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