The Case for Investing in European Equities

October 2013
This document is intended for institutional investors and investment professionals only and should not be distributed to or relied upon by retail clients.

The Case for Investing in European Equities

The investment backdrop

As concerns about pan-European economic growth and structural strains on the Eurozone continue to dominate headlines, it is understandable why many investors are sceptical about the return prospects on offer from listed Europe. However, the economic challenges facing the Euro-zone need not necessarily translate into a negative view on European stocks. The regions equity markets are not an exclusive play on the domestic European economy, but offer real breadth, in both geographical exposure and product diversification terms. There are many worldclass businesses in Europe with the potential for good long-term returns and which are trading at relatively attractive valuations. The problems dominating headlines are overshadowing the real attractions of investing in European equities: access to world-beating companies with very strong franchises in

businesses ranging from engineering to luxury goods. Europes stock universe includes many companies that are global leaders with a proven ability to withstand macroeconomic headwinds. Such companies are well diversified across geographies and product lines and continue to report strong earnings growth. They are underpinned by solid balance sheets and many offer healthy, and growing, dividend streams. However, on most valuation metrics, they are trading at significant discounts to their counterparts in other global markets because of wider Euro-zone issues. Our analysis shows that a large number of European stocks have enjoyed significant capital appreciation upside in the last six years. Given the structural growth potential of numerous European businesses, many of which enjoy market leading positions on the global stage, we see no reason why this positive trend will not continue.

Chart 1: Many European stocks have enjoyed strong price gains in recent years
700 600 Absolute % total return performance 500 400 300 200 100 0 (100) (200) MSCI Europe constituents: absolute total return performance 1 January 2006 - 30 September 2013 Source: Thomson Reuters Datastream as at 30 September 2013

1 The case for investing in European equities

The perils of a macro mindset

The macroeconomic concerns that have been driving most global stock markets have resulted in an extreme risk-on/risk-off mindset with associated market volatility. For those focused on stock fundamentals and a reasonable time horizon beyond the latest official pronouncement, this can create excellent buying opportunities. We would argue that in an environment in which a greater proportion of market participants are overlooking stock specifics in favour of macroeconomic and sentiment drivers, the potential returns available to bottom-up stock pickers should be enhanced. While there may be periods of volatility when stock specifics do not appear to matter, when companies do deliver on the underlying investment case, such stocks will perform strongly.

ratings reflect their robust fundamentals, underpinned by strong balance sheets and very healthy cashflow generation. However, macro concerns have led to indiscriminate attitudes, with investors focusing more on where companies are domiciled rather than paying sufficient attention to the strength of the underlying businesses. This offers scope for discerning investors to buy into potentially well-run and growing businesses at attractive valuations.

The valuation gap

The structural, and presently underappreciated, attractions of European equity markets are further supported by several valuation metrics which show that Europe is trading at a discount to several other global markets, including the US. The sharp rally in core government bonds further strengthens the valuation case for European equities. Overall, European stock markets currently offer a dividend yield of 3.4%* (higher than that on offer from other developed equity markets) at a time when core government bonds are yielding around 2.5%. More surprisingly still, several high-quality European stocks are offering a stronger yield on their equities than on their corporate debt (notable examples include BMW, Philips and Siemens).
*Yield data: Dividend yield on FTSE Europe ex-UK Index - 3.4% as at 30/09/2013. Yield on 10-year US Treasuries - 2.6% as at 30/09/2013. Dividend yield on MSCI World Index - 2.6% as at 30/09/2013. Source: Bloomberg as at 30/09/2013.

Insufficient discrimination opens up stock-picking opportunities

Many listed European companies have shown an ability to withstand broader macroeconomic headwinds and to thrive in the current challenging environment. Many of these companies are not constrained to operating in their domestic economies and generate a significant proportion of their revenues and profits from outside the Euro-zone. Such companies credit profiles are often much stronger than those of the governments of their home market. These stronger

Chart 2: European stocks on a price/earnings basis

35 30 25 20 15 10 5 0

1988-91 Price/earnings ratios: Europe ex UK

1992-95 USA World

1996-99 UK

2000-03 EMG

2004-07

2008-12

2012-3

Source: Thomson Reuters Datastream as at 30 September 2013

The case for investing in European equities 2

Chart 3: The dividend yield on offer from European stocks further supports the valuation case
8 7 6 5 4 3 2 1 0 1988-91 1992-95 1996-99 2000-03 2004-07 2008-11 2012-13

Historic Dividend yields: Europe ex UK USA World UK EMG Source: Thomson Reuters Datastream as at 30 September 2013

Identifying the opportunity set

Sustainable long-term returns are primarily generated through investment in companies with leading market positions, strong financial fundamentals and a diversified customer base, in which we can establish an attractive entry point. Continental Europe offers investors exposure to just such a unique opportunity set, being home to a disproportionate number of the worlds market leaders in a wide range of sectors as varied as pharmaceuticals, engineering and luxury goods. Over many years, European companies have created a strong brand presence right around the world through their superior products and innovation. For these companies, their domestic markets (and indeed Continental Europe as a whole) represent only a relatively minor part of their total earnings and their future growth potential.

Value on offer from global franchises

As we have noted, many of Europes listed companies are truly global players. These companies as a whole generate about half their total revenues outside the regions borders. Consequently, many companies continue to report growing sales and strong profit margins, with some even managing to wield pricing power in the current costconscious environment. These global leaders can offer investors access to successful global franchises at discounted price levels relative to their peers listed in other domiciles. Several European exporters have invested heavily in their global distribution networks, ensuring they are particularly well positioned to benefit from opportunities to grow outside their domestic and immediate regional markets.

Chart 4: European stocks enjoy broad geographical revenue exposure

Based on MSCI Europe ex UK constituents
Europe (53.9%) North America (18.0%) Other (8.8%)* Asia Pac ex Japan (7.7%) Central & South America (4.8%) United Kingdom (2.4%) Eastern Europe (1.5%) Africa (1.1%) Japan (0.6%) Middle East (0.3%) Australasia (0.8%) India/Bangladesh/Pakistan (0.1%) * the high percentage of 'other' is a result of the way revenue is reported on individual companies accounts i.e., not all revenue is categorised on a regional basis Source: Thomson Reuters Datastream/Worldscope as at 18 October 2013

3 The case for investing in European equities

Stock examples: Nestle and BMW

Although based in Switzerland, Nestle operates a truly global business. As the worlds largest food company, Nestle products are sold worldwide. These products encompass nearly 30 so-called billionaire brands, including Nescafe and KitKat, which each generate annual sales of around CHF1 billion. Nestle consistently delivers strong results and continues to report growth in virtually all its geographic markets. Prestige German car manufacturer BMW continues to thrive in an environment in which many of its global peers are struggling. It benefits from a very strong product portfolio, including Mini and Rolls Royce vehicles in addition to BMW-branded cars. It also has well-diversified business operations, with a particularly strong presence in the US and, more recently, in China. BMW sold more than 1.6 million vehicles at record profitability margins in 2011 and is targeting a two million total by 2016, making it the worlds biggest luxury car maker.

Stock examples: GALP and Inditex

The earnings of Portuguese integrated oil and gas company GALP will be transformed by its exposure to the Santos Basin in Brazil. The company has a strong balance sheet and one of the best production profiles in the sector, yet trades at a large discount to the sum-of-its-parts. In Spain, clothes retailer Inditex (whose fashion brands include Zara, Pull & Bear and Massimo Dutti) is offsetting weak domestic demand by expansion in countries and regions with more dynamic consumption trends, like China and Eastern Europe. This has ensured that Inditex is now the largest clothes retailer in the world, with more than 6,000 stores across 86 different countries. It has also successfully introduced its online offering into a number of its markets.

Value on offer from exposure to the newest economies

Emerging markets have become an increasingly important source of revenues for corporate Europe. European companies tend to enjoy stronger exposure to such markets than many of their global counterparts. Around 25% of revenues from quoted Continental Europe stem from emerging economies, compared with, for example, the US level of around 20%. Many of the brands that emerging market consumers aspire to (ranging from champagne to luxury goods to cars) come from Europe. This greater exposure to markets experiencing secular growth should prove a key support for several European companies. Stock examples: Jeronimo Martins

Value from the strongest northern economies

It should be remembered as much as 40% of geographic Europe is not tied into the euro currency and hence enjoys a degree of insulation from the problems affecting the Euro-zone. Some of these northern European economies (notably Switzerland and Scandinavia) enjoy some of the strongest, most well-balanced growth trajectories in the developed world. Even within the Euro-zone itself, some of the stronger economies (most notably Germany) continue to grow. These resilient economies are home to a range of innovative global businesses, many of which offer compelling investment opportunities.

Value in the periphery

Even in Europes weaker peripheral economies, we continue to find significant value in attractive businesses that we believe have been overly penalised by domestic concerns but whose earnings outlooks, in fact, depend more on factors outside their home markets.

Portuguese food retailer Jeronimo Martins derives 75% of its profits from Poland, where the companys discount format is winning favour with costconscious consumers. Jeronimos good value, own brand products are helping the company rapidly increase market share beyond its current 12%. Longer-term growth will be enhanced by its recent investment in Colombia, where the demographics look particularly well-suited to discount retailing.

The case for investing in European equities 4

Value on offer from unique businesses

Europes stock universe offers investors a range of unique investment opportunities in several sector niches that are exclusively served by European companies. Some of these businesses operate in sectors where European companies enjoy a particularly strong heritage (for example, luxury goods and pharmaceuticals). Other niches in which European companies dominate are perhaps more surprising and include life science research and development and renewables/green energy. Stock examples: ASML and Grifols

consequent concerns about companies ability to sustain and grow their earnings, dividends look likely to prove an increasingly important component of the total returns on offer from equity investments. Against this backdrop, we believe Europes premium equity dividend yield should prove highly attractive. Many companies in Europe are increasing their dividends yearon-year and are committed to dividend growth policies, indicating that they remain positive on their own growth potential despite the macroeconomic pressures on the countries in which they may be listed. Stock examples: Swiss Re

ASML is a world-leading semiconductor equipment manufacturer which enjoys a very strong competitive position versus its key peers, which are mainly Japanese. As it has grown, ASML has continued to strengthen its global position and to take market share from its peers. Spanish pharmaceuticals company Grifols is one of the few businesses world-wide that provide blood proteins. The company derives 60% of its sales from North America and just 8% from Southern Europe. Grifols looks poised to benefit from its leading position in the plasma proteins market, where both pricing levels and volumes are on the rise.

Global reinsurer Swiss Re is the second largest reinsurer in the world. Although based in Switzerland, nearly half its business stems from the US. The company benefits from a very strong capital position alongside positive reinsurance market dynamics. Swiss Re has established an attractive dividend policy in the wake of extensive restructuring of its business. It is committed to a healthy (normalised) dividend of over 5%.

Value being recognised at a corporate level

Several European corporates with strong cash reserves are now pursuing revenue growth and greater market share via increasing capital expenditure. Recovering capex levels provide a supportive backdrop for the regions stock markets as does an upturn in M&A activity. Corporates outside Europe are among those recognising the value inherent in regional assets and are buying into European companies whose valuations currently discount their strong fundamentals. Examples of this trend include the 7.7 billion takeover of Germanys largest cable TV operator Kabel Deutschland by UK mobile phone group Vodafone.

Value on offer from growing dividend yields

Continental European companies have been attaching a higher priority than ever to dividends and dividend growth, to the extent that Europe offers one of the highest yields among developed markets. Many European companies provide attractive dividends and have the balance sheets that can sustain these dividends. In the current environment of weak economic growth, and

5 The case for investing in European equities

Conclusion

The depth and breadth of the European equity market, and the access it provides to leading global companies with strong balance sheets, continue to provide our European equities team with many attractive buying opportunities. The economic challenges confronting Europe should not be under-estimated. These inevitably present potential risks for companies in terms of funding availability, currency volatility, pricing power against a backdrop of economic austerity and a lack of customer confidence. However, operating

within uncertain political environments, coping with volatile currencies and rapidly adapting to sudden changes in economic and political policy is nothing new for many of Europes leading global franchises. Many Europe-based industry leaders have been successfully conducting business in global regions with extreme market disruption for many years. In our view, day-today market volatility can result in compelling opportunities to buy into selected, highly attractive European businesses.

Chart 5: Why stock picking matters: relative performance of Standard Life Investments European Winners List since inception
120 100 80 60

cumulative relative performance (%)

40 20

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

The Winners List is an equally weighted portfolio of our 20 highest conviction stocks

Source: Standard Life Investments, cumulative relative performance (%) to 30/09/2013

Visit us online

standardlifeinvestments.com

The case for investing in European equities 6

All information, opinions and estimates in this document are those of Standard Life Investments, and constitute our best judgement as of the date indicated and may be superseded by subsequent market events or other reasons. This material is for informational purposes only and does not constitute an offer to sell, or solicitation of an offer to purchase any security, nor does it constitute investment advice or an endorsement with respect to any investment vehicle. Any offer of securities may be made only by means of a formal confidential private offering memorandum. This material serves to provide general information and is not meant to be legal or tax advice for any particular investor, which can only be provided by qualified tax and legal counsel. This material is confidential and is not to be reproduced in whole or in part without the prior written consent of Standard Life Investments. Any data contained herein which is attributed to a third party (Third Party Data) is the property of (a) third party supplier(s) (the Owner) and is licensed for use by Standard Life**. Third Party Data may not be copied or distributed. Third Party Data is provided as is and is not warranted to be accurate, complete or timely. To the extent permitted by applicable law, none of the Owner, Standard Life** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates. **Standard Life means the relevant member of the Standard Life group, being Standard Life plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time.
Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL and is authorized and regulated by the Financial Conduct Authority. Standard Life Investments (Hong Kong) Limited is licensed with and regulated by the Securities and Futures Commission in Hong Kong and is a wholly-owned subsidiary of Standard Life Investments Limited. Standard Life Investments Limited (ABN 36 142 665 227) is incorporated in Scotland (No. SC123321) and is exempt from the requirement to hold an Australian financial services license under paragraph 911A(2)(l) of the Corporations Act 2001 (Cth) (the Act) in respect of the provision of financial services as defined in Schedule A of the relief instrument no.10/0264 dated 9 April 2010 issued to Standard Life Investments Limited by the Australian Securities and Investments Commission. These financial services are provided only to wholesale clients as defined in subsection 761G(7) of the Act. Standard Life Investments Limited is regulated in the United Kingdom by the Financial Services Authority under the laws of the United Kingdom, which differ from Australian laws. Standard Life Investments Limited is registered in Ireland (904256) 90 St Stephens Green Dublin 2 and is regulated in the UK by the Financial Services Authority. Standard Life Investments (USA) Limited is registered as an Investment Adviser with the US Securities and Exchange Commission. Standard Life Investments (Corporate Funds) Limited is registered as an Investment Adviser with the US Securities and Exchange Commission and is regulated in the UK by the Financial Services Authority. Standard Life Investments Inc., with offices in Calgary, Montral and Toronto, is a wholly owned subsidiary of Standard Life Investments Limited. www.standardlifeinvestments.com 2013 Standard Life, images reproduced under license INVBGEN_12_0739_CASE FOR INVESTING IN EUROPEAN EQUITIES_WHITE_PAPER_TCM 1113