Outlook 2024: Why quality matters in European equities

We are fundamental stock pickers looking for the best quality growth companies in Europe. These companies have differentiated products and economic moats that allow pricing power. They are businesses that can generate high and sustainable returns enabling reinvestment of excess cash in long-term growth opportunities and in maintaining their competitive advantages – compounding shareholder value.

These quality traits are particularly important as we move into a period that’s likely to be more challenging for economic growth. Companies are facing increased cost pressures and softening demand, which puts pressure on profitability and cash generation, particularly when compounded by higher financing costs due to higher interest rates.

We believe companies with high-quality business models will be the best-positioned to navigate the current macroeconomic environment. Pricing power, strong cash flows and balance sheet strength are especially important in this context. Over the long term we expect these companies to materially outperform the broader market.

The companies we seek are exposed to secular trends that can transcend business cycles and short-term market challenges. These secular trends include digitalisation and the need for computing power, onshoring of the global supply chain due to geopolitical tensions, the green economy, and aging populations and health care innovation. We have found companies that benefit from these secular growth opportunities scattered across the European market.

For example, the Biden Administration’s efforts to isolate China has led to companies moving production of key technology components such as semiconductors to the US. In addition, the passage of the Inflation Reduction Act in the US provides substantial fiscal support for green technology and upgrading the country’s manufacturing base. Manufacturers throughout the semiconductor manufacturing supply chain are benefitting from these plans to build new plants in the US, including several European companies. These companies include ASML, which produces lithography machines used in chip production, and VAT Group, which makes vacuum valves used in chip manufacturing. Advances in AI also highlight the relentless need for more sophisticated microchips; we believe ASM, which produces wafer processing equipment, should benefit from increasing chip complexity.

Building efficiency is a key area requiring investment in the pursuit of a green economy, and companies such as Ireland’s Kingspan, which makes insulation products that reduce building emissions, and Italy’s Carel Industries, which makes heating and cooling control components, should be beneficiaries, in our view.

Meanwhile, in health care, there are many companies helping in the development of drug therapies that can help save lives or prevent disease. Denmark’s Novo Nordisk is a leader in the treatment of diabetes and obesity, producing 50% of the world’s insulin supply. The company continuously reinvests in research and development to uncover new treatments and ensure that their products remain relevant.

European markets have remained out of favour for global asset allocators in 2023, the outcome being that their valuations remain below long-term averages (based on forward P/E multiples). Meanwhile US equities are trading at what we consider to be an extreme valuation premium to Europe and most other markets, based on history. The US equity premium versus Europe reflects in part the outperformance of the so-called Magnificent Seven US technology companies as well as market concern about the proximity of the Ukraine-Russia conflict and the European macroeconomic outlook.

We are cognisant of the headwinds caused by such political uncertainty, such as supply chain disruption, energy shortages and inflation, but would argue that the challenges caused by such events are global in nature rather than regional. We are seeking to invest in European companies that are global leaders, which are well positioned with manufacturing or servicing capabilities close to their customers around the world. In fact, European equity benchmarks have a larger exposure to global sales than US companies, which tend to be more domestically focused, and our funds tend to have even more exposure to global revenues than our indices.

Europe is one of the world’s most important economic regions and is home to many leading global companies, and we believe that European equities warrant their place in any well-diversified investment portfolio.

Please note: Company examples are for illustrative purposes only and are not a recommendation to buy or sell.