Online Extra: Dissecting Europe's Top 50

S&P equity strategist Clive McDonnell picks out the trends that moved sectors and companies up and down this year, and looks to next year
The BusinessWeek 50

The real winner in BusinessWeek's annual ranking of European companies is the energy sector, as high oil prices have pushed a disproportionate number of these outfits into the top 50 performers, according to Clive McDonnell, Standard & Poor's European equity strategist. McDonnell works in London with a team of analysts to create an investment portfolio for institutional clients weighted according to sector. (Like BusinessWeek and BusinessWeek Online, S&P is a unit of The McGraw-Hill Companies (MHP ).

On the release of BusinessWeek's top 50 rankings for Europe, McDonnell spoke to BusinessWeek Online reporter Beth Carney about changes he expects to see in the makeup of next year's list, why the performance of the materials groups isn't as strong as it looks, and why the drop in German companies in the top 50 could bode well for the country in the future. Following are edited excerpts from their conversation:

Q: Industrial and financial businesses have the best representation in the top 50, each with about 18% of the list, while energy companies occupy 16% of the spots. Since you look at European equities from a sector perspective, is that what you would expect?

A:

In the S&P 350, 17% are industrial companies, and financials are 22%, so they've performed as one would expect on a long-term basis. Financials [are] a little worse, but I wouldn't be too concerned about it.

Energy clearly is a runaway winner. It has 16% [of the top 50 spots], but [energy companies] account for a much, much smaller proportion of the S&P 350 -- only about 3%. If you look at Statoil (STO ), last year it was outside the 50, and this year it takes No. 2. That's a very, very good performance. But across the board there have been improvements [including in companies such as] Shell (SC ) and BP (BP ).

It's a reflection of the overall performance of the sector, which in turn is a reflection of high oil prices.

Q: Do you think that performance will be sustained next year?

A:

Obviously it very much depends on the outlook for oil prices. However, even if the oil prices were to slide from where we are now, given that the compilation of the index looks at things over a one-year and a three-year view, [the sector's] good performance in the past couple of years should help it be one of the top-ranked sectors next year.

The great uncertainty is what happens to the oil prices in the longer term. But the assumptions about long-term oil prices are changing. A lot of [energy] companies are moving from the current long-term assumption of $20 to $25 a barrel up into the $30s. They're preparing the groundwork. Without officially adopting [the higher price as an assumption], they're seeing what the attitude of investors is if they nudge it up.

If they nudge it up long-term, it has a big impact because it makes potential acquisitions easier to justify.

Q: The materials sector, which includes mining groups and steelmakers, has about 10% of the BW 50 slots. Is that in line with your expectations?

A:

If anything it's a little bit disappointing, given the cumulative effect of the significant improvement in commodity prices. In terms of the overall market, it's really punching at its weight as opposed to punching above its weight. It has 10% of the market as a whole in terms of number of companies and 10% of the [top 50 companies].

Given the scale of earnings growth that we've seen, I'd expect it to have done better. The big names have obviously done well –- BHP Billiton (BBL ), Rio Tinto (RTP ), Arcelor (ARLOF ) -– but I would have expected even some of the smaller companies to have climbed up the list.

Q: Do you expect to see the same number of materials companies in the top 50 next year?

A:

The outlook for materials this year is going to be a lot tougher...mainly because of the weakness in commodity prices.

Q: There's only one health-care company in the top 50, the Swiss pharmaceutical group Roche (ROCHF ). Does that surprise you?

A:

No, I know health-care companies are the best performers year-to-date -- they're up 14%, compared to the market, which is up 9%. But if we look back on '04 when the euro was appreciating, it hit companies' earnings. Next year I would expect to see companies climb up the list mainly because a weaker euro would help their earnings somewhat.

Q: Are there any other surprises in the sector makeup of the list?

A:

The consumer-discretionary sector is a little bit disappointing. There are fewer companies compared to last year. It's punching a little bit below its weight in terms of representation in the index, and it's probably going to deteriorate moving forward, given the outlook for eurozone growth and particularly the outlook in Britain, since [the sector] is quite exposed to British companies.

It's interesting that there are no info-tech companies [in the top 50]. SAP (SAP ) has fallen out. Basically [the sector] has performed in line with the market, but last year it was the worst performer, and in 2003 it didn't have a great year either. Certainly I would expect to see some IT companies come in next year. I wouldn't pick it out as a top performer, but it should improve.

Q: What does the geographic representation of the list tell you?

A:

Britain has slipped back. It has seen a dip in its ranking representation, and Germany has as well. Germany has seen a major slide. It has two companies in the top 50, when it had five last year. It's really disappointing. In comparison, France held steady at five companies.

Q: Why has Britain fallen back?

A:

The deterioration in British banks' ranking on the list is obvious. They've seen a big drop compared to last year. Royal Bank of Scotland has dropped out of the top 50. Barclays (BCS ) has dropped back, and HSBC (HSBC ). They've all seen their numbers come off. I think it's probably the weakness in British banks that has been the biggest factor.

Q: Why are the banks doing so poorly?

A:

There's normal cyclical concern about the outlook for the economy, and banks have suffered as a result.

Q: How do you explain Germany's drop in top 50 rankings?

A:

Germany is probably a different story. Although disappointing from an investment perspective, one way of interpreting Germany's deterioration and France's stability is that it reflects the fact that Germany has implemented some painful restructuring reforms that are hitting the performance of the companies.

You have to have pain before gain. German investors have been squeezed, and it's painful in the short term, but they are laying the foundations for more robust performance going forward.

French companies have ridden the cyclical economy. They've been rising with the rising tide, but they haven't addressed any of the structural problems. They haven't taken any of the painful decisions there.

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