THE HIDDEN OPPORTUNITY FOR EUROPEAN STOCKS

The US stock market has outperformed Europe in the last decade. Of course, the better returns can be explained by structural (such as the higher proportion of Internet companies in the US) and cyclical arguments (the global slowdown affects Europe more negatively). But there is also an important cultural factor, which has grown significantly in the world of zero interest rates in recent years. This is the most favourable attitude to the repurchase of shares in the USA.

 

Source: BofA Merrill Lynch, Hold Asset Management

During a share buyback, a financially sound company borrows capital on a little higher interest rate than the government bond yields and invests this sum into itself. If the interest rate is lower than the profit margin produced by the company (reciprocal of the P/E rate), the repurchase of the shares will result in an increase of the earnings per share, therefore it will indicate a (seemingly) lower valuation (P/E) rate). However, this is only a seemingly lower valuation, because the company’s indebtedness and its risk have increased, but most investors are not paying attention to these.

Repurchase of shares, on the one hand, generates additional demand for the shares in the market, on the other hand, gives a better look to companies that are doing so more actively (higher growth). When we compare the American and European stock markets with the buybacks point of view, we get a strange picture. It would make sense for European companies to be much more active in share-buyback programmes. On one hand, the value of the European market is slightly lower, even if we compare the two continents in a sector-neutral way, i.e. we pay attention to the different composition of the indexes (Europe is overrepresented by companies that are cyclical and therefore deserve lower value). On the other hand, in Europe, as a result of the ECB’s aggressive interest rate policy, yields are about two per cent lower. A very stable European company can now borrow slightly above 0 percent interest rate, fixed in the long term, whereas in the US it is more likely to be 2.5-3 percent. As a result, buybacks in Europe have a much more positive impact on profit growth.

However, the situation is reversed. As the chart below shows, US companies spend on share buybacks about four times as much as the European corporations. And this is not just a distortion caused by the purchase of some giga companies, such as Apple. While about 80 percent of large American companies are actively buying back shares, in Europe only 15 percent do so. If European companies were as active as the ones overseas, European earnings per share would have doubled since 2010 compared to what they did, therefore greatly reducing the gap with US performance.

Source: Bank of America, Morgan Stanley

Moreover, the effect on stock demand is more important, since it is a significant item. In 2019, investors continued to withdraw capital from European equity funds due to the worsening global economy. This is in excess of € 100 billion, the largest outflow in the past ten years. As shown in the figure above, it eliminated half of the demand from repurchases. (If we take into account the excess supply of equity issues, this year’s cash outflow from European funds offset the total net repurchase.) Meanwhile, the outflow from US equity funds is much smaller and downright negligible compared to the repurchases. This huge difference in the cash flow of the capital markets of the two continents is likely to have a significant impact on prices.

Our own investment experience is in line with the picture in the statistics. During our meetings with European companies, we often see that the lack of share buybacks is a result of the corporate culture. Of course, the repurchase of the shares doesn’t always worth it, for instance when the stock is overpriced. But we often find ourselves in a situation where stable (non-cyclical) European companies with a strong capital structure and normal (historically not high) pricing, do not take advantage of this opportunity.

Historically, European stock prices do not seem to be low, but rather average. On the other hand, bond prices are extremely high (yields are extremely low). For managers, it is a mistake, and an untapped opportunity, to try not to create value from this relative mispricing when they would otherwise be able to do so easily due to the strong capital structure of their company. As an investor, it may be worthwhile to focus on these companies, because with the continued existence of negative interest rates, these managers will be under increasing pressure (mainly from American activist investors) to buy back shares, which is likely to have a positive effect on stock prices.