European equity valuations have become more positive on a relative basis but still aren’t cheap and a degree of caution is warranted, according to AB’s Tawhid Ali.

AAA-rated Ali, who runs the AB European Equity Portfolio alongside Andrew Birse, said there may be early signs of headwinds to earnings growth for European companies, such as the strength of exporters and waning pricing power.

‘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,’ he told Citywire Americas sister site Citywire Selector.

Ali said 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.’

With 10.63% of the portfolio allocated to industrials and 10.11% allocated to materials, Ali said companies that fall into this sector are being overlooked by investors.

‘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. In our view, the company’s operational scale and know-how give it an underappreciated but very sustainable competitive advantage.’

Positive bets

Despite the fund favouring financials, with 18.52% of the portfolio allocated here, Ali said telecoms (6.11%) are a positive bet for European investors.

‘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 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, Ali said strong and growing demand for silicon wafers is now driving prices higher in what was perceived to be a poorly-structured, commoditised industry.

‘It’s important to remember that a positive macro economic picture doesn’t always translate into strong equity markets,' he said.

'By zeroing in specialist companies, we think investors in European stocks stand a better chance of sourcing strong and sustainable returns.'

Over the three years to the end of July 2017, the AB Europe Equity Portfolio returned 17.04% in euro terms. This compares with a 8.50% rise by its Citywire-assigned benchmark, the FTSE World Europe TR EUR, over the same time period.