European value stocks have rallied recently. But identifying cheap stocks with recovery potential is still extremely difficult. It’s time to consider new approaches to discover attractively valued equity opportunities across Europe’s 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.
What’s 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 naïve 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 they’re struggling to cope with changing capital ratio requirements, while historically low interest rates are compressing earnings.
That’s 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 risks—and are potential value traps because they don’t 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 flows—with much more sophisticated tools—in order to find good value.
So what else is needed? In addition to P/B and P/E ratios, we think it’s important today to gauge the valuation of cash flows, incorporate the impact of a company’s debt profile and understand exactly how accounting practices can affect some measures of a company’s intrinsic worth. Incorporating price/cash flow in an analysis can help investors gauge a company’s 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 company’s revenues, while also taking into account a company’s debt position.
It’s too early to predict whether the rebound of value stocks seen in the third quarter will continue. But it’s not too soon for investors to look for new ways to identify value in Europe’s tricky market conditions. By expanding the value tool kit—and combining quantitative measures with fundamental company research—we believe investors can discover cheap stocks that offer real recovery potential to deliver sustained outperformance in Europe’s complex conditions.