improved profitability, as gross profits (earnings before interest, tax, depreciation and amortisation or ebitada) had grown less than 2% a year.

‘What has been happening is debt has been growing to fund acquisitions and share buybacks, while interest costs have been falling as rates go ever lower,’ said Jane.

‘In fact, debt for the group has grown at over 8% per annum while shares outstanding have fallen and hence, earnings per share have been growing rapidly.’

He added: ‘So, the dividend growth we have seen has largely been driven by financial engineering not a fundamentally attractive business model.’

Consumer group debts have risen with dividends

Company	Dividend yield %	Dividend growth (5yr) %	Sales growth %	Gross profits (ebitda) growth (5yr) %	Debt growth (5yr) %	Debt / /Ebitda
Coca-Cola (KO.N)	3.22	8.37	-1.92	-1.97	13.55	2.22
Procter & Gamble (PG.N)	0.03	5.76	-4.88	-3.63	-0.90	1.04
Diageo (DGE)	2.91	7.94	1.79	5.24	4.33	2.68
Altria Group (MO.N)	3.70	8.26	4.21	12.64	1.16	1.35
British American Tobacco (BATS)	3.44	5.53	-2.01	-3.54	10.65	3.71
SABMiller (SAB)	2.35	12.52	-0.76	-1.88	6.77	2.26
Anheuser-Busch (ABI.BR)	3.10	34.69	1.58	0.81	1.96	2.89
Philip Morris (PM.N)	4.16	9.77	-4.19	-5.80	11.53	2.42
Pepsico (PEP.N)	2.86	7.90	-1.72	0.63	5.98	2.09
Reynolds American (RAI.N)	3.75	9.80	7.89	18.65	33.59	1.23
Unilever (ULVR)	0.03	5.36	3.15	3.23	9.89	1.40
Imperial Brands (IMB)	4.03	10.51	-1.60	0.61	6.53	4.33
Colgate-Palmolive (CL.N)	2.16	6.77	-1.61	-0.34	13.93	1.69
Reckitt Benckiser (RB)	2.00	4.13	0.04	-5.63	-1.75	0.79
Heineken (HEIN.AS)	1.70	11.52	3.89	7.23	7.43	2.69
Average	3.25	9.77	0.44	1.84	8.41	2.14

Source: Miton Group

Source: Why ‘expensive defensives’ are running out of road, CityWire UK, Sept 26, 2016

Caution is warranted with picking up consumer staples at current levels. Instead of simply buying these companies for the dividend yield and dividend growth, investors should aim for total return over many years. So investors can wait to add when prices decline. Buying even at 10% lower rate would generate higher total returns if held for the long-term.

Another report titled The Elevated Risks of Safe Stocks by Charles Roth at Thornburg Investment Management also discussed about expensive defensives. From the report:

Traditionally safe, dividend-paying stocks have attracted tremendous investor inflows, raising their share prices and valuation multiples to levels that aren’t supported by earnings growth. The risks of a correction in the “expensive defensives” are running increasingly high, especially as the specter of benchmark interest rate hikes grows.

Executive Summary
• Unprecedented monetary easing and asset purchases by major central banks have pushed yield-seeking investors into dividend-paying stocks, driving up their valuations.
• Earnings growth in the defensive sectors hasn’t supported the expansion in their valuation multiples. The technical flows have been reinforced by the predominant capitalization weighting model in passive investing, which at its essence becomes a momentum trade.
• Risks of a correction are growing, particularly in the U.S., where defensive stocks could be hit if the U.S. Federal Reserve hikes rates sooner than later, as some Fed officials are publicly advocating.

In the US sales are down for consumer staples companies but the P/E continues to grow higher.

Click to enlarge

Similar situation exists with international consumer staples also.

Source: The Elevated Risks of Safe Stocks by Charles Roth, Thornburg Investment Management, Sept 2016

Disclosure: Long Reckitt Benckiser (RBGLY)

European equities are currently at a discount to their US peers.In the past, whenever  this scenario occurred European stocks have played catch and have eliminated this discount as investors gobbled up shares that were undervalued. However that is not the case in the past few years.European stocks continue -to lag US stocks for a number of reasons. Even though the EU is a single market, each individual country has its own issues including political and economic problems. For example, up until a while ago sovereign risks dominated the headlines with countries like Greece on the verge of economic collapse.That risk declined after multi-year multiple bailouts. It seemed like Europe was finally getting back on track. But then the usually calm UK erupted in chaos with the Brexit vote.Today banking issues in Germany and Italy have come to the forefront of economic issues facing the continent. With all the never-ending issues it seems like it will take a few decades or even a century for Europeans to solve their issues.

According to a report by Schroder’s political risk is weighing heavily on European stocks and as a result investors are demanding a bigger discount. In addition to the political risks, other issues like banking industry problems and deflationary risks are well known and are already priced in. It is indeed surprising that political risk usually identified with emerging and frontier markets is the major risk facing the European markets today. One factor that differentiates emerging and frontier basket-case countries from Europe is that political issues in Europe will be solved peacefully and is unlikely to lead to political revolution or a military takeover of a country. For instance, countries like Egypt or Thailand have gone from democratic to dictatorship or military almost overnight. This type of radical change will not occur in Germany or France or any other European nation. So pressure of political risks hanging over European stocks will eventually go away and they will recover to catch up with their American counterparts.

The following chart shows European stocks are lagging their US peers:

Click to enlarge

The table below lists seven political events that pose adverse risk to equity markets:

Source: Schroders Economic and Strategy Viewpoint, Oct 2016, Schroders

Investors looking to take advantage of the current discount can consider the following stocks for further research:

• Banking: ING Group (ING) – Buy with both hands under $10 per share, Nordea Bank (NRBAY), Svenska Handelsbanken AB (SVNLY)
• Industrials: Siemens (SIEGY)
• Chemicals: b BASF AG(BASFY), Arkema(ARKAY)
• Auto-parts: Valeo (VLEEY), Continental AG(CTTAY)
• Consumer staples: Nestle(NSRGY), Unilever (UL)
• Oil: Total(TOT), Royal Dutch Shell (RDS-A) and Eni Spa (E)

A simpler and easier way to invest in major European firms is via ETFs. Two ETFs that fit the bill are SPDR EURO STOXX 50 ETF (FEZ) and SPDR STOXX Europe 50 ETF (FEU).

Disclosure: Long ING, CTTAY