Europe has never looked better – what should you buy now? We invited some of the best investors we know to dinner and asked what they would put their money into now.
Merryn Somerset Webb: Let’s look at the market as a whole first. How’s the rest of the year going to go do you think, Tim?
Tim Price: I think it looks good. The fact that things have shot back as far and as fast as they have since the correction in February has to be interpreted as a fundamentally bullish signal. There’s still a lot of liquidity out there and there’s a strong appetite for risk too.
Simon Pickard: I wouldn’t disagree with that. I’m a long-term bear and I thought on 27 February that I was about to be proved right – it really looked like things were breaking down. By 5 March, it was clear that they weren’t. Right now, it is easier to hear the good news than the bad. Markets aren’t expensive; interest rates are not too high; there’s lots of liquidity; there are lots of mergers and acquisitions; and there’s no sign of profitability falling off. The big bearish factor out there is the state of the US subprime market, but that doesn’t affect Europe that much. I still think the markets will see a major fall at some point. But not this year.
Rob Burnett: The correction was all about US growth, but the thing that investors have now picked up on – and which stopped the correction becoming a crash – is that leadership, in terms of global growth, is shifting from the US consumer to areas outside the US, namely Asia and Europe. So the weakness we’re seeing in the US is going to be substantially mitigated by growth elsewhere.
SP: It’s apt that European equity-market capitalisation has overtaken that of the US for the first time since World War I.
Julian Pendock: If you accept that history never repeats itself exactly, but it always rhymes, there’s a few other interesting things to look at too. Think back to the 1980s, when Germany and Japan were the twin pillars of growth. You can see that happening again in this cycle. Germany and Japan are coming out of
15 years of deflation and starting again.
TP: Add the growth coming from the BRICs (Brazil, Russia, India and China) and it does look rosy internationally.
Mike Hollings: We’re a bit more cautious. We don’t think equities are a sell. Global equities on the whole aren’t expensive, but if something causes some sort of retrenchment globally there is risk. Markets are so highly correlated that if one market falls, all markets get hurt. No market is immune. What could cause a sudden fall? I wonder whether we are too sanguine about inflation. We talk about Europe and Asia taking up growth slack, but the flip side of this is that a rising middle class expect higher living standards – more cars and air-conditioning units and food. That pushes up prices. The other bigger, and more obvious, risk is some kind of major ‘credit event’ that gives the market a shock. For us, that makes it hard to invest – you might think things look cheap, but how do you protect yourself against this event that may or may not occur, but will be nasty if it does?
RB: But what will drive that kind of event? The reason credit spreads are so tight is corporate profitability is so good, interest cover is so high, and balance sheets are so strong. So what might do it is a releveraging of balance sheets or a massive further upswing in debt-driven mergers and acquisitions, but that in itself is inherently bullish. I wouldn’t worry about a credit event until after the bull market has gone substantially higher than it is now.
MSW: In Europe, are there some countries that look like better bets than others?
JP: We are stock pickers – we don’t necessarily look at things in terms of country – but time and again, when we investigate stocks, it is German ones that look good. It makes sense. Property has been doing badly for a long time and consumers haven’t been spending. The savings ratio is over 12%. So it’s possible to be bullish on German consumption. There’s also still scope for restructuring. You have a real chance of making money.
SP: I would say that looking at Europe by country is more important now than it has been for the last five or ten years. Country investing in Europe is fairly important. It’s clear, for example, that German housing companies are attractive and Spanish and Irish ones are limited. The Spanish housing bubble has to collapse. I would far rather short the Spanish index than I would the German.
JP: In Spain the listed sector has a net debt to equity ratio of 143% (in the UK it is 66%) and return on equity (ROE) is being propelled upwards by nothing but leverage. I’d be cautious about it too.
MH: What has amazed me is the way the euro keeps getting stronger, but it doesn’t seem to be denting anybody’s competitive edge. Instead, European exporters have actually gained export market share.
RB: Clearly, something quite powerful is going on. Our thoughts on this relate back to Germany and the idea that it connects to the amount of capital it puts behind each employee. In the US and in Japan, they put two to three times more capital behind an employee than we do. But in Germany, it is six times as much. So each employee in Germany is intrinsically that much more productive. We think this is why they can hold their own, even as the euro rises. It’s also one of the reasons why we like German companies. This isn’t just a domestic recovery story in terms of consumption or property, but a story about the solid foundations of the exports that make up the majority of Germany’s economy. Rising productivity effectively negates the strength of the euro for German firms.
MSW: What about Italy? With the difficulties they are facing, might they leave the euro?
TP: I’d say a more serious concern in Italy – as in Spain – is corporate governance and the fact that in certain pockets of Europe people still bang on about protecting the interests of national champions. That throws sand in the wheels of commerce.
JP: Yes, and I can’t see that changing. Most politicians in Europe have not had a very thorough grounding in capitalism. But here’s what’s interesting: there’s a lot of noise made about high-profile cases where deals are blocked and things come to a crashing halt, but that’s not the case for smaller companies. They just get on with it and ignore the politicians.
But for the mega-caps, I think protectionism is not going to go away. Some say the mega caps in much of Europe will always be cheap, simply because they can’t be bought by private equity or a foreign company for political reasons. I would never buy a company hoping it will be taken out anyway – it’s got to stack up on its own fundamentals – but I do think that that might be the case with the really high-profile companies. So small- and mid-cap firms might be the ones that keep outperforming in Europe.
SP: Still, I would rather be invested in Italy than in Spain. It may be a basket-case in most ways, but there is very little consumer debt there. They still all tend to stuff their money under the mattress.
And for good reason. Italian and French savings rates are still 15%, which makes for a great buffer. Ireland and Spain aside, there is no subprime in Europe. Add this strength to the export scenario and it makes for a robust story.
RB: There are also great dividend and free cash-flow yields – the free cash-flow yield of Europe ex-financials is nearly 6% this year. That’s quite a new story for Europe.
TP: I’d add to that the fact that while equities are massively over-owned in the United States, in Europe they are not. European mainland investors are used to investing in bonds or property.
MSW: Shall we move on to looking at specific investments?
JP: A specific stock I like at the moment is Sweden’s Oriflame Cosmet, which sells cosmetics – mostly to the Russians.
The company will be spending a lot of money restructuring over the next 18 months. Strip that out and you’ll see that their underlying margins are better than the published ones. We used to hold a lot of Russian stocks directly to get exposure to Russian consumption, but they’re expensive these days. This is a cheap way to get in. Another firm we like is a small German company, Thielert. It makes piston engines for aircraft, which can run on diesel and/or kerosene and are both economical and powerful. Its engines now power the best-selling twin light aircraft by Diamond in Austria and they’ve been accredited by Cessna and the big flying schools. Thielert has had accounting scandals in the past, but it still makes bits and pieces for the United States State Department and it also does lots of the high-tech stuff for Formula One car-racing teams. So the firm is blue chip in that sense. On our valuations, there’s about another 20% upside in the shares over the next 18 months.
MSW: Any others?
JP: German DIY company Praktika. This isn’t necessarily a play on rising home ownership in Germany (although that is slowly happening). It’s more about the upturn in general consumption – even if you rent a house, if you live in it for 20 years, you’ll want a new bathroom, and the average German bathroom is 20 years old. Praktika has bought competitors, cut costs, changed the product mix and is now picking up some operational gearing along with gentle top-line lift in revenue.
I think it’s going to be a story that will run and run.
MSW: Simon, what’s interesting you at the moment?
SP: We’re sticking to general restructuring stories and consumer stocks where the volatility of earnings is fairly low. One stock we like, which will make everyone extremely frightened, is Parmalat.
RB: It’s a lawyer play, Parmalat, isn’t it? It has provided for a huge number of law suits and as any legal events come through positively for them, those provisions will come back on the books. It’s effectively a bet on the success of Parmalat’s legal team.
SP: I think it’s more than that. There isn’t much downside in that the stock is not expensive and it’s got good recovery and restructuring potential. The legal stuff is ¬just the cream on the cake. It’s complicated, but in a nutshell, in the wake of its bankruptcy in 2003, Parmalat is now trying to clawback around e7bn paid out in the year before bankruptcy that shouldn’t have been paid out. It’s also after another e30bn in damages from foreign and Italian banks who are supposed to have abetted its bankruptcy and enriched themselves in the process. It’s impossible to know how much of this money could come back to the firm, but it’s not in the price, so you effectively have an in-for-free, potentially large upside.
Another stock I like is Mediterranean Oil & Gas. It’s listed in the UK, but has its operations in Italy, and I think could easily go up three or four times.
They have two big projects in Italy and are one of the few oil companies on Aim that make cash, so they won’t be back to the market looking for more capital in six months. Unless there is something crooked about the company, it’s hard to see much downside – whereas the upside is to my mind very, very substantial.
MSW: Great tips. Thank you. Tim?
TP: I’d go for Continental AG, in Germany. It is the world’s second-largest electronic brakes supplier and fourth-largest tyre maker. It is expecting a deal with a unit of Siemens, which could transform the business. There is probably further restructuring to come, it’s significantly cheaper than its peer group, and we think it’s a wonderful stock. In Italy, we like Autostrada – it’s dull, but it’s the largest motorway operator in Europe. The company did fail to complete a merger with Abertis of Spain last year, but probably some kind of deal is still going to happen. It is a classic infrastructure story and it’s also a quasi-monopoly.
MH: One of our aims is to try and access emerging-market growth via mature, stable companies. So on that basis, buildings materials supplier Lafarge is a stock that we like. Trading at under two-times book value and eight-times cash flow, it’s a solid company. As well as being well run, it’s globally diversified, and it plays into the infrastructure story as well as the emerging markets story. It’s dull, but we like it – it’s got room to grow.
Another is Rautaruukki in Finland, a steel firm. Steel is a truly global business and Rautaruukki is well-positioned in both western and eastern Europe. It’s also got a dividend yield of 4%.
Finally, a stock that’s going to put everybody to sleep – but I come from a fixed-income background and so this is the kind of thing I like – Italy’s energy giant ENI. It’s got a 5% dividend yield and a p/e of just under nine times.
I particularly like the fact that it has got some good assets in Russia. It may get its fingers burnt there – as Shell and BP have done – but I think they probably learnt from past experiences. Anyway, when a stock is this cheap, you don’t have to worry too much: it’s the kind of valuation that lets you sleep at night.