It’s been a tough year for high-quality stocks in Europe. Yet despite vexing market conditions, the underlying business features that define quality stocks often remain intact. For investors, there are compelling reasons to maintain conviction in companies with robust profitability and resilient business models—even when short-term returns disappoint.
Recent European market trends have challenged investors who focus on quality. Over the past year, European value stocks outperformed growth and quality stocks by a wide margin (Display), in contrast to the previous decade when all three styles delivered similar returns.
What’s driven the value rally? First, European financials—the largest sector in the value benchmark—were buoyed by a steep yield curve, which boosted the profitability of lending activity, as regional banks also benefited from capital discipline and low valuations. Second, expectations of an increase in future defense spending across Europe lifted defense stocks, fueling strong returns for the industrials sector. While industrials are a significant cohort of the region’s quality growth stocks, defense stocks are more closely aligned with the value style.
Meanwhile, high-quality stocks have underperformed in part because many have expanded beyond Europe to accelerate growth, given their strong products and technology offerings. As a result, they tend to be more vulnerable to US tariffs and a weakening US dollar.
Now, however, we believe the stage is set for a recovery. Active investors can find select quality stocks trading at attractive discounts to cyclical growth stocks and at relatively low premiums to the broader market. To find them, you need to look beyond recent volatility and focus on long-term fundamentals.
Structural Growth Drivers Persist
Quality growth companies benefit from structural growth trends—such as digitization or automation—that are less dependent on the broader economic or market environment. When market trends turn against quality stocks, it doesn’t necessarily mean that the structural growth foundation upon which quality businesses are built has been impaired.
For example, in the specialty chemicals industry, manufacturers are increasingly outsourcing distribution to cut costs and improve efficiency. This creates an attractive growth backdrop for companies like IMCD of the Netherlands, a pure-play global specialty chemical distributor. IMCD’s exclusive long-term distribution agreements with many chemical producers positions it well in a highly fragmented market. While the company’s end markets are currently depressed, its resilient business model, solid margins and growing market share create a strong foundation to thrive in a potential industry recovery.
Beijer Ref of Sweden offers another quality model that can defy market headwinds. The company, a wholesaler of heating, ventilation and air conditioning systems, benefits from increased demand as climate change reshapes heating and cooling needs. Since more than 80% of its business comes from repair and replacement orders, Beijer Ref’s quality business model provides more visibility into growth and less exposure to economic cycles, positioning the company to capitalize on long-term growth drivers.
Structural industry growth drivers are rarely derailed by economic weakness. When stock prices and valuations in these industries detach from their underlying growth trends, we see this as a temporary anomaly. During the COVID-19 pandemic, we saw the valuations of many quality companies get ahead of their fundamentals, while this year we believe the opposite is true. Over time, market dynamics typically normalize and realign with the positive industry environment, rewarding patient investors.
Resilient Business Models Can Endure
Quality companies typically exhibit durable business features such as high and consistent profitability, competitive advantages and strong balance sheets. Strong competitive edges and high entry barriers help companies sustain growth through changing market climates. Skilled management and disciplined capital allocation are key to navigating uncertainty. Solid financial metrics, like high returns on equity and invested capital, support steady cash flow and earnings growth.
Ryanair is a case in point. The low-cost airline is expanding market share via a quality business model, based on its growing cost advantage versus peers and significant net cash position. The company also owns all its aircraft outright, which provides additional financial stability and flexibility. Strong profitability has enabled the budget airline to build formidable competitive advantages, for example, investing countercyclically by purchasing 300 new aircraft at deep discounts during the COVID-19 pandemic, and more recently, by investing in its own engine repair shops.
Follow the Long Earnings Trail
Solid companies may suffer short-term lapses in stock performance that don’t necessarily signal a fundamental erosion of their long-term potential. That’s because earnings and cash flows are the best predictor of equity returns over long time horizons.
Of course, investors must always be alert to the possibility of a negative turn in a company’s earnings outlook that warrants reducing or selling a position. However, absent signs of fundamental deterioration, we think investors shouldn’t discard conviction in a long-term investment thesis because of unrelated wobbles in a share price.
Today’s market environment is also subject to heightened uncertainty on many fronts. Artificial intelligence exuberance, simmering trade tensions and macroeconomic fragility all suggest that market sentiment could quickly change. As we see it, a reassessment of risk could prompt a rotation toward quality stocks that have recently been out of favor.
Selective investors who target quality growth companies can find portfolio candidates trading at especially attractive valuations, based on a long-term outlook.
In fact, we think a five- to 10-year time horizon is the best way for equity investors to capitalize on opportunities. Just as business owners don’t change strategy because of a weak spell, equity investors with a strategic view of business health can develop conviction in earnings sustainability for many years ahead. With a view to the distant future, investors can resist succumbing to market pressures that often prove temporary and enjoy an added potential bonus of the compounding effect on returns when a recovery materializes.
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. Views are subject to revision over time.
References to specific securities are presented to illustrate the application of our investment philosophy only and are not to be considered recommendations by AB. The specific securities identified and described do not represent all of the securities purchased, sold or recommended for the portfolio, and it should not be assumed that investments in the securities identified were or will be profitable.
Thorsten Winkelmann is Chief Investment Officer of European and Global Growth Equities.
Marcus Morris-Eyton is a Portfolio Manager for European and Global Growth Equities.
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