Investors in European stocks likely all have the same New Year’s resolution: figuring out how to navigate what promises to be 12 months of heightened economic and geopolitical uncertainty. One tactic is to focus on companies that have a proven track record of stable earnings growth in all market environments, but what may be surprising is where investors can find these ” regular compounders”.
Uncertainty about global economic policy is currently high, which is understandable given the many political changes and economic surprises that have occurred over the past year.
This lack of clarity is particularly evident in Europe.
Germany, Europe’s largest economy, is set to hold early elections amid slowing growth. The competing parties have very different views and projects on the country’s “debt brake”, an amendment to the balanced budget adopted in 2009 which helped prevent excessive accumulation of debt, but which has arguably hampered public investment and growth. This disagreement makes the outlook for fiscal policy very murky.
Meanwhile, France is struggling to adopt a budget. The legislature is roughly evenly divided between left- and right-wing parties that are willing to increase deficits to pay for political promises and a centrist bloc that seeks to reduce deficits to stay within the limits set by the European Union Pact. stability and growth.
At the same time, it is unclear whether China, one of the European Union’s main trading partners, has found the right mix of policies to revive economic growth.
Added to all this is the return of Donald Trump to the White House. If he follows through on his threats to impose significant tariffs on goods imported from China, the EU and other countries, global trade uncertainty could skyrocket, as it did in 2018 in response to its previous wave of tariffs.
“Regular compounders”
How should European fund managers consider investing in such an environment? One option is to focus on compounders regulars, i.e. companies that have demonstrated stable profit growth, whether economic conditions are good or bad.
It is generally considered that the compounders Regulars belong to defensive sectors such as food and beverages or pharmaceuticals. But if we look at stocks with earnings growth volatility in the bottom 20% of the Stoxx Europe 600 index, using annual data for the past 20 years, it becomes clear that companies with a stable composition constitute a much more diverse group.
The largest sector in this basket is industrials, which is not commonly perceived as defensive. There are also companies in cyclical sectors such as technology, media and construction. Indeed, more than 40% of the companies in the basket belong to sectors generally perceived as cyclical.
It may come as a surprise, but many companies in cyclical sectors such as manufacturing and technology today have business models that create remarkably stable revenue streams. Just think of subscription-based IT services (SaaS, cloud computing, etc.) or industrial services such as consulting. Another industrial segment that stands out, especially in the current context of high geopolitical risk, is the defense industry.
Outperformance
In times of increased uncertainty, earnings stability is a sought-after characteristic that is often rewarded with strong stock price performance. It is therefore not surprising that the compounders have outperformed the Stoxx Europe index when uncertainty peaked over the past 20 years.
Take the example of Donald Trump’s first term. During these four years, the funds composed of compounders European regulars outperformed the Stoxx Europe index at an annual rate of 6.9%. If we exclude the 2020 pandemic, the outperformance rises slightly to 7.2%.
This outperformance was also seen during other periods where measures of uncertainty surrounding trade, economic policy, and geopolitics were in the top 25% of their respective historical ranges. These include the period 2002-2003, marked by the rise of global terrorism and the outbreak of the Iraq War, and the years following the pandemic, marked by supply chain disruptions, the outbreak of a war between Russia and Ukraine and growing trade frictions between China, the United States and Europe.
Of course, caution should be exercised when extrapolating past performance into the future, especially considering the magnitude of differences between historical periods. For example, Mr. Trump’s first term was mostly marked by very low interest rates, low inflation and steady economic growth, which is not the case today.
Nonetheless, it is reasonable to assume that companies that have managed uncertainty in the past – largely through an above-average reliance on recurring revenue – will also be resilient to future shocks. Their stock prices should reflect this through consistent performance, which could prove very helpful if the current uncertainty translates into choppier markets in the year ahead.
(The opinions expressed here on behalf of Reuters are those of the author, an investment strategist at Panmure Liberum, the UK’s largest independent investment bank).
