Above the noise: 20 European stocks to consider in crisis times

Last week I promised a guide to finding European stocks with potential in this current turmoil. Today, I will present 20 European stocks that might be good candidates to pick up following the sharp index declines last week.

Stage 1: Find the 20 European stocks with the lowest R-squared

The idea is pretty simple.  Since the general market is very volatile in crisis periods, we want stocks that are decoupled from the market. 

We went in search of them by finding stocks whose recent performance is least explained by the market (Stoxx 600). What we did was run 600 regressions, one for each stock's last 51 weekly returns against the Stoxx 600's return. Then we found the R-squared for each stock, which is essentially how much the stock market's returns explain the stock's returns. We sorted the R-squared figures from lowest to highest to find the 20 stocks that are least explained by the market. The result is shown in the table below.

Not surprisingly, the result is overweight with defensive sectors such as utilities, health care, consumer staples and telecommunication services. Note also that the average raw beta is significantly below the market's (which is 1) and performance year-to-date is close to Stoxx 600's (minus 1.7 percent) this year.

Now, there can be many explanations why a stock's performance is not explained very well by the general market. Either it has outperformed based on an outlook that is not correlated with the underlying economy (typically a growth stock) or else it might be a broken company that just continues to fall no matter what - National Bank of Greece, which is mentioned in the table, could very well be such a case. A third explanation for why R-squared is low could be a company with a very resilient business model with low growth which is typically found among utilities. In this analysis we will concentrate on the longer investment horizon, so essentially we want to find the growth stocks and thus try to adjust the first output with other factors.

Stage 2: Adjust low R-squared stocks for quality factors

Which factors make sense if we want to filter out the broken companies whose stock performance is not explained by the market? To make it simple, we select three additional factors to our R-squared figures: 3-month change in EPS estimates, year-to-date (YTD) performance and return on invested capital (ROIC). You might argue that the correlation between the change in EPS estimate and YTD performance could be high and thus the model gets little extra benefit from having both factors. The argument has some validity, but in my assessment, including both factors add to the overall improvement in finding quality stocks.

In the next step, we rank the R-squared figures and our three factors in order to create a combined ranking that finds the 20 European stocks that have the lowest R-squared, highest positive change in EPS estimates, highest ROIC and highest YTD performance when all factors are taking into consideration. The result is shown in the table below.

I can already hear some readers saying "Yara International is cyclical stock and if the economy goes down the stock goes down". The beauty of this quantitative analysis is that the data say something else. It says that Yara International's performance is not explained very well by the general market and has seen its earnings estimates go up in the last three months.

Of course, this list of 20 is just a place to begin your research: there are no guarantees in investing, and the same goes for this strategy. However, instead of guessing which stocks might be good in Europe, this approach quantifies the stocks that are least likely to move in tandem with the Stoxx 600. At the same time, all of the companies listed in the second table have a high return on invested capital, which is normally a sign of quality in the underlying business. If you want European stock exposure, consider those 20 stocks. taking into consideration your risk profile, investment horizon and current portfolio.

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Above the NOISE is written by Peter Garnry.  It celebrates free markets, highlights a quantitative and growth-oriented approach to investing, and advocates macroeconomic fiscal discipline.  If you’d like to be notified whenever a new Above the NOISE piece is available, become a TradingFloor member – it’s free, and you can sign in using Facebook, Twitter, Google or LinkedIn – and follow “Above the NOISE.”  You can also book the Above the NOISE  page.