This week’s panel discusses European equities and the impact of the Greek tragedy
Europe is a big continent that is getting bigger all the time with expansion of the EU a topical subject. Let’s start with top-line initial thoughts, what is your house view of Europe?
Alister Hibbert (AH): We are broadly positive towards Europe, for a number of specific reasons. The corporate profits cycle is under way and going very solidly. We think that is a very good backdrop for equities generally.
When we think of Europe versus other developed world equities at least, the recent rout that has come through the euro and the wobble in the markets courtesy of Greece, is very much a buying opportunity, as the fundamentals that make up the index and the investible area remain very solid.
Paras Anand (PA): We are fundamentally positive on Europe and I agree with the points Alister made. On top of that, one of the things we feel very strongly about is that Europe is one of those places where shareholder culture remains in its infancy, and that is something that has evolved a long way.
If we go back 10 or 15 years ago, investing in Europe was really about country and market selection, trying to look at differences between various underlying economies.
Now you can access global businesses that are run well, with good capital allocation records, and where things like payout ratios are low versus equities in other developed markets.
From both a valuation perspective and from an evolution in shareholder culture perspective, that is one of the reasons why we think Europe is so interesting.
Richard Falle (RF): We are structurally long-term bulls on Europe as well. I agree the recent sell off has provided some opportunities and valuations are reasonably supportive.
The market is at a crossroads and trying to make its mind up. Technically, it is trying to test new highs but we are seeing a lot of up days on low volume and the breadth is not quite there.
The market is wrestling with how strong is the economic recovery going to be and what it wants to pay for it.
Is there a shareholder-friendly culture developing, particularly for non-European investors?
RF: It very much depends on what stock and sector you are talking about as well as the level of government influence and Shareholder structure including things such as A and B Shares with different voting rights. The key to us in terms of the nuts and bolts of analysing these companies has been the normalisation of accounting standards across Europe. This makes it a lot easier to compare stocks in the same sectors in different geographies and understand their relative valuation better.
It is a structural move for these companies to need the equity market more and it will become more of an issue as bank lending becomes more and more difficult to find. These guts are going to have to come to the market more to fund their businesses going forward.
PA: One of the things we have certainly seen is bear markets are good for Europe – they force management to get real and require them to go to the market for equity issuance, therefore they require that ongoing relationship with shareholders if they want that source of capital financing going forward. That will be increasingly the case because banks are going to be much more circumspect about lending, even some of the conservative European banks – the evolution is glacial.
What often happens to people in Europe is that they buy into a restructuring story and it fails to deliver because these things take place over many, many years. We see it as a long-term structural positive taking place over many years, rather than 2010 being the year of European turnaround or something like that.
A couple of years ago when I was living in the States, there was a programme called Mad Money – the Jim Kramer programme. He was touting Germany as the big story and I just knew it was complete nonsense because these things take years and years to manifest.
AH: As Paras said, it is glacial, but that does not mean to say you do not see it when you look at anything over three to six months. If we look at the history of the European market versus the other developed world markets, especially the last five to seven years, you can see European earnings, real earnings growth and real earnings progression have significantly outpaced that which you would have seen somewhere such as the US, despite the fact the US economy grew faster than the European economy over that five- to 10-year period.
Peter Fuller (PF): It comes down to the fact accounting rules are getting far clearer, especially among the exporting companies. There is pressure on them to improve their accounts, if there is less bank lending. This is certainly so in the German secondary markets. We are finding more and more that bottom-up stockpickers are actually moving into those markets because they are getting a clear view. The one thing managers do not like is unpredictability.
Are we all getting too caught up in the problems in Greece and what it means to the rest of the eurozone?
AH: They are legitimate concerns, and we should not take the problems of peripheral Europe lightly. One of the obvious implications of what is going on in Greece is that it is going to be a profoundly difficult domestic economic environment for some time, which will affect certain businesses. But, as was commented earlier, the reality for me as a manager in Europe is that Greece represents 0.9% of my benchmark, so it is an irrelevance from that perspective.
As an economy within Europe, Greece is extremely small and has little implication for most assets held by the vast majority of managers quoted.
What matters more for Europe is the fact we have more emerging markets exposure as a percentage of total quoted revenues than many other developed world markets. That is where I think Europe is being forgotten.
If we look at it on our numbers, we think something like 25% of quoted corporate revenues in Europe are now coming from emerging markets and that is an enormously strong asset. That has developed because there are many fewer companies quoted in continental Europe (compared to the size of the economy) than you would find in the UK and the US – there are still lots and lots of family-owned enterprises. Because they are not quoted, they would typically be more dependent on the European economic trajectory. The quoted market you buy if you buy European equities is one that is well placed to take advantage of growth in emerging markets.
Is Europe partly a proxy for emerging markets?
AH: Yes, insofar as it has that exposure. Rather than worrying about what is happening economically in Greece, its relevance for Europe and its outlook, I would worry about the emerging markets and what is happening in China, which is increasingly an extremely large part of the business.
Airbus reported some numbers just recently: their order backlog now is over 70% emerging markets with just 8% of the backlog in the US and 18% in Europe.
We cannot talk about Greece without talking about the rest of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) economies. Would you agree those countries are a relatively small part of the overall Europe benchmark of companies, so, as an investor, you are probably taking a view on the individual companies and not economies themselves?
PA: Yes, absolutely. In environments where the capital availability is more limited, some of these factors come back into play, so you do have to worry about political risk and country exposure that little bit more. But the opportunity is the payback on the hard work you do in terms of individual company selection and analysis, is greater because you do not get the rising tide factor.
The thing that interests me is not to say there are not extreme outcomes that could take place – someone leaving the euro, pressure on the euro, etc. I would not use the word collapse as that is a little strong, but people have tried to draw this parallel between Greece and something very bad like Bear Sterns and the collapse of the financial system. This often happens after a crisis – before a crisis you do not see any black swans, and then after one people see black swans everywhere.
The probabilities people have described, of something very bad happening to the whole European setup, are probably a little high and that is based on the fact they are anchoring or recalling very recent and easy-to-recall events.
RF: The longer-term issue for Greece, Portugal and Spain is the time and pain they are going to suffer to normalise their budget deficits. We are talking about them having to cut anywhere in the region of 6-9% of GDP over the next three years. That has never been done before so the longer-term impact and fallout (in terms of the politics, strikes and unrest) is going to be severe in Greece and to a degree in Portugal and Spain.
If you are investing in businesses that are very dependent on those economies to make profits, that is obviously a place you would want to avoid. But I agree totally with Paras and Alister, a lot of the businesses we invest in are very internationally focused and, when a company is domiciled in Spain, Italy or Portugal, sometimes what you do see is it actually getting de-rated with the market, especially if it is a big liquid component of that market. That does provide opportunities in terms of investments.
PF: It is far more significant for the debt markets. You have a strong currency, you have little inflation, how on earth are they going to repay that debt?
AH: We have to be careful about what we see coming from Greece and whether it is a harbinger of problems ahead. It may be, but may not necessarily turn out to be problems we have to face in Europe. If the Greek issue is one of sovereign debt, burdens and credibility, yes, that would be very severe and something that you would be concerned for Portugal about, but the most concerning outlook from our perspective would be that for the UK where we think a sterling crisis is a strong possibility. One of the most famous bond managers in the world described the gilt market as sitting on nitro-glycerine, so the problems are often not in the same economic area as the original problem.
PF: We are finding there is an increased risk aversion among fund managers at the moment in Europe. But that is short-term.
What it has done is cause portfolios to tighten and become more focused on large-cap stocks creating a crowded market. If you look behind that, the largest active bets in the portfolio are the second line stocks, and they are the ones expected to move, not now but towards the end of the year.
Everyone seems to be gloomy for the next few months, but longer-term, it will become rather more positive. If you look at the portfolio top 10 and focus on active positions, you can see a growing confidence among managers that by the third or fourth quarter or early 2011 Europe will be a good place to invest.
Would you say there is a good case for Europe, you have got the emerging markets exposure but also you have got an increasing number of truly global companies operating within the continent?
AH: Yes, and that is a very subjective question. Who has the most global leaders and effectively the richest opportunity set within the developed world? When we look at that, it is going to be a race between the US and continental Europe. The UK is clearly lagging in terms of the number of quoted businesses, which I believe are highly attractive in a global context, with strong franchises and good growth prospects and the ability to take market share.
It is a continental Europe versus the US thing and last time we tried to write down who we thought had the most global winners in each sector, we found it was pretty much a tie – the US walked away with media and IT (we have very little over here as there is no Google in Europe). We have SAP, but clearly the US has way more companies.
In other areas that are traditionally better businesses, with better franchises and stronger returns, Europe wins all the way and you will find that in a number of areas.
Luxury goods, which is just a European-dominated industry, and always will be because of the historical reasons and the brand, has equity that has been built up over hundreds of years, so that is an incredibly strong asset for Europe.
We have private client banks as well and the world’s leading financial institutions. We have some of the best capital goods companies in the world too. There is a whole range of different businesses that are global leaders.
With Europe, you start from a very unloved market in the short-term, which has the ability to improve returns on a more structural basis over the next three to five years, and which is on a much lower valuation. For preference, I would be more interested in European equities than the US.
What would you argue is the key message about Europe and European equity funds?
PF: Look forward to the end of the year. There has been a fundamental shift between 2009 to 2010. Last year was about momentum – we had a cyclical rally. Now it is about quality, sustainability, profitability. If you look at the mid-cap area, you will see there is a lot of enthusiasm building up. I would look to see strong returns coming through towards the year end, but not strong in double digits, strong in relative terms.
RF: For me you invest in Europe for cheap valuation, good long term structure and a great choice of different businesses. That is part of the issue with the UK market it is dominated by certain industries. The next 18 months is going to be a real stockpicker’s market. With the withdrawal of QE and cheap funding winners with good profitable business models will do a lot better and be rewarded for it via share price and performance.
PA: You do not look back and see a lot of positive statements about investing in Europe.
People will increasingly look to Europe as a source of diversification for those seeking yield, because you are now at a point where headline yields are at parity with the UK and that was not the case, even five years ago.
You have a more diverse opportunity set than in the UK. 50% of the yield is basically in six stocks. So you get much greater diversification in Europe and that is going to be one of the reasons people will come back to Europe.
AH: Europe has a lot of things going for it. We have very strong emerging market franchises. Take the example of Novo Nordisk. Diabetes is growing very, very quickly in China. The insulin market used for the treatment of diabetes in China is dominated by Novo Nordisk, who have a 60% market share and have been there for 40 or 50 years.
In Europe there is a great opportunity set of world-class companies with structural reasons to manage, keep and retain very high returns in their emerging market franchises.
Those emerging market franchises take advantage of all the growth we see through industrialisation of the world, especially Asia and Latin America but hopefully places like Russia in the future.
You have world-class, high-quality franchises, good management teams and strong accounting. You get those and strong fundamentals for very low valuations.
In our view, the euro is likely to be a very strong currency over time, compared to the dollar or sterling, and, in the short-term, for a sterling-based investor. It would make sense to diversify any investments you have into international currencies, because the risks for something like sterling, and latterly the dollar, are significantly higher than for the euro, despite the perception being that risk is the other way round.
