What next for the eurozone? And where can investors look to maximise their profits? John Stepek talks to our panel of experts to find out.
John Stepek: The Greek election result didn’t cheer the market much. What happens next?
Laurent Millet: The earlier Europe is forced to face the fact that Greece is bankrupt, the quicker we’ll reach a solution. That’s why the election was so disappointing – it was a missed opportunity to put Greece out of its misery. The problem began with too much debt. Three years later, there is still too much.
Greece will leave the euro anyway – within two years, I expect – and they’ll be poorer than they are now. We’re not investing there – I just don’t think it’s investable right now.
Marcus Ashworth: Spain’s funding costs have doubled in the past month.
Julian Pendock: It makes sense. The €100bn ‘bail-out’ figure is a random round number that won’t solve anything. Spanish banks have been hiding their debts for years through ‘ever-greening’. Say you’re a bank and I’m a construction company. I come to you and say I can’t make my loan repayments. So you give me another loan, which I use to make payments against both loans. So your assets go up, and the total value of non-performing loans (NPLs) stays the same. That means NPLs as a percentage of assets fall, income goes up and everyone’s a winner – until it all unravels.
These problems could have been nipped in the bud. During the Asian financial crisis in 1997, it was handled much more cleanly – partly because the then-head of the International Monetary Fund (IMF) wasn’t interested in running for president anywhere in Asia.
Bankrupt banks were made to open their books, ‘fess up, and shut down. The problem in Europe is that you have a whole generation of euro politicians who are steeped in euro politics but know nothing about economics. Against the advice of any independent economist worth their salt, they created the euro in its current structure and it is time for some countries to call time on it. It’s as simple as that.
John: So why not just let Greece go?
Our Roundtable panel
Head of fixed income and macro strategy, Espirito Santo Investment Bank inc. Execution Noble
Laurent Millet
Co-manager, Artemis European OpportunitiesJulian Pendock
Founder and chief investment officer, Senhouse CapitalChris Wright
Senior investment manager, Premier Asset Management
Julian: Because Europe hasn’t yet built a proper firewall to stop the contagion spreading. Spain is bust, so it can’t contribute to the bail-out fund. Italy is still meant to contribute, but looks in a bad way too. Portugal is in such a mess I don’t know where to begin.
And I don’t see how everyone demanding free money with no strings attached will solve anything, because that makes it all the less likely that Germany will start writing blank cheques. In fact, all it does – and I may be wrong, because none of us knows what’s going to happen – but in my view, all it does is give more covering fire for Germany to leave the euro.
Laurent: But that is the best thing that could happen. The remaining countries could pool liabilities, and the new European Central Bank (ECB) could print money so they could inflate their way out. Meanwhile, they impose capital controls, and that solves the problem in two years.
Marcus: But did you just see the numbers that came out from Germany on its exposure on Target Two? It’s now €698bn.
Laurent: Germany could easily deal with that. But then some of its banks would go bankrupt. And that’s the big issue – no one wants to open the books of the banks and say, right, let’s solve this problem.
Marcus: No, but this is why I don’t think Greece can leave, why Germany won’t leave, why no one is going to leave and why it carries on. Here’s a brief example of what I’m talking about – Dutch housing association Stichting Vestia has 89,000 houses it rents out. It also has a €22bn derivative book, which it’s been using to hedge interest rates on a €6.1bn loan book.
It just lost €2bn in an interest-rate swap deal that went wrong and had to be bailed out. The deal was with Citigroup, Deutsche, ABN Amro, Rabobank and five other banks. There’s lots of that sort of stuff all across Europe.
Julian: Yes, Germany has to accept that leaving Europe will cost it a bundle in sorting out its banks – to quote Michael Lewis [of Liar’s Poker fame], “There’s always some idiot in Dusseldorf who will buy this.” But once they open the books, they can add up the liabilities and say: “It will cost us this much” and, if they want, they can print deutschmarks to stop the currency from going too far through the roof when they leave. That might be anathema to the Bundesbank. But the point is, it’s a one-off. They clean up the mess on their books and in their banking system with their own money and that’s it – off they go.
Marcus: They can’t.
Laurent: They can. Look at the numbers.
Marcus: You are missing the point. That €698bn, that’s just Target Two. What about the German banking system itself? The Landesbanks, the Sparkasses?
Laurent: But since when has closing a bank and taking the hit been an odd thing to do? It happened in the 1990s – in fact, it happened in Iceland. You do that, you can move on. Iceland has 2% growth – they’re pretty happy with that.
Marcus: No bank in the European Union can go bust, because then the whole damn lot comes down. They cannot write this stuff down because then you have to mark everything to market, and it kills everyone. I’m not saying it’s right, but they can’t acknowledge these losses. They are just too far in.
Laurent: Come on. Yes, if they default on their debts some people will get poorer. There will be damage, but you can build on that, you have a future.
Julian: Germany can’t afford to back the rest of them anyway. First of all, we are using the wrong terminology. A bail-out is not a bail-out. If your neighbour has a mortgage they can’t afford and is a junkie too, and you lend them £10,000 – that’s not a bail-out is it? President Hollande has decided to make French labour laws even more inflexible to protect jobs. They are going backwards, by volition. There is no way that Germany should say, fine, we’ll just write open-ended cheques to keep things going.
Marcus: Yes, but the German banking industry is the one that’s the most badly bust. That’s what no one understands.
Laurent: Fine. Let them go bust. That’s capitalism!
John: Will the ECB end up doing print money (QE)?
Chris Wright: Yes. I don’t think it will work but I think they will have to – they will be under pressure to do so.
Julian: The trouble is it could spark the mother of all trade wars. If it pushes the euro down to parity with the dollar, China and America will go ape.
Marcus: One thing’s for sure: German bunds are the biggest sell of all time.
Julian: I can see bund yields hitting 3% without touching the sides.
John: OK. We agree that it’s an awful mess. But you all have to invest somewhere. So Chris, where are you putting your money?
Chris Wright: Well, I’m not putting it into banks, or bonds. I would much rather leave my money with GlaxoSmithKline (LSE: GSK).
John: Ah, but we don’t want Glaxo – we want to hear about something in Italy that’s going to rocket 200% in the next three years!
Marcus: Hah! Any European bank – doesn’t matter what it is. In fact, the worse, the better, because none of them are going to go bust, because they can’t. So buy all the worst European banks.
Julian: Except that as a shareholder you might get diluted to nothing.
Chris: We all know that governments have problems, and that banks have problems. Let’s move on. The fact is, many companies are generating lots of cash, yet equity prices reflect very little growth. They are already pricing in long-term stagnation in Europe, whether it’s set to last for two, three, five, ten years – or even forever.
But remember that Lloyds was effectively busted by its Latin American exposure in 1982/1983. It worked through the problems over seven or eight years, and once it had sorted itself out, it took off. The European thing will work the same way, probably over a longer period. Stocks have been pretty flat. But they yield roughly 4% while inflation is around 2%-3%. So you are getting a real return without moving. Better yet, management is nervous. That’s wonderful. I love nervous managements, because they don’t waste your money.
John: But where to invest? Economic historian Russell Napier has noted that several European indices are cheap on a cyclically adjusted price/earnings (CAPE) ratio basis.
Laurent: Yes, but what he actually said is when you’re on a CAPE of nine or whatever, you’re going to make money, except when one of two things happens: either they confiscate your money or they go bankrupt.
Julian: In any case, the indices are irrelevant because they include things like banks, commodity shares and companies that were at the top of their cycle.
John: But would any of you buy stocks in the PIIGS (Portugal, Italy, Ireland, Greece, Spain)?
Our Roundtable tips
Investment Ticker Glaxo LSE: GSK Piaggio IM: PIA De’Longhi IM: DLG Telefonica SM: TEF Repsol IM: REP Syngenta VX: SYNN Zodiac FP: ZC Nestlé VX: NESN Prosegur SM: PSG Amplifon IM: AMP Kerry LSE: KYGA Rio Tinto LSE: RIO Montanaro LSE: MTU Creston LSE: CRE Seadrill NO: SDRL Sky Deut. GR: SKYD Inditex SM: ITX
Julian: Yes, yes, yes, yes. Despite the macro backdrop being horrible, the Italian small- and medium-sized enterprises (SME) sector is every bit as good as the German SME sector. The head of the French SME confederation once said they wished they could all relocate to Italy or Germany where they were respected.
I like Piaggio (Milan: PIA), which makes Vespa scooters. In 2006 its largest market was Italy – in 2009 it was India. They’ve just opened a third factory in Hanoi and are rolling out across southeast Asia and areas where the secular credit cycle is taking off, like Indonesia, where mortgage debt to GDP is just 3%.
Marcus: Who is their competition? The Japanese are all waking up to the fact that the future is motor bikes.
Julian: Yes, but they don’t have the Vespa brand. People trade up as they get wealthier. Piaggio’s not cheap – Italian SMEs generally aren’t. But it’s a good company. Another I’d like to own at the right price is De’Longhi (Milan: DLG), the coffee machine maker.
One I do own is Telefonica (Spain: TEF). It gets more of its earnings before interest, tax, depreciation and amortisation (EBITDA) from Latin America than from Spain. I know there are some issues with Brazil and the region generally, but it’s got an equity-free cash-flow yield of 15%.
Chris: But a lot of it is in Venezuela, isn’t it? Can it actually repatriate that cash to the parent equity holders?
Julian: Not from Venezuela it can’t. But it hasn’t been confiscated yet – which brings me to the next company we have, which has been painful to hold but is actually well managed – oil company Repsol (Spain: REP).
Laurent: I don’t think much of the management. I think they’ve wasted money on making stupid acquisitions.
Julian: The assets they have around the world are worth a lot. And they’re not making stupid acquisitions now.
Chris: If you start on a p/e of six with better growth than anything else – like Repsol – that looks good value to me. I take the view that management at the top level – the top 150 companies around Europe – means almost nothing.
Julian: There are also some great firms outside the PIIGS. The likes of agri-business Syngenta (Zurich: SYNN), or aeroplane equipment provider Zodiac Aerospace (FP: ZC): global niche players. More obvious firms like Nestlé (Zurich: NESN) people say are defensive and boring, they’re not, you’ve got a nice prospective yield. I’d stay away from German exporters though – they could get walloped as the China bling trade comes to an end.
John: What you are buying Laurent?
Laurent: I have one Spanish firm, one Italian and one Irish. The Spanish one is Prosegur (Spain: PSG). It’s a security company with a market cap of €2.5bn. A bit more than half of the business involves looking after cash in transit. It has a Spanish operation, but it’s a relatively small percentage of pre-tax profits – Latin America generated 54% of sales and 83% of earnings before interest and tax last year.
It’s a market leader in 90% of the countries it operates in, and where the cash-handling industry operates as an oligopoly it is particularly attractive. In Brazil, Prosegur bought a local firm, Nordeste, just before foreign companies were stopped from competing against locals in the market. So you have a barrier to entry there – no foreign company can come in and buy up a rival, and Prosegur’s market share is north of 50%. The nice thing about Latin America is that you have high inflation, which means there’s lots of cash in circulation, which is good for business. You’re only paying 13 times earnings per share (EPS), for typically double-digit EPS growth.
Chris: But is a p/e of 13 for high-inflation profits good value?
Laurent: Yes, when EPS has historical growth of close to 20%.
Chris: How much of that is inflation and how much is real?
Laurent: In Latin America growth is 10% – half due to inflation and half real.
Chris: So real growth of 5% – which these days is not bad, actually.
Laurent: In Italy I like Amplifon (Milan: AMP). It’s the global leader in hearing aid retailing, with a 9% global market share. Demand is growing at 3%-5% a year, driven by ageing populations in developed markets, and rising penetration in emerging markets. There’s a barrier to entry: firms need to employ audiologists, as the hearing aids can’t be sold without a hearing aid specialist. Operating leverage is high – in Italy, where Amplifon has reached optimal size, it has an EBITDA margin of close to 30%. It’s trading on a p/e of 14, with double-digit EPS growth expected. In a recession, people might delay buying a hearing aid a little, but they won’t put it off for long.
Julian: We saw this in Asia post-crash – you bump along the bottom because of the replacement cycle.
Laurent: In Ireland, we like Kerry Group (LSE: KYGA). It’s evolved from a dairy co-operative into a multinational food and ingredients manufacturer. It has two divisions. Its ingredients and flavours unit also sells systems and chemical compounds to various food, drink and drug producers. It’s the leader in a fragmented market, with a 9% share. The big food groups sold off their own divisions long ago, so there are few rivals with the potential to catch up with Kerry. Earnings have compounded at 15% a year over the last 15 years – the worst year was 2006 when earnings were flat. It trades on a 2012 p/e of 15.
John: What about you Chris?
Chris: One boring one – it might be risky but in round terms it is the lowest-cost producer and is a price taker – it’s not normally a stock I’d buy: mining giant Rio Tinto (LSE: RIO). Everyone says it’s on a p/e of six. It’s not. It’s probably eight or nine. But that’s still a low valuation.
Julian: But price takers should trade at a low valuation at the peak of the cycle.
Chris: Yes, but the point is it finally does. Another is Montanaro UK Smaller Companies Investment Trust (LSE: MTU). Over the last five years it has outperformed the small companies’ index by 32%. The discount is about 13%, which is about average.
On a portfolio approach, a good-quality small company manager can make you a lot of money. I have some in my self-invested personal pension (Sipp). Creston (LSE: CRE) is one for the more adventurous investor. It’s in PR and media. It’s on a p/e of four. It’s got a market cap of £32m and it’s generating between £7m and £8m a year, and it’s got no net debt. In two years it will have £14m of cash.
John: What do you hold in Europe?
Chris: I like Seadrill (Norway: SDRL), which yields 9%. It’s listed in Norway, so it’s still outside the eurozone. It hires out oil rigs, and should have two or three years of good order books. Those might deteriorate, and I suspect the yield reflects that, but even if the dividend is halved, I’m still getting a decent 4.5%.
Marcus: We like Sky Deutschland (GR: SKYD). Pay TV is a great business – we reckon sales growth in Europe has beaten GDP by six percentage points on average over the last ten years. But German pay TV has underperformed the European trend by about four percentage points. Penetration is 22%, against a eurozone average of more than 50%.
Sky Deutschland has just 8% of its addressable audience. But the economic backdrop for Germany looks better than for the rest of Europe. Since its management changed in 2008 there’s been a shift in momentum. Subscriptions grew by 18% in 2010, and 17% in 2011. Churn has fallen and average revenue per user (ARPU) has gone up. It looks set to hit four million subscriptions by 2015, with strong growth in ARPU. With a potential audience of more than 40 million households, it could have plenty of upside.
I also like Inditex (Spain: ITX). The market is currently drawing a thick line between good and bad firms, and it’s worth highlighting again how good a company this is. We reckon it will grow sales by 12%-13% per year over the next three years, and EPS by more than 15%. It sources about half its goods from the local area, Spain and Portugal or north Africa, which means it can be flexible, up to date on the latest fashions, and quick to deliver.
Yes, Spain accounts for about 25% of sales, so that’s an ongoing concern, but it will fall to below 20% by 2014. Meanwhile, the likes of Asia and Africa will continue to be a big source of growth. Even on a p/e of around 20, it’s much cheaper than the historical average, which is closer to 25.