As the investing public searches for signs of what the post-pandemic landscape will look like, a growing number of institutions believe battered, unloved value stocks could be candidates to bounce off the bottom and displace overvalued momentum companies as market leaders. Some of these same investors think that value may reside in an unlikely place—continental Europe.

The Continent’s equity markets possess many characteristics of a classic value play. Mature industries, reasonable valuations and slow growth are anything but sexy, particularly when contrasted against America’s vibrant technology companies. Between the end of the Great Recession and July 2020, the S&P 500 outperformed the MSCI ex-U.K. European index by more than 160%.

Europe’s management of the pandemic has been far from perfect, but advocates of investing there see that economy extricating itself from lockdown faster than the United States. Moreover, its equity markets offer “more exposure to early cycle businesses for the next two years,” observes Gabriela Santos, global market strategist at JP Morgan Asset Management.

One consequence of the epidemic is that some growth companies have been temporarily transformed into bargains. Santos cites the luxury goods industry, where many of the “biggest, most competitive companies” are European and well-positioned for an emerging markets recovery.

Simply because a company is domiciled in one nation doesn’t mean that’s where it does business. Santos notes that many global European businesses derive more of their revenues from abroad than their U.S. rivals.

When American investors think of Europe, they often think of sclerotic economies with aging populations like those in Spain and Italy, she adds. But northern European nations’ economies are tilted toward businesses that can compete globally. “Europe isn’t going to grow faster than the U.S.,” Santos explains. But some of their health-care companies offer a play on their demographic profile while allowing investors to “indirectly participate” in the growth of Asia.

A Real Game Changer
A recent development she finds particularly encouraging is the new willingness of the wealthy European nations to raise a 750 billion euro stimulus package to address problems created by the pandemic. It is the first time these nations have contributed more to a fund than they will receive. “The recovery fund is a true game changer,” she says.

European equities are the second largest overweight sector in BlackRock’s Global Allocation Fund. However, its manager, Russ Koesterich, argues it is important for investors to “differentiate between value and growth.” Like America, the Continent is home to a number of cyclical companies that “are secularly impaired.”

Koesterich fears that some European cyclical stocks that have run up in prices could be vulnerable if a second wave of the pandemic appears or if other factors cause the recovery to stall out. Energy businesses, parts of the European financial sector and expensive consumer staples stocks favored by “bond-market refugees” are among sectors he is wary of.

“We’re looking for cyclical exposure without sacrificing earnings consistency,” Koesterich says. Industries he likes include machinery, specialty chemicals and semiconductor companies likely to participate in the early stages of a turnaround.

An Overlooked Service Tech Sector
Some European markets are heavily weighted toward financial, industrial and materials companies, but Steve Gorham of the MFS International Large Cap Value fund believes many investors are overlooking stable service businesses with recurring revenues. Investors won’t find high-tech giants like Amazon and Apple, but there are a number of service businesses helping European businesses accelerate their operations in an increasingly digital world. Gorham’s fund has about 12% of its assets in European tech companies, while the MSCI EAFE Index has an allocation of only 8.5%.

Along similar lines, Todd Morris and Dan Fields of the Polen International Growth Fund are structuring a portfolio that they argue is at once defensive and poised to participate in a recovery. Analysts would describe their strategy as one adhering to the high-quality factor, investing in companies with strong returns on assets, low debt levels and predictable cash flow.

Polen’s international holdings include Ireland-based Accenture, a permanent in-house consultant for global multinationals that helps them transition to a digital world. Morris notes that 98% of the company’s clients have used it for more than 10 years. Other observers have noted that more than half of Accenture’s clients don’t put their contracts up for bidding when they are renewed.

German enterprise software giant SAP is another Polen holding. Many European businesses are a few years behind American companies in moving their operations to the cloud and, as a result, this high-growth revenue stream could have a long runway for SAP.

Another Ireland-based company that Polen favors is Icon plc, one of the world’s largest contract researchers for the pharmaceutical industry. Icon’s business, which includes assisting drug companies through various phases of drug approval, is growing at double digits, Fields says.

A Most Unloved Sector
Few European sectors are more controversial among professional investors than banking. Virtually the entire yield curve in many countries is in negative territory, loan demand is weak and many banks failed to recapitalize after the Great Recession.

Many banks on the Continent have suspended dividends, either voluntarily or at regulators’ demand. MFS’s Gorham sees that as beneficial for European economies but not shareholders in its banks. Polen doesn’t invest in banks on principle, while BlackRock’s Koesterich avoids them because of their current fundamentals.

For the bold investor who likes cheap stocks, Europe’s troubled banks offer selective opportunities. That’s the view of Causeway’s fundamental portfolio manager Alessandro Valentini, who argues that the current “short-term pain is being priced in indefinitely.”

Markets are handicapping certain banks twice—first because of where they reside and second because they are banks. “This crisis is not a financial crisis,” Valentini says. Several institutions are in far better shape than others and have jettisoned low-return operations.

New management at Italy’s second-largest bank, UniCredit, has raised capital and restructured the bank while dumping non-performing loans. Valentini says this has reduced its cost of equity. “Their loan losses are manageable,” he maintains. “They have built excess capital [and] suspended dividends. Even if interest rates stay low, they can return enormous amounts of capital to investors.”

Another European company Valentini likes is aerospace giant Airbus, which shares a duopoly with Boeing. Both businesses are experiencing serious postponements and outright cancellations of orders for new jets.

But Airbus looks poised to benefit from Boeing’s self-inflicted wounds arising from its troubled 737 Max airplane. Furthermore, Valentini believes Airbus’s jets are more efficient in energy usage and other metrics.

Europe’s recovery from Covid won’t be linear. Some nations like France are experiencing setbacks on the road to reopening. The huge debt and demographic challenges faced by some nations on the Continent rival Japan’s and dwarf America’s. But as JP Morgan’s Santos observes, the nature of Europe’s industrial base, combined with valuations, make a compelling case for investors worried about pricey U.S. equities.