Solid economic growth and receding political risk continue to support sentiment towards European equities, despite the recent market pullback. As market conditions shift, a selective focus on companies with underestimated profitability is essential for investment success.

European equities have given back some gains but are still up 5.0% year to date in euro terms through August 28. Many investors remain bullish on the asset class, pointing to strong and better balanced growth in the euro area. Even countries like Italy that have been laggards in the past are now showing year-on-year growth (Display).

Diminishing Political Risk

Reduced political risk has also helped restore investor confidence. In France, the election of President Macron in May dispelled fears of a populist surge. In Germany, the region´s largest economy, Chancellor Merkel seems to be heading for yet another election victory in September. The results of a recent Eurobarometer survey, showing support for the euro hitting record highs in the core eurozone countries, are also encouraging.

In many ways, we share this optimism. In addition to the positive economic backdrop, European equity valuations remain attractive relative to US stocks and to bonds, even if they´re not cheap compared with their long-term history. But we also think a degree of caution is warranted. History shows that the performance of local equity markets is only weakly correlated with the local economy. And there may be early signs of some headwinds to earnings growth for European companies, such as the strength of the euro for exporters and recent data suggesting pricing power may be waning.

Resisting the Challenges

Identifying companies that can resist these challenges will be the key to generating strong return potential in a variety of environments, in our view. Thinking like a business owner rather than a short-term investor is a great way to find companies that can sustain strong or improving cash flows through their own efforts.

This approach shines a light on three types of companies that we believe are good examples of underestimated profitability in Europe today:

1. Companies Moving to Boost Margins

Profit margins at many European companies have lagged their US peers in recent years. But companies in several sectors, from retail to utilities, are taking self-help measures, such as cutting costs and expanding product ranges. The resulting improved margins should provide a boost to shareholder returns. For example, French auto supplier Faurecia has moved to structurally lower costs across its North American and European operations, and sold off underperforming businesses.

2. Companies with a Sustainable Competitive Advantage

Many European companies, including several in specialist manufacturing sectors drawing on a strong engineering tradition, have the assets and know-how to sustain growing profitability, but remain underappreciated by investors. Grifols, a Spanish company, is one of three major global blood plasma suppliers. The company’s operational scale and know-how give it an underappreciated but very sustainable competitive advantage.

3. Companies in Industries with Improving Dynamics

Buying companies when industry conditions are improving, for example after pricing competition from new entrants has calmed down, or capacity has become constrained, is often a great strategy. We find many such opportunities in industries like telecommunications and technology in Europe today. German company Siltronic has been a beneficiary of improving supply/demand dynamics in the silicon wafer industry (used to manufacture semiconductors). After years of industry oversupply, strong and growing demand for silicon wafers is now driving prices higher in what was perceived to be a poorly structured commoditized industry.

It’s important to remember that a positive macroeconomic picture doesn’t always translate into strong equity markets. By zeroing in on companies like those described above, we think investors in European stocks stand a better chance of sourcing strong and sustainable returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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