With the debt crisis spiralling out of control, you would think only a madman would invest in the eurozone. But there are pockets of value in the equity market, finds George Mitton.
Let’s have a recap. Several European countries have accumulated large debts and now investors do not want to own these countries’ bonds. Bond yields have gone sky-high, pushing the most troubled states, currently Greece and Italy, into a downward fiscal spiral.
These countries cannot resort to the traditional escape route of devaluing their currency because they are tied to the euro; in economic terms they are member states and not sovereigns. As Keith Wade, chief economist at Schroder Investment Management, puts it: “Italy is a bit like the state of California. If California goes bust it has to go to the US Treasury and get a loan.”
The current debate concerns how to provide the likes of Greece and Italy with this kind of loan without bankrupting the other nations. Europe has a bailout fund that is designed for this but at the time of writing did not have enough firepower. It seems external capital is needed to save the day.
Does this mean investors should pull their money out of Europe? Not necessarily. For amid the turmoil, many high-quality European companies are now trading at low prices. Price-to-earnings ratios among European companies are as low as they were in the 1980s, according to the Shiller PE ratio.
This could be a good opportunity or a bad sign, depending on your point of view.
“European equities are cheap but that’s a euphemism for saying they’ve been derated,” says Dominic Rossi, global chief investment officer, equities, at Fidelity Worldwide Investment. “The question is whether they’ll be rerated upwards any time soon.
While you’ve got this hideous macro outlook, it’s difficult for even well capitalised, well managed companies with strong franchises to get rerated.”
Rossi takes the view that European equities “are going to stay cheap for a while”. Slowing GDP growth will put pressure on earnings and the ongoing debt crisis will continue to deter investors.
But that does not mean European companies are weak. Far from it.
“Excluding financials, the health of corporate Europe is really quite strong,” says Matthew Leeman, head of European equity strategies at Morgan Stanley. He notes that free cashflow generation continues to rise, while net debt to equity is falling, and has been since 2008.
“When you see certain corporates in Europe funding themselves below the rates that sovereigns can fund themselves, that should tell you something,” he adds.
What it means is that European companies have been doing a much better job of living within their means than the peripheral countries. They have deleveraged since 2008 and begun to save, which is why many are still considered creditworthy.
Some argue that this prudence has not been reflected in the share price though, which is why this year asset managers have focused on dividend-paying stocks.
Assuming one takes an optimistic view of Europe, which European stocks might represent a good bet? It is no surprise that all the fund managers interviewed for this article say they hold underweight positions in the troubled peripheral states such as Portugal, Ireland and Spain. The prospects for growth in these regions are poor and until there is some resolution to the eurozone crisis, most managers will steer clear.
Instead, managers are targeting northern European countries such as Germany and the Netherlands, which are not saddled with debt and which have economic prospects, if they are considered in isolation from the rest of Europe, that are similar to the United States.
What is important is where a company does business. A German industrial firm that sells in Asia may have good growth prospects despite the economic trauma in Europe. But a similar firm that sells mainly to the Spanish construction market is considered not so appealing.
Matthias Born, co-manager of the Allianz RCM Continental European Fund, believes some European stocks offer a better way to gain exposure to the emerging markets than stocks in the markets themselves. “In Europe, if you are selecting the right companies, you have good opportunities here,” he says. “You get companies cheaper and we have a higher standard in terms of transparency and corporate governance compared with some emerging markets.”
Born accepts that GDP growth in Europe will slow, which is why he is avoiding “higher beta, higher cyclical areas” which will contract the most. Instead, he endorses companies in defensive markets, such as food, healthcare and pharmaceuticals.
Another approach to European equities is to see the current crisis as an opportunity to pick up stocks at low valuations.
Rory Bateman, head of European equities at Schroder’s, argues that the indiscriminate sell-off of European stocks has created a valuation anomaly: European companies are much cheaper than similar firms in Asia or elsewhere, simply because they are based in Europe.
But, he says, markets are not irrational forever. “If I’ve got an international business with a very similar footprint, just because it’s listed in Europe does that mean that in perpetuity it trades at a big discount?
“Even though the characteristics, growth profile, profitability, balance sheet, are the same, if not better? For me, that’s a valuation anomaly and I believe those anomalies will close over time. For those willing to take a three-year view, you can pick up those kinds of businesses.”
Some fund managers consider Europe’s banks are dangerously exposed to the risk of a sovereign default, which could cause a banking collapse. Bateman also counsels against utilities. There has been uncertainty after the Fukushima nuclear disaster in Japan in March, about the future of European energy and many of the large utility plays are on hold, being used “as a piggy-bank by governments”, he says.
The optimistic views expressed above depend on the euro continuing to exist in some form. A disorderly break-up could be so disastrous that most equity managers are refusing to predict it. Is such an event likely?
When European leaders drew up a rescue package on 27 October, 2011 there was optimism. The deal called for a voluntary 50% haircut on Greek bonds, a recapitalisation of Europe’s banks and an increase in the firepower of the European Financial Stability Facility (EFSF).
But since then the problems have grown more serious and the spotlight has moved to Italy, which has debt worth about 120% of its GDP. Yields on ten-year Italian bonds exceeded 7%, a dangerous and unsustainable level.
European leaders need to support Italy, which is the third-biggest economy in the eurozone. If they do not, the country may be forced into a partial default, perhaps imposing a 50% haircut on its bonds like Greece.
Can Europe afford to bail out Italy? Unfortunately, the plan to expand the firepower of the EFSF has not happened yet, and European leaders’ plan of selling bonds to China seems implausible. Nevertheless, Europe needs external capital to expand the EFSF to a credible size of perhaps €1 trillion. Some say this may have to come from the International Monetary Fund.
The only other option would be for the European Central Bank to give itself unlimited firepower to buy bonds. But Germany is opposed to what would effectively be quantitative easing on a huge scale.
Ultimately, all these schemes depend on reassuring bond investors that it is safe to start buying European bonds again. And traders have been discouraged from taking this risk by the uncertainty over credit default swaps (see box, right).
At time of writing, the future of the eurozone is uncertain. European equities are at the mercy of turbulence. But there may be some hope for strong companies with global ambitions.
©2011 funds europe