Amid the political uncertainty in Europe prompted by upcoming elections and the start of Brexit negotiations, another story is quietly playing out, involving improved economic and corporate conditions. Here, Philippe Brugere-Trelat and Katrina Dudley of Franklin Mutual Series explain how they’re cutting through the political noise to uncover potential opportunities in European equities. They take a fresh look at two areas in particular that have been prominent in the financial news of late: UK-listed stocks and European financials.

We believe the economic and financial backdrop for European stocks has improved and the region is better able to weather unexpected shocks than in recent years. Although recent history shows there is reason to be skeptical of political polls, we do not believe populist parties will score victories significant enough in national elections to cause an existential threat to the European Union (EU). If elections play out as polls suggest, and if the United Kingdom and the EU can begin constructive Brexit negotiations, we believe pent up corporate demand and relief among investors could lead to strong economic and financial market performances across Europe.

On balance, we maintain a positive outlook for European equities, but we feel selectivity is crucial. Our bottom-up stockpicking process focuses on buying good companies trading at discounts to their intrinsic values based on fundamental analysis (e.g., price-to-cash-flow multiples or sum-of-the-parts analysis). Macroeconomic conditions and political events may affect an individual company’s valuation, but we do not make top-down sector or geographic positioning decisions based on an expected event outcome.

Based on our fundamental analysis, we believe conditions have begun to turn more favorable for European stocks, especially value stocks and companies in cyclical industries. Comparing the S&P 500 to the MSCI Europe Index, European stocks are significantly less expensive than US stocks on a number of metrics, including price-to-book (P/B) and price-to-cash-flow; the recent outperformance of US stocks relative to European stocks has made valuations even more attractive, in our view.1

Stronger economic growth in Europe and the positive turn in inflation are good news for profit margins and should enable companies to regain some pricing power in our view. At similar stages of the economic cycle in the past, we have found that companies in economically sensitive industries, such as automotive, construction and industrials, have generally fared well, and are attractively priced relative to their historical averages. On the other hand, our analysis of companies based on a combination of factors, including price-to-earnings (P/E), P/B and dividend yields, shows that areas of the equity market considered defensive or lower volatility (e.g., consumer staples) are trading at historically elevated levels.

Any rise in interest rates and steepening in yield curves are also likely positive for financials but for “bond proxy” stocks, such as staples and utilities. Within the financials sector, we have found a greater number of potentially attractive opportunities in the region’s insurance industry, which we regard as being in relatively better financial shape and operating in a more stable regulatory environment than banks.

In addition, a number of insurance companies are working through restructurings of their business, including the monetization of non-core assets, in order to seek to improve their operational performance.

We are of the view that, generally, banks in Europe are still challenged by issues of asset quality (non-performing loans) and insufficient capital levels. In addition, the negative interest-rate policy of the European Central Bank (ECB) has adversely impacted banks’ net interest margins and profitability. However, not all banks in the region are unattractive to us and we continue to see opportunities in French and UK banks that offer relatively solid balance sheets, are well-leveraged to a resumption of credit growth and have exposure to parts of the world other than Europe, namely the United States or Asia.