LONDON (Reuters) - European equity investors take note: the emerging markets bet which paid off so handsomely last year may have run its course for the time being.
For the year ahead, exposure to surprisingly strong domestic European growth may prove more lucrative than investing in markets such as China, still fast growing but which could be affected negatively by factors such as rising inflation.
Shares in plenty of companies heavily exposed to emerging markets outperformed last year, but some investors have already started to seek cheaper valuations among stocks which stand to benefit from domestic growth.
“The emerging market story has got a long, long way to go ... (but) in the short term, some of the valuations might be a little bit generous. With the prospects of recovery in Europe, it’s going to be less of a short-term theme,” a London-based fund manager, who declined to be identified, said.
“It’s more likely to be companies which are poised for the recovery in Europe,” he said, adding he favours European banks .SX7P, among them Deutsche Bank (DBKGn.DE).
Picking the best domestic plays isn’t necessarily easy.
Although not all companies disclose how much of their sales come from emerging markets, Thomson Reuters data shows in 2010 the performance of a portfolio of European stocks with high foreign sales outpaced a basket of domestic-focused firms by 23 percent.
However, so far this year the domestic-centric portfolio has outpaced the overseas exposed basket by 4.8 percent.
The change in sentiment was the result of a mixture of Europe’s improved economic outlook and concerns about inflation and lower returns in emerging markets.
Germany, Europe’s biggest economy, on Wednesday lifted its 2011 economic growth forecast to 2.3 percent from 1.8 percent, while stronger than expected Chinese fourth-quarter GDP raised concerns of further monetary tightening in the world’s second-biggest economy.
In terms of valuations, companies relying on domestic sales may offer better value. The domestic-focused basket of European companies carries a one-year trailing price-to-earnings of 12.7 times versus the portfolio of foreign exposed stocks’s 18.7.
“Germany is obviously recovering more. At some point, it might become less dramatic between domestic and the emerging market plays. The emerging market plays have gone up quite strong,” said Nick Nelson, equity strategist at UBS.
According to Goldman Sachs, companies with relatively high exposure to the country’s consumers included Axel Springer (SPRGn.DE), Fielmann (FIEG.DE), Tomra Systems (TOM.OL), Suedzucker (SZUG.DE), Praktiker PRAG.DE, Gagfah GFJG.DE, Metro MEOG.DE and ProSiebenSat1 PSMG_p.DE.
It also highlights Volkswagen (VOWG_p.DE), which has high domestic as well as emerging market exposure.
Some investors have cashed in gains from shares in companies with large developing country sales after their outperformance in 2010, as concerns over inflation in emerging economies grew.
For example, Swatch Group UHR.VX, the world’s largest watchmaker and which Barclays Capital said has about 35 percent of its sales to emerging markets, have fallen 11 percent so far this year after soaring 59 percent in 2010.
“With inflation picking up, we have seen tightening policy in reaction to that which will be a headwind for emerging markets or emerging market-related assets, certainly in the first half of this year,” said Ronan Carr, European equity strategist at Morgan Stanley in London.
Carr said consumer cyclicals that are operating in emerging markets would lose some of their momentum and Morgan Stanley is underweight consumer discretionary. However, he was positive on emerging market exposure as a long-term play.
The other issue is that the bet on companies with high emerging market sales has been popular, meaning that the returns on the trade are smaller.
“One of the easy trades of last year was basically buy companies with exposure in emerging markets ... based on the fact that growth within developing emerging markets is considerably above developed markets,” said Alec Letchfield, chief investment officer at HSBC Global Asset Management’s private client arm.
Letchfield did not expect policymakers in emerging markets to slam on the brake too fast to derail growth but said the situation had changed. “It’s not the kind of slam dunk that it was perhaps of last year,” he said. (Editing by David Holmes)