Today, Royce Global Value Fund and Royce European Smaller Companies Fund will celebrate five-year anniversaries. With the ongoing European debt crisis, it seems hard to believe there is attractive value on the continent. However, Royce Portfolio Manager and Director of International Research, David Nadel, thinks that 2012 could prove to be a year when international equities come storming back.
Looking back at Europe in 2011, what is your overall view? What has worked and what hasn’t?
That’s a big question. First, you have to separate the macro picture, which is dire, from the select group of what we believe to be well-positioned companies, in many of which Royce is invested.
Also Read: Jacob Wolinsky Interviews David Nadel – In which David Nadel tells Jacob about the two funds he manages: Link to the interview page
From a macro perspective, the region is home to a disproportionately large number of countries that have unsustainable debt burdens, a situation exacerbated by the euro currency crises. Whereas prior to the creation of the euro, less-productive European countries could conveniently devalue their currencies to manage a credit crisis and/or to stimulate growth via exports, the euro takes that tool away, leaving those countries hard-strapped. Plus, many of those same countries have historically had weak mechanisms for tax collection. While “core Europe” has been more fiscally-prudent than so-called peripheral Europe, it too is conflicted: Germany and other members of core Europe want a weak currency, but they don’t want to continually subsidize and bail-out more profligate nations. Unfortunately, it’s tough to have it both ways.
Add to these structural problems an aging population, generally high taxation, a lack of natural resources, and declining social mobility, and you have, to say the least, a very challenging environment for businesses selling to Europeans.
Despite all that, Europe still offers some compelling investment opportunities; you just have to be careful what you pick. More than any part of the world, Western Europe is well-schooled in designing and marketing products the world demands. Many European markets are small so European companies, including the smaller ones in which Royce invests, have been forced for many, many years to think pan-regionally and even globally. They never had the luxury of selling to a single, 300-million person market like U.S. smaller-companies have. In today’s global economy — where the West is licking its wounds while emerging markets drive growth and demand — that makes Western European exporters very well positioned, while many U.S. smaller companies are still catching up. We particularly like the classic exporters based in German-speaking Europe, the UK and the Nordics. Many of these companies manufacture around the world, so they are not that vulnerable to the high labor-cost and currency issues of their home market. We have generally eschewed PIIGS (Portugal, Italy, Ireland, Greece and Spain) Europe because of its high levels of leverage, and comparatively weaker corporate governance and managements.
Is the European recession priced into shares? Are the companies you own feeling the recessionary pressures yet?
Given trough P/E multiples and elevated dividend yields for European markets, it’s safe to say a less-than-rosy picture has been priced into European stocks. Recession is the consensus view for Europe, which indicates that it is at least somewhat priced in. And, the companies we own that sell to Europe – these are American companies, Asian companies and European companies alike – are feeling recessionary pressures in the European end markets. However, we have deliberately structured our portfolios to have less exposure to the European consumer, and for that matter to the American consumer, who in my opinion is just as troubled as their European counterpart, whether or not our government reports U.S. GDP as recessionary.
Have our investments been more affected by headline news than fundamentals?
Yes, in the short term. When the Swiss national bank drew a line in the sand and committed to the 1.20 exchange rate versus the euro in September, Swiss stocks abruptly stopped their rapid descent that had been fueled by the strengthening Swiss franc in the weeks leading up to that decision. When Italy’s sovereign bond yields suddenly spiked in November, Italian companies got hit hard, even if their sales were not dependent on their home market.
Headlines are a funny thing. What passes for investing in today’s markets looks to me more like headline-driven speculation: a choice between a “risk-on” or “risk-off” day, breathlessly reported by the TV business channels. We see this as mostly noise, and ignore it for the most part.
Interestingly, international investing still seems to be treated as some sort of ghetto by a lot of investors. It has taken these massive European sovereign debt crises that have been dominating headlines for two years for many mainstream investors to accept a notion that should have been more apparent – namely that Europe is not a monolith, and that Germans and Greeks are about as different as any two peoples can be culturally, despite being geographically close. Amazingly, this hasn’t stopped investors from treating all of Europe – be it the troubled PIIGS countries and severely compromised French banks on the one hand or the well-positioned exporters with global operations on the other – as uniformly European and therefore undesirable. We think this is a major mistake. Fundamentals continue to be strong for many European exporters, as they have been for the past 100 or 200 years. Certain companies have been succeeding through all the previous crises.
The fact that all of Europe is painted by many investors with the same brush means we can try to take advantage of the reduced valuations of these companies. As they say, never waste a crisis. If 2010 and 2011 were the years that certain investors finally woke up to the historical differences between, say, a Switzerland and a Spain, then we think 2012 could be the year they more carefully separate the wheat from the chaff in terms of companies.
Describe the type of companies that you look for.
We try to invest in companies with sustainably high returns on capital, strong balance sheets, and defensible market positioning. They tend to be largely self-funding businesses managed to take market share in tough periods. For the most part, I think our companies have defended quite well and are executing in a more than satisfactory manner. Important operational achievements like accumulating market share don’t always reveal themselves immediately. But we think they will over time.
What is the biggest risk factor for your portfolios? Is it the collapse of the Euro? An Italian default? China slowing?
We don’t see default as a major risk factor, but more as a potential cleansing event. After Brazil defaulted on its sovereign debt in 1983, its stock market roared back in the next two years. The Bovespa surged about 125% per year.1 Think also about Mexico in the two years after its 1982 sovereign default: The Bolsa rose 115% a year.1 Russia had a similar bull run after its 1998 sovereign default, up 116% per year for two years.1 Similarly, today, the Greek market has lost 90% of its value in four years, with the Greek stock market’s aggregate market cap at just 14% of the country’s GDP. However, history shows that sovereign defaults are far from the end; they are often a new beginning for stock investors. In fact, we’ve got our “shopping list” of Greek and other PIIGS equities at the ready should defaults materialize. We’ll be buying while many others hide. Our portfolios currently have very little invested in ‘PIIGS’ companies, but we’re watching that situation carefully for opportunities.
I think the single biggest risk factor would be something that would derail the entire investment world as we know it, such as a sharp, synchronized reversal in demand from creditors like China and other emerging economic champions such as Brazil, India, Turkey, Indonesia, South Africa, Singapore, Malaysia and South Korea, to name a few. These countries have some combination of relatively young and socially mobile populations, natural resources, fiscal prudence, and even in some cases relatively sound banking systems.
A second risk would be a sharp rise in real interest rates within the developed debtor world, particularly U.S. Treasuries, which would stall or perhaps weaken commodity prices, particularly gold and silver. Our international and global funds have significant weightings in precious-metals mining companies, which we believe are on the cusp of being embraced by mainstream investors, much as many oil exploration & production companies were from 2004 onwards after oil prices ran higher in the wake of the Iraq War. Historically, when the U.S. Treasuries’ real (i.e. inflation-adjusted) interest rate is greater than 2.5%, the price of gold stops climbing, which is the risk I’m describing. However, given U.S. inflation is at least 1.5%, the Fed would have to jack up rates by a whopping 400 bps to hit that 2.5% rate. I see that scenario as highly unlikely, given our economy.
We are invested in several German and Austrian exporters, and many people assume that a return to the Deutsche Mark would be catastrophic for them. I don’t agree. First of all, Germany has a long history of being a successful exporter even with a powerful Deutsche Mark. Second, the German, Austrian (and for that matter, Swiss and British) exporters in which we’re invested have continually diversified the geographic exposure of their manufacturing and production. When it comes to currency, what matters is not where a company is domiciled, but where it manufactures and sells. Interestingly, many investors gloss over these points in their rush to throw the baby out with the bathwater. And third, don’t forget that our investments are valued in U.S. dollars, so if a German investment suddenly switches from the Euro to the Deutsche Mark then the value of our investment could be marked up proportionately.