European equity valuations have been driven down to 11x forward price to earnings (PE) - a considerable discount to the long-term median, with more than a 30% PE valuation discount to USA equities now, the highest discount in over 30 years, as you can see in this chart:

Source: Refinitiv Eikon Datastream, 31 October 2022

In short, sentiment on Europe is poor and valuations are attractive. This puts us in mind of Warren Buffett’s famous adage: “Be fearful when others are greedy and greedy when others are fearful.”

Fear and greed are, of course, emotions, and emotions have no place in an analytical research-based investment process. Let’s put it another way – we see opportunity where others see risk. We also wonder, how much risk is being taken by those who ignore the wide range of options that European equities offer?

Four big trends

Here are the four big trends that we believe will drive markets in the coming years, and some opportunities we are finding to take advantage of them via European equities.

Source: abrdn

1. Companies with pricing power - at a time of high inflation, it is companies with the ability to pass higher input costs onto their customers by raising prices that are best positioned. Luxury goods company LVMH is a good example. It has a diverse collection of brands and a relatively resilient customer base, which puts it in a strong position to deal with elevated inflation. Despite its size, LVMH’s revenue is growing about 20% a year organically and the company has been sharing this with investors through big increases in its dividends too.¹

2. Companies that benefit from higher commodity prices - higher commodity prices are a headwind for many sectors and companies within Europe and this is a key driver behind the more challenging outlook, especially in energy-intensive sectors. However, there are companies set to benefit from higher commodity prices, including in the energy sector. In the space, there are multi-energy companies such as Total which can harvest higher cash flows, de-lever, offer generous cash returns to shareholders and invest more in its energy transition businesses to compound attractive dividends.

3. Companies helping to manage energy security challenges and deliver energy transition - clearly the current crisis drives energy security towards the top of the political and societal agenda. Certain sectors and companies such as RWE, the German utility company, are well positioned to help solve these challenges, both in the near and medium-long term. The company’s conventional electricity generation assets (e.g. lignite, nuclear, biomass and gas) will likely need to run at higher output and benefit from higher prices in order to help Germany, given its heavy reliance on Russian gas. In the medium term, RWE is well-placed to help drive the energy transition in Germany, with its capital expenditure on renewable electricity and hydrogen playing a key role in both diversifying away from Russian gas and in driving decarbonisation.

4. Companies that benefit from higher interest rates - higher interest rates affect debt servicing costs and we think it’s wise to avoid companies with high leverage. However, industries like Financial Services are well positioned to benefit from higher interest rates in terms of improved earnings and capital positions. For example, Nordea is a leading pan-Nordic bank which has one of the strongest capital positions in the sector and an excellent capital return track record. Higher interest rates are driving up net interest income for the bank and enhancing its ability to make significant capital returns to shareholders.

Heritage and innovation

Aside from those four big trends, we also believe that Europe offers a unique blend of heritage and innovation that is hard to find in other markets. Heritage matters because it is hard to replicate and suggests a long-term approach to managing companies. Innovation matters because it provides resilience to change and access to growth. The table below provides a snapshot of European heritage and innovation.

Source: abrdn. Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. © owned by each of the corporate entities named in the respective logos

Being dividend-driven

There’s one more theme worth mentioning here, and that’s dividends. Numerous academic and financial industry studies have demonstrated that dividends are a key driver of long-term equity returns. Furthermore, companies with the capital allocation discipline to pay dividends offer attractive risk adjusted returns over the long term in our view. We therefore believe it helps to ensure all holdings have an income case.

As income investors, we find Europe offers a great opportunity set, backed by a strong culture of dividends. Headline yields are attractive across most sectors and countries – which means investors can choose the best income stocks from a diverse and deep pool of ideas.

We also think a portfolio with three categories of income – High Dividend, Dividend Growth and Dividend Upgrade, has the potential to access the main drivers of long-term equity returns in Europe – i.e. growth and income – rather than just targeting one or the other.

Final thoughts

It is hard to say what lies in store for markets in 2023, but we are likely to see another volatile year. An approach focused on investing in dividend-paying companies that tap into key global trends has the potential to deliver attractive returns for clients in our view. Europe, with its blend of heritage and innovation and strong culture of dividends, would seem to be a promising hunting ground for investors, particularly given current attractive valuations.

Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.