Shaping a Portfolio for 2017: Europe

EU and UK

I started out to title this the EU instead of the more generic Europe.  But then I realized we have to treat the UK as a separate issue, even though it exhibits many of the same structural characteristics as the rest of Europe.  So I changed my title.

Two factors about Europe stand out to me as an investor:

currency

–the euro, which cost $1.40 each as recently as 2014 and which went for as much as $1.15 earlier this year, is now trading at $1.04.  A pound sterling, which cost $1.71 in 2014 and $1.45 prior to the Brexit vote, now goes for $1.22.

A 26% decline in the euro vs. the US$ and a 29% fall in sterling are immense moves.  While they represent a catastrophic contraction in national wealth for the individuals and nations affected, they also act as a big boost to the global competitiveness of Europe-based multinational firms.

EU warts showing

–in June, the UK voted to leave the EU. That prompted Scotland to revive its efforts to secede from the UK and become its own (EU member) nation.  Italy, in many ways the Japan of Europe, just rejected reforms that would have put government finances on somewhat better footing and allowed it to address the problems of its woefully weak banks.  Angela Merkel, the political leader of the EU–as well as of Western democracies, many would say–appears to be in deep trouble in Germany because of her stance on immigration.  Greece continues to resist fixing its economy.  France only looks good by comparison.

My stock market experience is that, with the possible exception of Japan, politics rarely matters.  Better to focus on company by company prospects than media headlines.  However, this is a real mess.

my take

My overall economic view is that Europe is about two years behind the US in recovery from recession.  That would suggest domestic enterprises are in for another year of struggle before we see strong signs of general economic growth.  Currency weakness should strongly accelerate the pace of improvement.  The ongoing efforts of traditional political/economic elites to preserve their place of privilege without regard to the cost to their countries should retard meaningful progress.

To my mind, Europe remains a special situations market.  I think the best course for equity investors is to be underweight and play the currency rather than the economies.  That is, to remain with multinational stocks based in Europe which have significant non-European sources of revenue.  Hotel companies with US presence, and which also stand to be beneficiaries of increased tourism in a now-cheap Europe, seem to me to be particularly well-placed.

 

 

 

 

 

internal/external adjustment and the EU

Yesterday I wrote about the tools a country has available if it faces a combination of sluggish GDP growth, excessive borrowing/weak banks and non-competitive industry (processes are outmoded and costs are too high).  Greece is the poster child among EU countries   …but Italy is the major EU economy that this description calls to mind.  France is riding a compartment or two away.

What can an EU country whose economy is structurally out of balance do?

Well, external adjustment–meaning currency depreciation–is out, since it’s part of the euro.

That leaves internal adjustment, which can take three forms:

–tariff or other regulatory barriers.  Yes, the EU can, and does, erect barriers to protect local industries against imports.  But most EU countries trade more with each other than the outside world.  So, say, Italy can’t bar imports from super-competitive Germany or lower-cost eastern Europe.

–slowing the borrowing, which is intended to maintain the current (unsustainable) lifestyle, by raising interest rates in a way that will cause a recession.  This is the German “austerity” solution, which few, if any, other countries (nor any politicians concerned about being reelected) will willingly adopt.  The EU experience after the 2008-09 recession shows austerity doesn’t work particularly well, either.

–that leaves structural reform.

This gets me to why I started writing about this.  Paul Krugman recently reviewed a book I haven’t read, The End of Alchemy, by  the former head of the Bank of England, Mervyn King. In the review, found in the New York Review of Books, Krugman says of King:

“He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be.”

What grabbed me is the “imbalances in production costs” part.   In other words, despite almost two decades of having the euro, plus all the time before its debut when companies knew it was coming, inefficient EU countries have done very little to bring their production costs down.  In addition, the reason Mr. King gives for this is “the lack of will.”  In other words, the forces of the status quo, aimed at preserving local fiefdoms (both political and industrial), are so strong that no progress can–or will–be made.

Sounds a lot like Japan, with a twenty-year lag.

Tomorrow:  investment consequences, if the King/Krugman analysis is correct.

 

 

Brexit looming

Voting takes place a week from today in the UK on the question of whether the country should remain in the EU or leave.

If the vote is in favor of Brexit, the government will presumably inform Brussels of its intention to depart, which will start the clock on a two-year waiting period before Britain can officially withdraw.

Recent polls have begun to show for the first time that a majority of citizens favor severing ties with the EU.  This is the reason for recent weakness in London stocks.

My thoughts:

–polls on issues like this are notoriously unreliable.  Some are either tacitly or overtly political, with question design (on the order of “You do favor leaving the EU, don’t you?”) slanted to one side or the other.  As far as internet surveys go, it’s impossible to know whether the respondents are a representative sample of likely voters.  During in-person, and especially during phone, interviews, respondents often tend to be less than truthful, giving instead what they perceive to be expected responses

–Pro voters, who seem to think that exiting the EU will return Britain to its eighteenth-century glory, are delusional

–the two-year waiting period gives both sides time to renegotiate trade agreements (almost half of Britain’s exports are to the rest of the EU).  It’s reasonable, I think, to assume that new agreements will be less favorable than the current ones.  But it’s hard to know whether they’ll make a significant practical difference

–non-EU multinationals who have located operating divisions and general headquarters in the UK because of its being inside the EU will presumably begin to shift operations elsewhere (Ireland?)

–as far as portfolio investors like us are concerned, the main direct economic effect of Britain leaving the union will likely be the weakening of the currency that’s happening now.  So far there has been no counterbalancing positive movement by stocks where the costs incurred by the underlying companies are primarily in sterling but where revenues are in euros or dollars.  Such firms, however, should be star performers if the vote is for Brexit and as the currency stabilizes.

 

My conclusion:  prepare to buy multinationals traded in London on a further selloff that will likely occur if the vote next week is for Brexit.

Shaping a portfolio for 2013 (iv): Europe

 The Eurozone, which comprises most of the EU, is in recession.  Not only that, but it’s suffering a crisis of trust that threatens to tear it apart.  But you wouldn’t know it from the recent performance of EU stock markets.ward

a quick look back

In over-simple terms, the Eurozone was formed solely as a monetary union, without any fiscal checks and balances.  It was like a partnership where everyone got to use the common credit card.   On the tacit assumption that gentlemen always pay their debts, the EZ never checked to see if users could, or did, pay their bills–even though the group as a whole was responsible for any charges.  The chief lenders were government-controlled banks run by bureaucrats with no notion of how to analyze creditworthiness or detect fraud.  If all else failed, the “parent,” Germany, would presumably pick up the tab.

Not a great real-world concept.

The fantasy balloon was popped in October 2009 when a newly-installed government in Athens discovered the previous administration had been faking the national balance sheets and income statements for many years.  Greece was broke, much more heavily in debt than it had previously revealed, unable to repay.  The new guys made the bad news public, but have been unwilling (my view) to do much, other than ask for debt forgiveness, to remedy the situation.

Members have been fighting about how to proceed since then.  Until very recently, no one has been willing to lend to economically weak nations like Italy and Spain, forcing them into crisis.

Pretty awful stuff.

2012 stock market performance

Last year, the S&P 500 was up by a stellar 13%+,  on a capital changes basis.  Despite the ugly picture I painted above, EU stocks outperformed the US by about five percentage points last year, in dollar terms.  That’s the result of a huge rally since July.  EU stocks, which I pointed out back then were yielding 5.5%, still have a 200 basis point yield preference over the S&P–meaning holders made close to eight percentage points more than the S&P on a total return basis.

A dollar-based investor who bought in late July (something I would have thought to be too risky for just about everyone) would have made over a third on his money in five months.

why?

Some people talk about a four-stage process in problem solving:

Stage 1:  deny the problem exists

Stage 2:  blame someone else

Stage 3:  blame yourself

Stage 4:  begin to fix the problem.

I think the Eurozone reached Stage 4 last July   …and the markets picked up on this very quickly.

where to from here?

I read the positive market reaction so far as being basically an anticipatory rally, in the expectation of change that’s yet to come.  In other words, I think it’s far from a sure thing that the parties involved have the political will to create the closer fiscal union that is needed.

still, some positives

a 4%+ dividend yield indicates there is still considerable skepticism still in the markets–implying further upside for stocks if good news continues to flow from Brussels and Berlin

–it’s now much less probable that the EU will come apart at the seams (if anything, there’s likely only to be a slow unraveling)

–the end of the scorched-earth “austerity” policy and its replacement with a more accommodative monetary regime means eps growth in 2013 might surprise skeptics on the upside.  For what it’s worth, the OECD is projecting that Europe as a whole will begin to see (admittedly meager) positive year on year comparisons in the second half.

my bottom line

An EU that’s at least not falling apart and where overall GDP is stable or better is a plus for the rest of the world.

Any value investor, I’m sure, will have a field day poring over the financials of the many companies that are trading at under net equity value–the risk, of course, being that there may be legal and cultural barriers to asset value ever being realized.

But there are better places in the world to invest, to my mind, for the moment at least.  If I were forced to have actively managed money in Europe, I’d certainly be significantly underweight.  I’d be emphasizing Germany, Scandinavia and the UK.  I’d also be trying to find well-managed companies with unique products/services, especially ones with the ability to sell outside the EU.

Since I’m not compelled to be in Europe, I’m content await further political developments and to hold only a few names, concentrating on firms listed in the EU but doing most of their business elsewhere.  Personally, I own small positions in a couple of Vanguard Europe funds, plus IHG.  I’d be happy to add a couple more individual stocks, once I have time to do the research.

the dividend yield on European stocks? … 5.5%!!!

the MSCI Europe index yields 5.5%

That’s according to the analytic services company Factset, in a news release about a week ago.  Yes, the data are from the end of April, so they’re a bit dated and may be off slightly.  But, still…

Why so high?

1.  investor preferences

Historically, investors in European equities are much more income oriented than those in, say, US or Asian shares.  In fact, “growthier” European companies, which tend to plow back the cash from operations into expanding their businesses–rather than paying it out in dividends–may try to go public in venues like New York or Hong Kong instead of on their home ground.  Doing so gets them a more sympathetic/compatible audience, and therefore a higher price earnings multiple (meaning a lower cost of equity capital).

As a result, the European bourses are top-heavy with bank and telecom shares.  The former yield around 12%, the latter about 8%.

2.  the ongoing financial crisis has beaten down European stock markets…

…which have declined sharply over the past year.

Consider what current dividend yields in the EU are saying today:

–Two-year government bond yields in Germany and the Netherlands are currently slightly negative.  In both cases, you have to pay €1001 today in order to get €1000 back in July 2014.  Buying a telecom stock instead gets an investor an income pickup of over 8%–an extraordinarily high amount.

–Over the past ten years, the yield on the MSCI Europe index has averaged 4%  It has only been higher than today on one occasion–a brief period in early 2009, when panic selling of equities pushed the yield to 6.5%.

–The dividend yield on MSCI Europe is typically higher than that on the S&P 500.  The current 3.5% spread is, however, the widest gap seen in the past decade.

what does this mean?

On the most basic level, the numbers say to me that European equity investor confidence is completely shattered.  At the nadir for world stock markets in early 2009, German two-year bonds were yielding 1.5%.  The MSCI Europe was yielding 6.5%.  So the spread between the two was 5.0% then.

Today, the spread is 5.5%+.

Buying the MSCI Europe index, which would return 11% over two years, assuming no change in either stock prices or dividend payments.  Investors are choosing instead the safety of a German bond that they are assured of losing money on.

Put a little differently, the expectation built into today’s stock prices is that they will lose more than 11% over the next two years, wiping out the entire yield pickup–and more.  This would presumably come through some combination of dividend cuts and price declines.

Shades of Japan in the 1990s!

what to do

This view strikes me as excessively pessimistic.

Nevertheless, this doesn’t mean Europe is a screaming buy. The experience of Japan since 1990 may also be applicable here.

To my mind, there are several lessons that may be appropriate:

–although extremes of fear can’t be sustained, at least mildly negative views about equities can persist for a surprisingly long period, especially when the domestic investor base is relatively old and therefore particularly risk averse

–negative sentiment affects the prices of all stocks in a given market to some degree, not just the basket cases

–companies whose main virtue is their high current yield are probably not going to be the big relative winners.  In my view, and also the way I read developments in the Japanese market over the past twenty years, the real winners are well-managed companies which are growing quickly and whose profits come mainly from non-domestic (meaning, in the case of Europe, non-EU) sources.  Better if they pay a current dividend, but the rate of earnings growth is more important.

Feeling for a bottom in Europe is not a task for the faint of heart.  Nor is it anything one should do with more than a small fraction of his portfolio.  Still, it seems to me that we’re at, or near, a degree of negative sentiment that’s excessive and can’t be sustained for long.

thinking out loud about Euroland (II)

Euroland is small

Yesterday, I tried to argue that in world economic terms the Eurozone is smaller than many investors believe and that, therefore, even a severe recession there next year will only have a mild negative impact on global growth prospects.

There are two additional economic factors to consider–trade and investor expectations.

trade

Ex oil, most trade among Eurozone members is with each other.  Sales to the EU from China–Europe’s largest external trading partner–amount to less than 3% of the economy of either.  The same is true for business between the US and the EU.

Trade usually rises and falls faster than a country’s overall economy, though.  So a 5% decline in Eurozone GDP next year might translate into a 10% decline in imports.  Certainly not a good thing, but not by itself a disaster, either.

investor uncertainty

To my mind, the bigger issue by far is investor uncertainty.  Such fears typically turn out to be wildly overstated.  That knowledge doesn’t help much, however, if it’s your portfolio that’s being swamped by waves of irrational selling.

Even though Americans have been investing in foreign stock markets in a serious way for almost thirty years, I think most people still don’t understand that there isn’t a one-to-one relationship between world economies and world stock markets.  The relationship works for bonds, which comprise a much larger class of securities, but not for equities.

There are two reasons for this:

–in most countries, large portions of the economy have no publicly listed companies.  In the US, for example, the real estate, housing and auto sectors, all of which are important for GDP growth, have very little stock market representation

–in many countries, the owner of a domestic enterprise can easily be a foreign company.   In this case, the owner’s main public listing is probably in a foreign country–if it is listed at all.  Again, it contributes to GDP but has no local stock market presence.   TIF, for instance, is a US company but earns money and adds to GDP in the EU, Japan and China.  Ikea is a global furniture company founded by a Swedish entrepreneur.  It’s incorporated in the Netherlands and not publicly traded anywhere.

world stock markets by size

In world stock market terms, the Eurozone is smaller than it is in a macroeconomic sense.

The world stock markets open to foreigners break out roughly as follows:

US          45%

Eurozone          11%

rest of Europe (mostly the UK, with a dash of Switzerland and Sweden)          13%

Japan          9%

Canada + Australia          8%

emerging markets          14%.

Slicing the Eurozone up a bit further, the area’s main components are Germany and France, which together make up more than half the total.   By far the biggest sector is financials.

Unfortunately, there’s no reliable information I’m aware of to sort out the relationship between where companies in continental Europe may be listed vs. the countries where they make their money.  I think we should assume that all financials are pan-European enterprises, no matter where they are listed.  For other sectors, the tendency has been for countries to declare that certain companies or industries are national treasures and can’t be acquired by foreigners.  My guess–and it really is a guess–is that ex financials, most multinational exposure is to non-Eurozone areas.  If so, this exposure would be an economic and stock market plus.

conclusions

In the parsing of world stock market above, which gets down to the level of markets that make up as little as 2% of the world’s stock markets, Greece, Italy, Portugal and Spain don’t show up at all. They’re that small.

In terms of investor concern that’s depressing overall European markets, then, the issue has got to be either the indirect effects on business in France and Germany of problems in smaller Eurozone economies and/or the negative effects on the very large banking sector.  My guess is that the negative signal European markets are giving is much more the latter than the former.

 

Tomorrow–how to structure an equity portfolio in light of European stock market weakness.

more on “discounting”

discounting

“Discounting” is the jargon that Wall Street uses to describe the process of factoring changes in consensus beliefs about future happenings into today’s stock prices.  I’ve outlined the basics of discounting in an earlier post.

fundamental vs. technical analysis

Fundamental analysis, the study of company-specific and economy-wide economic and financial information, and technical analysis, the study of charts, can be seen as two approaches to discounting.  In the first case, researchers try to figure out what information is most important for making a security’s price go up or down, and then actively search for relevant data.  In the second, investors study chart patterns as a way of figuring out what fundamental analysts are doing and then riding on their coattails.

the internet

The internet has changed the amount, quality and cost of information in dramatic fashion. For example:

–When I was building an international equity investing organization for a major financial institution in the early 1990s, it cost about $300,000 a year in today’s dollars to get access to all corporate SEC filings.  The data came on microfiche and was available about six weeks after the documents were filed.  Today, the information is free on the SEC’s Edgar website; documents are available the instant they’re filed (companies do this electronically).

–Thanks to regulation FD (Fair Disclosure), company presentations are routinely webcast and are available through the company website.  Typically, they’re archived for at least a year.  True, breakout sessions at conferences, small group meetings or one-on-ones aren’t, but these mostly serve to fill in the blanks for analysts not familiar with a firm.  Companies may sound like they’re revealing new information, but they’re not.

–A Bloomberg terminal still costs $30,000-$50,000 a year, depending on its capabilities.  But discount brokers offer most of what an individual investor needs to their customers on their websites for free.

discounting and Greece

Discounting isn’t a one-time event.  It’s a process.

1.  For one thing, what’s painfully obvious to a seasoned observer or an industry specialist may only dawn on the average investor a considerable time later.

2.  Also, bad news that relates to a specific event is typically not fully discounted until the event occurs–no matter how far in the future that may be.  The financial crisis in Greece is a good example.

A year ago, a new administration in Athens revealed that the country had been falsifying its national accounts for many years.  Greece had taken in less in taxes and also spent a lot more than it had ever revealed.  How so?  Its membership in the EU had allowed it to borrow much more than it could ever repay.

For at least six months, it has been clear that either the rest of the EU will be forced to pick up the tab and let Greece remain in the EU, or that Greece will default and lose its EU membership.  In default, holders of Greek sovereign debt would lose most of their money.  But, since that’s mostly big EU banks which might need government bailouts as a result, the effect is basically the same.  EU taxpayers ultimately foot the bill.

Over recent months, however, EU stock markets–and the financials, in particular–have been subject to periodic waves of selling, driving prices ever lower, as investors express their fears about Greece.  …despite the fact that in general terms everyone has already read the closing chapter of the story.

This pattern of discounting the same news over and over again is typical.  It begins in denial (inadequate discounting) and may end in despair (overdiscounting), the same emotional pattern that shapes a bear market.  While bear markets end in a whimper sometimes, however, discounting that anticipates a discrete event usually involves a final selling bout as the event actually occurs.

Over the weekend, the G-20 seems to have given the EU an ultimatum to resolve the Greek crisis quickly.  We’ll see tomorrow how the markets react.