Despite underperformance for much of the past decade, UK investors should stop ignoring Europe particularly when looking for income, according to Olly Russ, manager of the Liontrust European Income fund. 
There have been many challenges for European markets in recent years, with the decision by the UK to exit the EU the latest in a series of crises affecting the economies of the eurozone.
Indeed, the MSCI Europe ex UK index has underperformed the best performing market over the last decade – the S&P 500 – by an eye watering 124.88 percentage points (almost three times).
Performance of indices over 10yrs
Source: FE Analytics
Russ said: “If you look at the earnings of Europe versus the US, Europe amazingly has gone nowhere for more than 10 years - they’re still roughly 33 per cent below the all-time peak levels in 2007. The US has gone on to all-time earnings highs.
“They used to be well-correlated. They both go into the financial crisis simultaneously and start to recover and then Europe hits the eurozone crisis and they go in two fundamentally different directions and that’s reflected in market returns.”
As a result, the overwhelming reaction he has got from US investors looking at Europe is that it is structurally broken. However, there are a number of reasons to buy the region, the manager says.
Firstly, earnings are beginning to pick-up in Europe while valuations remain low particularly in comparison to the US, explains Russ.
“Not only are the US on arguably peak earnings but they are also on peak valuations and Europe has underperformed but it is also relatively undervalued on those depressed earnings. So there are two chances if you like for mean reversion here,” the manager said.
Secondly, European exposure helps provide diversification, particularly in an increasingly uncertain market environment.
He said: “If you invest in a European fund of course you diversify through currency predominantly but also sector – there are certain sectors in Europe that don’t get a lot of exposure to the UK –fish farming for example – but also individual stocks.”
At a stock level, a number of the UK equity income funds hold the same stocks. Russ says 93 per cent of UK income funds own GlaxoSmithKline while 84 per cent own HSBC, with 10 companies owned by more than 60 per cent of the sector.
“The point being that of course UK equities income is all very well and good but as you add more to your portfolio for the purposes of diversification you can’t help ultimately doubling up some of these underlying holdings,” the manager said.
On a more structural level, investors are becoming more desperate for yield, with a rising population of retirees coming through, and this presents an opportunity for income managers in the asset class.
Russ said: “There is going to be more retirees but what’s perhaps not quite factored in is how much longer those retirees are going to live.
“So if you’re retiring at 62 it’s entirely possible that your retiring period is longer than your working career and it’s going to be difficult to fund that on French government bonds yielding 1 or 2 per cent.”
Meanwhile, he says Europe has a lot of free cash flow and has on returning that cash back to shareholder through buybacks, dividends and special dividends.
What’s more, for overseas investors, is that Europeans do not tend to use income as a strategy themselves, with only 10 equity income funds in Europe compared to nearly 100 in the UK.
“Parts of Europe yield more than the UK, some yield less but in aggregate they are almost exactly the same. I’m not trying to force Europe to do anything it can’t naturally do – it is a good hunting ground for yield,” he said.
“On a global basis, the UK is probably the best market for yield in the world still followed very closely though by the eurozone and the interesting one is the US which is now yielding less than Japan.
“If you did a scan of every yielding country in the UK and then in Europe, what you’ll find is there is about 150 names in the UK – it is the biggest single market for yield.
“However, there is almost three times as many out in continental Europe then there is in the UK so you have a deeper pool to fish in.
“On the other hand the number of funds chasing that - approximately in the UK there are less than 100 funds but there’s about 10 European equity income funds – so few in fact that we don’t have our own sector so all the income funds are locked into the alpha sector.”
In his fund, which currently yields 3.88 per cent and has returned 69.22 per cent to investors over the last 10 years, he focuses on three main areas to provide yield – value, growth and special situations.
Performance of fund over 10yrs
Source: FE Analytics
Russ classes value stocks as consistent high yielders with substantial free cash flows to which the market is currently unwilling to accord a high multiple.
An example of this is Terna – the Italian equivalent of the National Grid in the UK, which Russ says is probably his “all-time favourite stock”.
“You now know everything there is to know about Terna because even its manager would say it is the dullest company in Europe,” he said.
“It is both Italian and a utility – neither of which have been passports for stock market success. It has done very well over the last few years and it does that by returning every spare cent in can to shareholders.”
While it may be boring, the company has maintained a yield of roughly five per cent every year since Russ bought it a decade ago and is still yielding close to 5 per cent today.
Moving onto growth, which the manager describes as fast-growing companies which require little or no capital to finance their continued growth – leaving earnings to be paid out to shareholders.
“A slightly more exciting story here is Drillsch Telecom which is a mobile virtual network operator,” Russ said.
“There are two ways you can run a telco – you can be like Vodafone – build the infrastructure, build the towers and maintain the network – or you can do what Drillisch does which is buy wholesale [infrastructure licenses] from people like Deutsche Telekom and then resell them on to individual companies.”
He said the company focuses on the lower end of the market where customers are more likely to constantly look to switch to more competitive prices.
“It operates 19 different brands in Germany so when people churn from one to another they don’t realise they are switching from Drillsch brand to another,” he said.
The final area is special situations, which are those companies with unlevered balance sheets, large cash balances, and the scope to pay or significantly enhance their dividend.
His example of this is Swedbank, which as a European bank has suffered from the poor sentiment towards the sector.
Over the last 10 years the sector has lost 34.99 per cent, as the below graph shows, yet Swedbank’s share price is at an all-time high.
Performance of index over 10yrs
Source: FE Analytics
“The lifeblood of a bank is its capital and the thing about Scandinavian banks – pretty much all of them – is that they are now overcapitalised,” the Liontrust manager said.
“As a result – and a pretty rare feat amongst banks these days - I think they are at all-time highs in terms of share price returns. So they are actually well above where we were pre-crisis.”
More impressively is that despite that market performance it’s still yielding roughly 5 per cent, Russ says, which comes from it being a very stable bank.
He added: “They got rid of all their rescue divisions, they freed up capital and now they find themselves the best capitalised bank in Europe and the share price has been rewarded.”