Investors in European stocks seems to breathe a sigh of relief. After many quarters in which the only thing they have seen were downward revisions in profit estimates, this earnings season seems to be positive. At the moment 15% of the European market capitalization, about 115 companies, has publishede, and this is on track to be the best results season in eight years. Net Income point to a 20% growth in the first quarter, compared to the previous year. The downward trend of the last eight years seems to be reversed.
The European investor has been clinging to the “value” argument as a last resort for many years. Anyone has heard it several times. “Europe is very cheap” … and disappointment ensued.
This “valuation” argument, repeated over and over again, hid the fundamental difference between the European stock market, plagued by low-growth and low-return-high-debt conglomerates, without a strong shareholder remuneration policy, compared to the opposite in the US. While in the United States, companies were posting single-to-double-digit earnings growth, increasing dividends and share buybacks in the face of excess liquidity, Europe continued with no growth, dividends paid with shares and more debt.
The interesting thing is that the consensus, for the first time in years, is revising upwards its earnings estimates
But that is changing. The average debt of the European stock market has not fallen much, that is true, but that is due to the disproportionate weight of banks and energy. What is interesting is that consensus, for the first time in years, is revising upwards its estimates, even if it is a meager 1%, but in the past fourteen years, the average downward revision of estimates in the first three months of the year was 5%.
However, markets have reacted cautiously. The positive reaction to good results has been on average an outperformance of 1% to the broad market, while poor results have been penalized with a 5% underperformance. This shows the level of caution from investors, who see companies still very timid in their guidance and outlook. Indeed, Eurostoxx 600 companies’ guidance for annual profits has not improved significantly.
We should not forget that a very important part of the positive surprise of the earnings season comes from the so-called base effect. What does that mean? That a large part of the earnings increase comes from the comparison with abnormally weak periods. In the energy sector earnings beats have come from commodity prices, while in Financial, lower provisions and a slight increase in inflation explain 90% of the positive surprise.
Investors’ caution is justified because, despite improved estimates, neither margins nor cash generation are improving significantly.
It is not clear that we are facing the end of the earnings recession we discussed here, but a base-effect rebound. In any case, this rebound may justify a floor to valuations. At least a scenario of steady downgrades in estimates seems to have been almost ruled out.
Investor caution is justified because margins are not increasing significantly
The great challenges of the large European stocks remain. Overcapacity has not been reduced – it has increased in the industrial sector in particular – and low margins and high indebtedness continue to weigh on multinationals’ multiples. Many of them are still in the process of digesting the binge of high-priced acquisitions made between 2004 and 2007. To this, we must add the eternal soap-opera of political risks and the increase in tax burden.
We cannot say that the earnings recession has ended, but it is worth noting that it seems that the European companies are beginning to breathe.
Daniel Lacalle is a PhD in Economics and author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)
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