European shares made a strong advance in the first half of 2019, but the gains were not evenly spread across the market, shows Simon Corcoran, Investment Specialist, UK & European Equities, at Schroders.
Given the headlines over the past six months, it feels a little odd to realise that European equities are up 16% in the same timeframe. From trade wars to slowing economic growth to Brexit, there are plenty of reasons why the market shouldn’t have rallied. But the gains perhaps look less surprising when we dig into the detail behind them.
We looked at the return for the overall index - MSCI Europe – and then for four style factors within this index: growth, quality, high dividend yield and value.
Style factor definitions:
- Growth companies may currently be growing at a faster rate than the overall market, and/or have higher potential for future growth.
- Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance.
- Dividend yield is calculated by dividing the dividend per share by the price per share; a high dividend yield could be a sign a stock is underpriced, or it could be that the stock is under pressure and future dividends may not be so high.
- Value refers to those stocks that have low prices relative to their fundamental value. This is commonly tracked by metrics such as price to earnings (a company’s share price divided by its profits).
As the table below shows, growth and quality have been the factors in greatest demand in the past six months. Returns from these parts of the market have significantly outpaced returns from value and high dividend yield stocks.
Past Performance is not a guide to future performance and may not be repeated.
The uncertain economic backdrop may be one reason why investors have favoured stocks with these growth and quality attributes. After all, this economic cycle has been very long. As we move towards the end of a cycle, investors often look for those businesses with reliable, predictable earnings that can potentially fare better than the rest of the market in a slowdown or recession.
The MSCI Europe Quality and Growth indices have outperformed the Value index by over 10%. Sectors such as industrials, technology, luxury goods and food products form a large weighting within these indices and have led the gains.
There is considerable overlap between the MSCI Europe Quality and Growth indices. The table below shows eight stocks that are among the top ten constituents by size in both indices, and the returns posted by these stocks in the six months to the end of June. Only AstraZeneca has failed to outperform the broader MSCI Europe index.
Any reference to securities are for illustrative purposes only and not a recommendation to buy/and or sell.
As well as offering quality and growth characteristics, large companies such as these are often favoured in times of uncertainty due to their size. Larger companies are often assumed to offer greater stability than small companies, and have usually weathered a number of economic cycles successfully.
What does this mean for valuations? The chart below shows the forward price-to-earnings ratio for the next 12 months for MSCI Europe Quality relative to MSCI Europe Value. It shows that investors have recently been willing to pay a larger premium than they did previously for quality stocks.
Quality valuations have become elevated
Martin Skanberg, fund manager, says;
“Such a situation can persist for some time, but is unlikely to do so indefinitely. There are signs recently that the quality rally is fading as companies struggle to meet lofty growth expectations. That said, it is impossible to time precisely when the trend might change. As investors, we look for the best trade-off between risk and reward that we can find”.
This information is not an offer, solicitation or recommendation adopt any investment strategy. If you are unsure as to the suitability of any investment please speak to a independent financial adviser.
For more on the factors driving the market, see why growth stocks look vulnerable.
See our Alpha Equity strategic capability page for further equity insights.
This article has first been published on schroders.com.