Over the past couple of years, we have been bullish on U.S. equities driven by attractive valuations and a slowly improving economy. This was despite the countless negative headlines which kept many investors on the sidelines during a very good time to stay invested. Using our bottom-up approach, we saw attractive investment opportunities in a number of very strong businesses with exposure to cyclically depressed (but recovering) end markets trading at low valuations.
Unfortunately, these opportunities are becoming harder to find in today's environment. In the U.S., an improving housing market is now the consensus view and valuation multiples have expanded considerably. In fact, the majority of the S&P 500 gains over the past two years have been driven by multiple expansion versus actual earnings growth. While we are still optimistic on the names held in our funds, in many cases this revaluation has forced us to reduce or outright sell positions. As we look to find replacements, many of the more attractive opportunities are popping up in Europe.
But doesn’t Europe have so many structural problems?
This is exactly the same sentiment that we heard from skeptics about the U.S. a few years ago. Had we took heed to their warnings about the presidential election, the debt ceiling debate or shadow inventory flooding the housing market, and how each was sure to cause chaos, we would have missed out on buying excellent companies at great prices.
While Europe has its challenges, it is home to many excellent businesses and in many cases some that are priced at discounts to their North American peers. With the region's housing market having been sluggish for some time, many of these companies are operating well below their potential, providing a further source of upside once the overall economy improves.
But will things ever get better?
There have been a number of signs that indicate things are getting better. European Purchasing Managers' Indexes (PMI) data has exceeded 50, spreads have been narrowing and Target II imbalances have been improving. More importantly, commentary from a wide variety of companies (automotive, consumer goods, retailers, manufacturers etc.) suggests that Europe is likely at its worst or has already passed it. I recently met with the CEO of one of the largest global paint manufacturers. His message conveyed that Europe's economy has experienced a surprise to the upside.
We have not turned to Europe because of some major macroeconomic prediction. After all, most economists are better at giving confident forecasts than being consistently accurate. We are simply looking to find quality companies at attractive prices which are performing well despite a difficult economy. That way if the economy improves, it’s a bonus. If the economy stays challenging, we still own a quality business at a good price.
Today, we are finding more of these opportunities in Europe.