The three engines of stock returns, and why tomorrow's European technology companies may be getting overlooked

The European technology sector is best known for what it doesn’t contain. The lack of homegrown mega caps or hyperscalers makes it much lower-profile than the Asian or American tech sectors. But what it does include, in a mirror image of the broader European opportunity set, is a number of global leaders in attractive niches.

Essentially, what this means is that there are a lot of companies which are exceptional at very specific things within global value chains. The accumulated intellectual property, process power and reputation create formidable barriers to entry and, as these companies benefit from a multitude of secular tailwinds, it creates long profitable growth runways.

This is most obvious in the European semiconductor industry. Whether it’s ASM International and Aixtron in deposition equipment, Soitec in performance-engineered wafers, or ASML, the behemoth in lithographic systems - Europe is a leader in producing world-class semiconductor capital equipment and materials companies.

Semiconductors aside, European companies have also established dominant market positions in parts of the software market, classifieds marketplaces, payments and even music industry. Given this, there’s lots to like about the European technology sector for a long-term, growth-oriented investor. And this is the world I dove into in a recent trip to Barcelona, where I spent my time meeting with and listening to European technology companies’ executives at a November conference.

Everyone appreciates some winter sun, particularly if you live in an increasingly dark Edinburgh like me, so the timing was most welcome. Sadly, it was less sun, sea and sangria and more software and semiconductors as I spent my time in underground conference rooms. Here's what I learned.

For opportunity, look to the empty rooms

At the conference, you could predict a room’s attendance by taking a quick look at the company’s price-to-earnings (P/E) multiple, with higher valuations counterintuitively leading to fuller rooms.

But investing is an expectations game and while there are returns to be earned from continued growth in earnings, when expectations are already high there is less upside to be had.

This felt like a visible metaphor for European equity markets in 2024. Companies with a high degree of near-term earnings visibility, like software businesses, have seen their multiples bid up, while companies whose earnings are depressed in the near term, such as some in the semiconductor value chain, have found few friends. Indeed, our own analysis suggests the primary driver of index returns in the 11 months to the end of November 2024 for both the MSCI Europe ex UK and the MSCI ACWI has been multiple expansion, rather than growth.

For the more expensive companies, questions tended to be something to the effect of, “how can your growth get even faster?" and “how much higher can margins go?”. These companies have all performed very strongly and the consistency of their operational performance commands a valuation premium. But investing is an expectations game and while there are returns to be earned from continued growth in earnings, when expectations are already high there is less upside to be had.

There are three engines which drive stock returns: earnings growth, change in the P/E multiple and income. It struck me that the companies in the emptier rooms might have the first two of those engines. Companies like Soitec and Aixtron, which we hold in our International portfolios, both have long growth runways, are profitable and have very strong competitive moats – but questions over when the cycle might turn back in their favor have led to material drawdowns.

To find opportunities, we must look for the companies which can be among the fastest growers of earnings over the coming years. That’s not always those which have generated that growth over the past few years.

What we heard from these companies, and others like them, was a message of quiet confidence. A growth reacceleration in the coming years provides the prospect of material fundamental growth – growth which is yet to be priced in, providing twin return drivers.

It’s a similar story outside of technology, in sectors such as MedTech and Industrials, where companies have felt the effects of a prolonged period of customer inventory destocking – something these companies are increasingly telling us is coming to an end.

Skate where the puck is going – not where it’s been

To paraphrase Wayne Gretzky, growth investing is a bit like ice hockey in that it’s best to skate where the puck is going. To find opportunities, we must look for the companies which can be among the fastest growers of earnings over the coming years. That’s not always those which have generated that growth over the past few years.

There is risk involved, but accelerating growth at low multiples makes for a tantalizing prospect. Our portfolios hold a number of these European opportunities across a variety of sectors, and we are finding more of them in the current environment.

Perhaps in a few years the lesson will be that we should all spend more time in emptier conference rooms if we’re to find the stocks with more than one engine pushing in their favor.

Written by Thomas Hodges, European Equities investment specialist.

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