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European value stocks have rallied recently. But identifying cheap stocks with recovery potential is still extremely difficult. Itâs time to consider new approaches to discover attractively valued equity opportunities across Europeâs complex market landscape.
From the sovereign-debt crisis to Brexit, Europe seems to have had more than its fair share of challenges to market stability in recent years. As a result, the forces that have shaped European equity valuations have changed. Systemic market headwinds are increasingly driving stock valuations instead of stock-specific controversies.
Whatâs Driving Cheap Stocks?
Consider the cheapest 20% of European stocks, based on price/book (P/B) value. Our research shows that a falling proportion of the share-price volatility is attributable to company-specific issues such as operating fundamentals, management behavior, or equity and debt issuance trends (Display). At the same time, more and more stocks in the market are finding their valuations compressed because of their exposure to market beta or macroeconomic uncertainty.
Because of these trends, taking a naĂŻve approach to finding value can be dangerous. Today, financials stocks dominate the cheapest quintile of European stocks, based on traditional valuation measures such as P/B and price/earnings (P/E) ratios (Display). Yet banks are far from optimal investment opportunities, as theyâre struggling to cope with changing capital ratio requirements, while historically low interest rates are compressing earnings.
Thatâs why banks account for only 1.7% of the most profitable European stocks, based on return on equity. At the same time, there are relatively few industrials and consumer groups among the cheapest group of stocks, while these companies make up a large proportion of the most profitable names. So exchange-traded funds that use P/B or P/E ratios to capture value stocks may actually be exposing investors to a very high concentration of financials that are vulnerable to systemic risksâand are potential value traps because they donât have many levers to pull in order to increase profitability.
Adding Tools for Identifying Value
In this environment, we believe investors need to focus much more closely on cash flowsâwith much more sophisticated toolsâin order to find good value.
So what else is needed? In addition to P/B and P/E ratios, we think itâs important today to gauge the valuation of cash flows, incorporate the impact of a companyâs debt profile and understand exactly how accounting practices can affect some measures of a companyâs intrinsic worth. Incorporating price/cash flow in an analysis can help investors gauge a companyâs health beyond reported earnings, which are easily manipulated. Measuring price/tangible book value can extract goodwill and other intangibles, which are notoriously hard to evaluate. And enterprise value/sales can help gauge the worth of a companyâs revenues, while also taking into account a companyâs debt position.
Itâs too early to predict whether the rebound of value stocks seen in the third quarter will continue. But itâs not too soon for investors to look for new ways to identify value in Europeâs tricky market conditions. By expanding the value tool kitâand combining quantitative measures with fundamental company researchâwe believe investors can discover cheap stocks that offer real recovery potential to deliver sustained outperformance in Europeâs complex conditions.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.
MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
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