The growth drivers of this decade are shifting in obvious ways: capital expenditure is rising, supply chains are being rebuilt and demand for materials is set to soar. Yet, investors have been largely fixated on a handful of technology companies when real opportunities lie elsewhere.
Even if the conventional narrative of sluggish growth with uninspiring political leadership in Europe and strong investment in the US continues, such opportunities could generate positive returns. That said, any reversal of recent conditions would boost returns with companies that are operationally geared and at extreme starting valuations.
Banking fundamentals stronger than ever
One of our highest-conviction ideas at the moment is UK and Irish banks.
There are two basic truths of banking that are often forgotten. First, it is an industry that tends to grow at least in line with nominal GDP over time.
Secondly, economies of scale are incredibly powerful, both from cost efficiencies – only increasing with artificial intelligence – and because new business flows tend to be less profitable than the sticky stock of customers, rendering new entrant economics poor. As a result, incumbents gain market share over time, organically or via consolidation.
After 15 years of extreme stress for the industry, we believe this norm is reasserting itself – as businesses have simplified, industries consolidated and interest-rate extremes corrected.
While many banks posted strong returns in 2024, those returns remain understated due to interest rate hedges. As these hedges unwind in the coming years, and banks are exposed to higher rates, we expect continued positive momentum.
Meanwhile, the high-risk premium implicit in current valuations seems increasingly hard to validate as traditional risks recede. The low level of provisions seen in recent years argues credit exposures are notably benign, given that was a period where rates rose appreciably, and Europe suffered a generational cost-of-living crisis.
Finally, that a tough UK budget and Irish elections did not yield increased taxes on the sector again suggests historic risks are alleviating. With hedges unwinding, balance-sheet growth outpacing cost inflation and share buybacks at low valuations, the growth of earnings possible for the sector is compelling.
Building materials poised for a rebound
The building materials sector is another area poised for growth. After a period of decline, we believe current valuations are anchored in the past and do not recognise the transforming strength of the sector.
For some time, house prices rose while volumes stagnated, benefiting owners but leaving materials companies behind. Housing volumes are now a universal political priority, and industries have immense capex needs given deglobalisation, the energy transition and digitisation. Years of underinvestment mean most infrastructure requires updating for services to meet voters’ demands.
Pricing power of materials companies has extended despite the weak volumes of the past 15 years due to tight industry supply. This could offer a potential opportunity if volumes normalise.
With supply constrained, pricing power should increase and current margins have ample scope for significant expansion.
Multi-year undervalued opportunities
Overall, in Europe, valuation and positioning are at genuine extremes. Such extremes tend to be poor guides to timing inflections but can be very good long-term indicators of risk-reward. Put another way, little needs to go right for these industries to witness a positive market outcome.
We also still strongly believe ultimate energy prices in Europe will be much lower than today, even though 2024 saw this slightly stall. Russian gas is being replaced by global liquified natural gas and renewables. The former should encourage European prices to decrease to historic norms relative to the US – estimated at around 70% lower than today. The latter has the potential to cut prices and even give parts of Europe a cost advantage versus the US.
Markets are paying a premium multiple of today’s profits for US cyclical exposure. However, we see a better risk reward elsewhere.
Jonathan Regis, partner and deputy head of developed markets strategy at Lansdowne Partners
