Although most of the banner financial stories out of Europe are negative, another narrative is quietly emerging that spells good news for canny investors who dig a little deeper, according to Jeremy Whitely.
If there were a gold medal for holding summits, the European Union (EU) would win hands down. Last year it held 18.
This has not discouraged investors. With every meeting, equities have rallied in the hope of a ‘quick fix’, only to fall later on the lack of substance behind talks.
In America they call this kicking the can down the road. But America can fund its debts because it is a unitary state and the dollar is a global currency.
The EU has no such luxury. Instead it has invented a language of obfuscation designed to prevent the unthinkable happening – namely the break-up of the EU.
To be fair, behind its acronymic rag-bag – LTRO, EFSF, OMT, SSM – the EU has a plan of sorts: to recapitalise its banks, bring them under a single supervisory regime and hence impose financial discipline as a first step to fiscal union.
That all requires money, of which there is a dreadful shortfall. But it also requires leadership.
Draghi to the rescue
When Mario Draghi declared last July that he would do everything to prevent a Euro collapse, insisting “believe me, it will be enough”, the EU found its man of the hour.
Looking back, his decisiveness has represented a stunning turnaround from the political vacillation that had prevailed.
In the markets the bond ‘shorts’ have fled, yields on peripheral nations retreated from danger levels and the Euro has strengthened.
Since January some sovereign nations have even started borrowing again, suggesting the downward cycle of austerity-led revenue shortfalls, higher debt servicing and credit downgrades can be arrested, helping the banks in turn to recapitalise.
Italy’s inconclusive election in February noticeably failed to dent this new-found confidence.
But Europe has a long way to go. Greece is in its fifth year of falling growth. The Eurozone in aggregate may not expand this year.
The pain this is causing is clear: rampant unemployment, the rise of protest parties (and worryingly the far right) and the risk of further political dysfunction.
And nobody thought that Draghi’s commitment to do ‘whatever it takes’ to save the Eurozone would include commandeering people’s savings.
Until now deposits have been sacrosanct, but actions from the Government in Cyprus (backed by the EU and the International Monetary Fund) to ‘tax’ savings have raised concerns over how safe deposits are – even if a deal was struck in this case to let off smaller depositors, consistent with EU-wide deposit insurance.
Angel or demon?
The fortunate exception thus far is Angela Merkel, Germany’s chancellor. She remains popular at home (if predictably vilified abroad).
By eschewing grand plans and not over-promising she has convinced voters that Germany will not be on the hook for more bailouts – unless she has sanction over how borrower nations are run.
Can the much-mocked ‘olive belt’ become more German? Provided these countries fear ejection from the Euro (whether forced or not) over all else, they may have no choice.
Retirement ages must rise, benefits fall and productivity rise if their economies are to be put on a sustainable path. On the revenue side, more efficient tax collection is vital.
But the key to restoring competitiveness is productivity. Wages in the likes of Italy have risen 40 per cent in the past decade or so.
In Germany that figure is around 5-10 cent. Until they have lower costs the periphery will struggle. Strong public unions and banks tied to the public sector present a challenge to reform.
Across Spain, Portugal and Italy banks are afraid to declare bad debts on their balance sheets for fear of making a bad problem worse.
Why have stocks done well?
Yet in describing this structural malaise there is one obvious incongruity. European stockmarkets have performed rather well.
Last year the MSCI European Index was up 17.86 cent. Given that, one must ask what investors see in European companies.
Have their shares just been lucky, caught up in a globally correlated search for real assets?
Or is there a more subtle discounting effect at work – put plainly, that European companies may be in better shape than economies might suggest?
There is no denying the world is awash with cheap money. Every investor has to be aware of the confiscatory risk of holding cash when real yields are negative.
But it is also true that European companies are profitable and they have been returning cash to shareholders.
Good quality blue chips are paying more in dividend yields than the bank. Equity risk can be had for free.
Four lessons
Where are these good quality companies to be found? Lesson one is to ignore geography. We find good companies around the region, with the Netherlands, Switzerland and Sweden home to a disproportionate number.
But ‘home’ is a qualified idea. Many European companies have been operating for decades and their true customer base is global. Exposure to fast-growing emerging markets is a common characteristic.
Lesson two is to ignore country of listing. The UK is the most confounding place in this regard. Few of its leading listed companies are domestic in any proper sense and for some the listing is a flag of convenience (London is a good place to raise capital).
Many are in globalised sectors like mining or pharmaceuticals where the domestic industry has in fact been rationalised or closed. (More paradoxically, there are UK domestic industries such as car-making that have become almost wholly foreign-owned and are thus inaccessible via the UK itself.)
Lesson three is to choose companies that benefit from high informal barriers to entry.
When we look at our favourite stocks – Standard Chartered in banking, Schindler in elevators, Unilever in consumer goods, Pearson in publishing – they all have some kind of edge: it could be regulatory or technological, historical (in the shape of distribution) or intangible (brand leadership). On the whole that makes for more sustainable profit growth.
The final lesson in our European primer is to find companies that are not only good at making money but run by boards that acknowledge all shareholders.
The prospects for growth
If Europe is in a mess but its best companies thriving because of their foreign connections, what could knock them off course?
In answering I would distinguish between the potential for individual company mishaps and market behaviour as a whole. Even the best companies can make errors of judgement. Protection from competition is often a recipe for complacency.
For every BMW, whose biggest market, China, barely existed a few years ago, there is a company that fritters advantage away, in spite of warning signs.
The failure of some retailers to adapt to ‘e-tailer’ competition is a classic case of technological disruption: today’s shop-boarded UK high street is a partial result.
However, it is the banks that take the prize for hubris. They have mutated from custodians of deposits and prudent lenders to gamblers who failed to understand their risks.
We still avoid the integrated banks, even though stock prices have soared in recent months on hopes that they have been nursed back to health.
They remain too reliant on government support (such as LTRO), too complex and too interested in regulatory capture (trying to water down Basel rules and prevent the separation of speculative activities).
Valuations, valuations
As to market behaviour, in my view the strongest support in European companies’ favour is price. Even after the recent rally, shares do not look expensive.
At at price to earnings ratio (p/e) of around 17 times, big companies are well supported by earnings growth. I am very comfortable that my holdings can grow bottom line profitability in the high single digits; hence I am comfortable paying a little more for them.
On this score it is interesting how valuations have also swung round with respect to some European companies’ listed subsidiaries overseas.
Anglo-Dutch giant Unilever is trading on a p/e multiple of 18.7 times. Its listed offshoot in India is on 36.9 times; and that in Indonesia 41.6 times.
It is a similar story for Swiss rival Nestlé. Right now the European parent companies offer the better deal, in my view – they may have slower overall growth but their price is much more compelling.
Europe does have its share of cheap companies, particularly among mid-caps. There is the temptation to think Europe has been ignored by investors for so long that value is there for the taking. Sadly, that is not the case.
As I ventured earlier, Europe’s best are very good; many companies however are stuck in a cycle of low growth, falling revenues and high overheads.
Corporate action is unlikely (the bankers too reviled, potential cost synergies too politically charged to exploit). Where then is their escape?
Unloved suits us
None of these observations on prices make any claim that European shares will continue to go up. In the short term liquidity and sentiment are the only things that count.
But I’m convinced Europe as a whole is under-appreciated and, from a stockpicking perspective, more attention is now being paid by the market to fundamentals.
To conclude, Spain may be a walking property-led disaster, but two Spanish companies exemplify Europe’s investment paradox.
Inditex is a company that leads the world in fashion, partly through its ability to produce new lines for different stores within days, which is a feat of supply chain logistics.
It is better known as the ubiquitous Zara. Viscofan will be less familiar. It is the world’s largest maker of artificial casings for the meat industry – a seemingly dull but very profitable one-product business.
Jeremy Whitley is the head of UK and European Equities at Aberdeen Asset Management.
