Five years ago today, European Central Bank (ECB) chief Mario Draghi changed the course of the eurozone with just three words: his now famous ‘whatever it takes’ declaration. It was the moment bond markets started to anticipate some form of monetary easing from the ECB. This had the effect of compressing European yields, which eventually translated into lower financing costs for European corporates. 
Against this backdrop of unconditional accommodative central bank policy, the renaissance of beleaguered European equities could gradually begin.
Between 2012 and 2016, European companies generally went through an earnings bear market. Every January, the year ahead was touted as the year European earnings would recover, but each year these expectations were gradually downgraded. This was largely due to the weakening European economic environment – which persisted due to high unemployment, excess capacity and deleveraging of balance sheets.
Period of restructuring
Faced with revenue pressure on the top line of the profit & loss (P&L) account, while rising input costs further depressed gross profits, companies had no choice but to attack the only area of the P&L directly under control – general expenses and overheads.
Companies restructured cost bases over the course of this period, in particular reducing fixed costs, allowing for lower breakeven levels and therefore a greater margin of safety through the downturn. For many companies, this was just a case of ‘running to stand still’. In the face of declining revenues, the more ambitious companies seized the opportunity to diversify sales into new regions and weeded-out less profitable or loss-making product lines. This allowed some companies to slow or even reverse sales declines and defend margins.
Turning point for European corporates
Earlier this year, we saw corporate Europe reach a turning point: all four major lines in the collective P&L account are now in an upturn. Top-line growth, long absent in the eurozone, is beginning to gather momentum – due to gradually rising employment, lower energy costs and improving consumer confidence. Gross margins have been boosted by lower input costs and efficiency gains have helped operating margins weather the storms rolling over the Eurozone since the onset of the global financial crisis. Higher demand is seeing operational gearing come to the fore, aided by the lubrication of QE and a competitive euro.
Gradually easing fiscal conditions and low financing costs complete this picture. Europe is now at the start of a positive trend for profit growth, with a strong likelihood of higher operating and net profit margins in this earnings cycle than what we have seen in previous upturns.
Investors return to the region
We are now seeing investor interest in Europe again, as some of the perceived political risk has dissipated post French and Dutch elections. We continue to urge investors to focus more on what is happening on the ground, and, on that front, things are looking promising.
European stocks might not be in the bargain basement any longer, but what makes Europe a source of exciting investment opportunities is that the companies which are performing strongly have already endured eight years of economic and political turbulence.
On track for strong earnings growth
European corporates had a very strong Q1, with almost a quarter of companies in MSCI Europe beating estimates by 5 per cent or more. Europe remains on track for mid-teens earnings growth in 2017, and encouragingly sales growth has also picked up. This is particularly important given the margin potential of European companies – which have adapted, restructured and improved efficiency to cope with years of meagre growth.
Performance of MSCI Europe over 5yrs
Source: FE Analytics
Technology continues to be an exciting area with strong growth prospects. Technology permeates every stock and sector to some extent, whether it is retailers enhancing online sales channels, banks overhauling legacy IT systems or telco’s protecting themselves from cyber threats. Companies need to embrace technological change, for the productivity-enhancing catalyst it can be.
A prime example is Madrid-based Amadeus, an IT solutions provider to the travel industry. Its Altea software is enabling airlines, hoteliers and others to manage capacity, inventory and pricing more effectively. This provides a boost both to top-line revenue and reduces operating costs.
Five years ago Draghi changed everyone’s expectations with his rhetoric. His supportive position provided a backstop to markets, creating a base from which declining European equities could begin their turn around. While the positive consequences of his bold monetary move have taken time to play out, both recent company earnings and investor flows suggest that we are now starting to see the benefits come through.
Martin Todd is European equities portfolio manager at Hermes Investment Management. The views expressed above are his own and should not be taken as investment advice.