The Quality Quandary in European Equities

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.

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.

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.