Strong returns this year have been driven by a combination of factors. These have included increased business confidence despite high energy prices, European shares being cheap on a valuation basis compared to the US, increased merger and acquisition activity and, since April this year, a weaker euro relative to the dollar (the euro has fallen around 9 per cent since April).
Within the large-cap area it is the new economy rather than old economy stocks, such as utilities and tobacco, that offer the most potential. Utility stocks have already doubled in value over the last two years as a result of power price rises. New economy growth stocks, on the other hand, have been derated to such an extent over the last three to four years that they now look very attractive from a valuation perspective. Therefore, technology, and in particular wireless stocks, have significant growth potential as the proliferation of consumer electronics continues. Other examples of attractive stocks include cruise shipping companies that are experiencing structural growth and companies manufacturing dental implants because of the demographics that favour the product.
Looking at small-caps as a whole, they have been supported by strong earnings growth, both relative to large-caps and on an absolute basis, and also by low volatility and tight credit spreads. Comparing the performance of large- and small-caps in the second quarter of 2005, sector weightings have played a crucial role. The sectors where small caps have outperformed include industrial goods and services, financial services, construction and materials. Underperforming sectors were healthcare and banks, both of which currently look expensive. Over the recent past, private equity has been a support factor for small- and mid-caps with approximately one fifth to one third of current European merger activity generated by private equity firms.
For European equities, as for global equities, there remain a number of risks. These include a further dramatic increase in raw material prices, the potential for rising interest rates, trade and current account imbalances in the US, and events such as terrorist attacks.
There remains upside potential for both large and small-cap equities. We expect similar returns for both asset classes for the rest of the year and going forward into 2006. However, we prefer large-caps on a risk/return basis as they are far more liquid than small-caps.
Jeff Currington, head of European equities, Credit Suisse Asset Management.
