We ALL know the reasons to be bearish on EuroZone equities, it’s on the front cover of every paper and likely most of our clients/grandmothers/”OWS” supporting friends could tell us why it’s a really stupid idea to buy European Equities right now. Investing is the only activity I can think of when the majority are usually most wrong when they are most convinced. Now, I am of the opinion that most market participants and especially the politicians do not yet believe how grave the situation is – last Thurs & Friday the market cheered what was essentially an announcement that there would be more important announcements in the future. However, I also believe that with so much attention on the big picture, there are likely to be some attractive “risks worth taking” out there. So let’s assess the facts.
The fact is that there is probably no geography with as large and diverse a range of companies as Europe for active managers to capitalise on irrational investors, macro turmoil and rapidly changing political dynamics. Within Europe we have the resource rich Norwegians and the Swiss with their strong currencies, the dynamism of a young developing east including Turkey and Poland, the profligate, uncompetitive PIIGS and the bickering core countries of Germany and France calling the political shots.
By extension of this diverse opportunity set, there is no other market where stockpicking can thrive to the same extent. Ruffer European has outperformed by 220% over the last 8 years, Blackrock European by 40% in 5 years and Odey European has outperformed by 343% in the 14 years since inception! With countries possessing different currencies, differing growth rates, different demographics, different debt dynamics there is likely always some company, industry, currency or country which is doing well relative to its neighbours.
Sentiment – EuroBulls Where Are You!?
At the moment there is a race on the part of fund managers to emphasise how little Euro exposure they have. Like the financials in 2008 or US Listed Chinese stocks this year, it has become a badge of honour to say you are avoiding Europe, pitching it to investors as a benefit of your “flexible” mandates.
The Chart below form Montanaro Fund Managers shows that investor sentiment on Euro Equities is back at crisis levels.
The institution that I work for currently has a large overweight US Equities, a near zero weight in Euro Equities and a neutral on Swiss Equities. It is my impression that this is fairly representative of where most market participants are right now. The US is a safe haven in comparison – earnings yields are way higher than the US 10 year, there is some serious momentum in the relative outperformance of the trade – it’s the easiest call to make.
But the shunning of Euro Equities has been going on for a few years. Look at the chart below, since the financial crisis basically no net fund flows to Europe! Even Japan is getting more love!
Let us not forget remember that so many European companies, as the part of the longest standing economic region on the planet, possess revenues that are Global in origin and a weaker Euro provides a boost to their comparative pricing as they become cheaper than their USD or JPY denominated peers. To use a simplified example, say the Euro weakens 10%, then ceteris paribus the 28 year old Chinese social networking millionaire will be able to buy Pirelli, Continental or Michelin tyres for his Ferrari relatively cheaper than he would be able to buy Bridgestone (Japanese) or Goodyear (American) tyres. Not to mention that the Ferrari itself will be cheaper in Yuan than a Corvette or an Aston Martin. This is why the Germans love the Euro, because it allows them to have a much weaker currency than if they were trading in the Mark.
One of the most attractive sector of the market is still the large cap, high-quality defensive, global franchises. After a decade of de-rating they have had only a few months of outperformance relative to the cyclicals, the “rubbish” and the small caps. I believe this might be the beginning of a secular relative appreciation for high quality franchises – even better that we can buy them now at low valuations which afford us attractive dividends and a margin of safety. The power of their cash generation and their commitment to capital allocation through buybacks and dividends means that names like Imperial Tobacco, Astra Zeneca, Roche or Total will or could effectively take themselves private within 15 years. High Quality Franchises currently offers revenue/earnings predictability without paying up for it, reliable and growing dividend streams and lastly, the opportunity for multiple expansion. (See GMO’s forecasts on high quality outperformance).
ECB is now moving from being the most hawkish bank in the world to a stance more in keeping with the world’s other central banks – extremely accommodative. 2 rate cuts in successive months won’t hurt equities but they are probably more indicative of a truly poisonous macro environment rather than anything to get too excited about. The danger, of course, is the fiscal austerity that the politicians have now decided is the best way to align the economies of Europe. There is a not insignificant chance that this forces a periphery depression rather than a recession and that this might cause the earnings of many EuroZone companies to disappear.
To me it seems that when they are finally forced to choose, in a great denouement, the politicians will opt to print to save their great currency experiment rather than to break it up and have their life’s work derided as a failure. This generation of politicians are just far too committed/ invested in the idea of a Euro currency. However, the monetization that would be an at least temporary elixir for equities seems some way off on the back of Draghi’s comments that there will be no “grand bargain” and that the ECB articles “embody the best traditions of the Bundesbank”.
Crispin Odey, who is rather bullish, has an interesting take on the macro perspective – he seems to believe that it’s the uncertainty that’s killing the market not the bad news. He intimated that a crisis will “bring resolution” and perhaps substantially higher equity valuations. Not sure I believe it, but an interesting thought.
It is my opinion that in 90% of occasions, valuation is all that matters. On average, good things happen to cheap stocks and bad things happen to expensive stocks. Today, there is an attractive valuation discrepancy across geographies. The reality is that most companies listed on the major bourses are global in nature and derive most of their revenue from trade with partners in a range of continents. We live in a global economy not a parochial one. Why then I ask, playing devil’s advocate, does the US market deserve to trade on a CAPE of 19x compared to the MSCI Europe trading on a CAPE of 12x. I accept that there are macro reasons for a valuation differential, in fact I’m about as Bearish on the Euro situation as anyone, but I suspect that investors are failing to make sufficient distinctions between the prospects of multi-national businesses and the prospects of “The Man on the Street” in much of Southern Europe.
The difference in the multiple of 7x, or a valuation discount between Europe and the US of 37% if you prefer, is as wide as it has ever been. The chart demonstrates that Europe does traditionally trade at a discount to the US, probably rightly so given the inflexibility of labour, less economic dynamism and less favourable tax regimes – however, at some point the discount is so great that it presents compelling value and the spread will tighten, as it has always done before.
From a valuation perspective we can see below some indicative long term returns that the 2 indexes are offering equity owners currently. A CAPE of 19x, which is historically about 20% above average, offers equity holders a small to slightly negative real return over the long term. Contrastingly, a CAPE of 12x offers very attractive long term equity returns – infact as the chart shows they have only presented as negative on the rarest of occasions, often compounding at 10-15% annualised.
In summary, if we were to use history as our guide, then European indexes are priced to provide long term attractive returns even if we enter a global recession in the next 12 months. If we were to muddle through or better then I think those returns would come much larger and much faster. It’s also worth emphasising that these are index returns and we have already mentioned that Europe is an area where alpha is easier to come by than most.
See below the GMO 7 Year Asset Class Forecasts which provide further evidence to this effect…..
The difference in prospective long term returns between the 2 large economic blocs is so great that Euro Bears could even go as far as to hedge the currency without too great a detriment to their expected outperformance. This is the approach which I am taking in my portfolio as it helps me sleep at night!
1) AVOID THE FINANCIALS. Do not touch the banks. If Italy takes a haircut they all blow up.
2) It would be easy enough to build a diversified basket of the Global Franchises I talked about with an average yield well in excess of 4% which are all trading on sub 12x this years earnings. That would include names like Total S.A, ENI, France Telecom, KPN Telecom, Tesco, Deutsche Telekom, Novartis, Roche, Groupe Bruxelles Lambert, Imperial Tobacco, Deutsche Post. This strategy is boring but the revenues and earnings lack cyclicality and the dividends are relatively secure.
3) If one has the inclination they could go digging amongst the smaller companies for unique bargains or special situations. For example, the Greek market is down 90% top to bottom, that’s as bad as anything in The Great Depression, I’m sure there are some bargains in there! I have one or two EuroZone smaller companies that I am monitoring, but again perhaps you’ll want to hedge the currency. I’ll add these at appropriate prices on top of the next idea which is already in the portfolio.
4) A Fund – the easiest option. Personally I have opted to add an initial small position in Ruffer European. The Fund is the best performing in the EuroZone over the last 5 years yet despite this only has £220m under management. My guess is that this is because they dare to “asset allocate” rather than just staying fully invested in equities the whole time. The fund currently sits about 30% in cash and index linkers with a further 3% in put option protection and almost all exposure hedged back to Sterling. They have the size/flexibility to play in the small caps where true bargains may emerge and they maintain the flexibility that has allowed Timothy Youngman to build the best track record in the sector.
5) Other ideas would be Senhouse European, a very disciplined, small fund which I think will provide excellent returns to investors who get on board at current levels and/or Cazenove European where I think Chris Rice has one of the best grasps on the Euro Macro environment – if you can get his commentary, read it!
Mark Carter said:
“One of the most attractive sector of the market is still the large cap, high-quality defensive, global franchises. After a decade of de-rating they have had only a few months of outperformance relative to the cyclicals, the “rubbish” and the small caps. ”
I notice that TSCO is on a PER of 11.1. Looking at Sherlock Holmes, this is acutally the cheapest it has been in a decade (taking yearly snapshots). Is that the kind of evidence you’re using to conclude that the high-quality defensives are cheap?
Also, what do you think about smaller/mid-cap growth companies?
Some interesting comment. I am a keen disciple of the CAPE method of valuing markets and companies. One of the reasons that the European CAPE is significantly lower than the S&P CAPE is that the weighting of Banks, Insurance and Utilities in European indices is reasonably high. I would imagine that if sector weights were (somehow artificially) equalised across the US and Europe, that the average large cap non-fonancial is only marginally better value than its Nth American counterpart. That said, there are companies such as those that you have mentioned that have very interesting long run valuation characteristics.
As well as some of those stocks mentioned, there are an increasing amount of high quality stocks in the global cement and aggregates sectors that have suffered a material derating (CRH and Holcim would appear to have the strongest balance sheets of these).
The telco position seems interesting, in that despite the high yields on offer, those yields still would appear to be covered by cashflow.
Anyway, nice post.
El Toro said:
Felix Zulauf gave an interview last week that I felt was very interesting.
Both he and Ray Dalio have advocated the view that we are in a macro environment far more negative that what many investors are prepared to contemplate.
In my experience the high quality European companies aren’t much cheaper than the high quality companies in the US. The indices show up cheaper on CAPE due to financials and cyclicals being much cheaper than in the US (and in my opinion the European cyclicals aren’t cheap in absolute terms, only relative to the extremely pricey US cyclicals). I can’t find anything in Greece worth owning and only 2-3 companies that are even worth considering – perhaps when they default and devalue the bargains will appear.
Another sweet post keep them up!
Reg Thruxton said:
European equity investing enshrines colossal risk that hugely outweighs any return.
Already in Europe – the interbank lending markets are freezing up. This puts at risk trade financing activities by the banks; this is why global corporates have been building cash balances – they are terrified that they cannot obtain short term trade finance and bills of exchange (this is what happened in 2008 and it crippled world trade – the Baltic Dry Index collapsed).
The ECB has had to extend its collateral at its emergency discount window – its like a pawn shop now – and eventually the Euro banks are going to run out of acceptable collateral. Then Euro corporates will have to start to draw down on their cash balances to fund day to day operations and international trading. This will be shock 1 to investors who now will see dividends rapidly dry up as corporates desperately need cash to finance trade and ops with the banks being to all intents and purposes closed. The second shock will come as ‘just in time’ supply chains collapse; it just takes one link in the chain to fail to get finance and fail to operate and the ripple of disruption would be huge. Confidence would evaporate and start a rush to dollars and treasuries. The third shock is the collapse of aggregate demand and the emergence of a true depression.
The ECB will NEVER print – the Germans will not allow it after Weimar. Politically and legally it is impossible. So we KNOW where Europe is headed. Default and depression – who wants to own Euro stocks!
Very interesting post, thank you very much and keep up the good work. In terms of Greece one company which powerfully lures me is OPAP, who run the former but still partially owned by the Government Lottery monopoly.
El Toro said:
OPAP’s monopoly is coming under attack as the EU deregulates government sanctioned gaming monopolies (they have already done this in Italy I believe). In my research the company was not very well run and did not have much brand loyalty among consumers – I’m not sure the business would hold up very well against competition from Paddy Power and William Hill and others. In addition, Greek consumer spending could decline by 30% in Euro terms if the company defaults and returns to the Drachma. OPAP is definitely the best option in the country but still has serious problems.
Thanks a lot, El Toro, your insights do help.
Pingback: Eurozone Crisis / European Sovereign Debt by Economics & Finance - Pearltrees