Europe changes gear

European equity markets offer a number of attractions over other developed markets at this point in the investment cycle; not least of these is the robust condition of the consumer balance sheet.

Over the past decade, cultural factors have led European households to be much more prudent than either their US or UK counterparts. While the average German has been saving around 12% of their salary each year, the average American has been spending in excess of what they earn each year. Other recent estimates suggest that the level of credit card debt in the UK is now equivalent to that of the whole of Western Europe combined! This has left European households in a much stronger position than their counterparts in other western markets.

The sovereign debt crisis has brought Europe, and the Eurozone in particular, into the financial headlines, although it is certainly not just a European phenomenon. Whilst the peripheral European countries like Greece and Spain are going to have to take painful steps to reduce their fiscal deficits, it is worth remembering the economic strength, often export-led, of countries like Germany, Switzerland, the Netherlands, Sweden and Norway.

Another attraction is that, unlike their peers in the US, many European large caps benefit from a far greater diversity in their revenue streams. This is because, faced with limited growth opportunities at home, European companies have spent the past 20 years or more expanding into growing overseas markets.

The result is a new breed of blue chip, large cap stocks which compete on a global platform but which offer far more geographically diversified revenues. Consequently, risks are spread over a far wider number of regions, resulting in a more stable, sustainable earnings profile. This is evidenced by the fact that Europe now broadly exports as much to the BRIC economies (Brazil, Russia, India and China) as it does to the US while Central and Eastern Europe also account for a similar slice of the export pie.

Whilst Europe and the Eurozone in particular are at the centre of the sovereign debt crisis, and the euro has weakened, there are a number of exporters who have materially benefited from this weakness in the currency. So whatever is happening in Europe or elsewhere, there will always be significant investment opportunities, as Europe's contains some of the world's best companies, stoking the furnace of world growth with their intellectual, financial and physical capital.

Meanwhile, European equity valuations look genuinely compelling, with many companies offering dividend yields greater than their PE ratios. In many cases there is an excellent buying opportunity for companies with strong balance sheets and sustainable cash flows.

This trend looks set to continue which is excellent news for European investors as currency strength should help to curtail inflation while a strong and stable currency helps ensure that investor wealth is protected during periods of market turbulence.

Meanwhile, European equity valuations have rarely looked so compelling. Dividend yields in particular stand out with areas such as the European telecom sector now offering significantly better yields than those available on German bunds. This represents an excellent buying opportunity for companies with strong balance sheets and sustainable cash flows.

Although Europe may not yet be regarded as a traditional source for high levels of equity income, this is likely to change. The income universe in Europe has a great number of diverse companies to choose from. As at 1st July 2010 there were 430 companies in continental Europe yielding more than 3% with a market cap greater than €500m. This compares to 100 in the UK¹. There is also a good breadth of industries to choose from - in the top 20 companies by market cap there is no one sector/industry comprising more than 20% by market value ².

Elsewhere, social and cultural changes within Europe's shareholder base also continue to exert a strong influence on the level of European dividends. A key factor is that Europe's population is now one of the oldest on earth.

By 2015 it is estimated that one in three Europeans will be over 65 years of age and with an ever greater proportion in retirement, life expectancy continuing to rise and interest rates still declining, there is huge investor demand at a grass roots level for income generating investments in Europe.

Another cultural change has taken place within European companies themselves. European company management are increasingly becoming shareholders in their own right and this has helped to foster the continued development of a European dividend culture.

It's important not to focus just on those companies that offer a high level of dividend yield as a high dividend yield can be an indication of a company that is experiencing difficulties. The trick is to focus on those companies that not only offer a high dividend yield, but can sustain that dividend in difficult circumstances.

Empirical evidence points to the past success of income investing in Europe. According to Morgan Stanley in Europe in the long run, reinvested dividends boost equity returns by over 4% per annum³. The real return after inflation from 1926-2009 was 5.6% (dividends reinvested) versus 1.3% (not reinvested). To put that into perspective £100 invested in 1926 would have turned into just £292 if you did not reinvest dividends. With dividends reinvested that £100 would have turned into £9,207.

In point of fact, there are few peers for Europe's most committed high-yield stocks. Leading names here include the oil major Total, which has a strong record of raising its dividends in recent years along with the likes of the food giant Nestle and major utility businesses such as E.on, the German power company.

The Newton European Higher Income Fund employs the same sort of strict yield criteria as the flagship Newton Higher Income Fund. The latter celebrated its 23rd birthday at the start of June this year and throughout its long life it has consistently offered one of the very highest levels of income for a fund of its type. It's partly this consistency of approach and objective that has helped the Newton Higher Income Fund to grow well past £2 billion in size today⁴.

By applying Newton's thematic approach alongside its yield discipline, the Newton European Higher Income Fund offers many UK investors a genuine opportunity to diversify their income portfolios right across European markets. Within the space there is a genuine paucity of European income funds. Like in the UK, many funds are happy to masquerade as 'income' players, especially when the label is in fashion, but really these funds do not follow specific investment processes adhering to yield criteria. It also offers those with existing European equity holdings the opportunity to reduce the investment risk in their portfolios as equity income investment generally has tended to be far more defensive in nature than investing purely for growth.

The Fund's approach leads to companies that are thematically attractive, have sound fundamentals and which offer a substantial yield. As a result, the portfolio contains a concentration of stocks with high free cashflow yields, higher returns on equity, higher levels of potential earnings growth and lower P/Es than those of the broader market. In essence, the Fund sets out to offer income investors a genuine opportunity to benefit from the best yielding stock opportunities in markets across Europe.

With European investors now faced with such significant headwinds and interest rates in the western world still at historic lows, such yield discipline will be highly attractive from here.

^*It should be noted that a steady and rising income received from an investment is what really matters with the opportunity to grow capital over the long term. Therefore, steadily growing dividend payouts, rather than the current yield, may serve as a better indicator of the actual health of the underlying investment. When considering the net current yields or historic yields on a fund it is important to understand how they are calculated. They are calculated on the basis of dividing the last 12 months' dividends by the current share price. Due to the calculation method, at times yields may be high and rising as a result of a falling share price, i.e. capital depreciation on your assets, and not a rising dividend. Please remember that dividend income is not guaranteed and may fall as well as rise due to stock and currency movements.

¹Source: Datastream, July 2010.
²Source: Dresdner Kleinwort, Dec 2007. Past performance is not a guide to future performance.
³Source: Morgan Stanley, March 2010.
⁴Source:Newton. Fund size £2.75 bn as at 30 September 2010.