Back in the late 1980s and early 1990s, the rest of Europe saw itself as being dominated by the seemingly unstoppable German economic locomotive. Germany's central bank, the Bundesbank, set the tone of European monetary policy. German export companies were raking in the cash by selling its "Made in Germany" brand to the rest of the world. And the public finances were healthy. Less successful European economies often had the feeling that the Wirtschaftswunder country was looking down on them, as Germans enjoyed the best standard of living of all the major European countries.
But it's been a long time since Germany had reason to feel smug about its economy. The attempt to rebuild East Germany with government money after reunification hammered the public finances and misfired in many cases. Persistent resistance to necessary structural reforms of the country's famously strict labour laws, for example caused an exodus of entrepreneurs to the likes of Switzerland or the UK. Other than software giant SAP, not a single newly formed German company has made it big on the international stage for at least two decades. Between 1990 and 2005, property prices went nowhere and, in real terms, actually fell back to 1975 levels.
But finally, in recent months, Germany has had something to cheer about. In fact, "a broad recovery is underway", reckons the New York Times. Unemployment is almost back to pre-crisis levels at 7.6%, well down on January's 9.1%. To put that into perspective, five years ago, unemployment stood at 13%. And German business confidence, as measured by the Ifo Business Climate index, last month saw its largest jump in 20 years. "The German economy is in a party mood," says the institute behind the index. Andreas Scheuerle of DekaBank adds: "These are fantastic numbers. It's incredible what's going on".
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No wonder the DAX index (constituting Germany's 30 leading companies) is at near-record territory. At 6,300, it is back above the 6,000 mark, which has only been surpassed on three previous occasions. In 1998 it had hit 6,200, only to fall back to 4,000 a few months later. At the end of 1999, it shot past 6,000, temporarily reaching 8,000, before collapsing back to 2,200 by spring 2003. Then at the end of 2006 it once more rallied all the way to 8,000, only to fall back to below 4,000 during the financial crisis.
Will the rally that has taken place since early 2009 continue? Could the DAX be about to hit five-digit territory for the first time? As is often the case in Germany, not all is as it seems on the surface.
The German renaissance
Tempting though it may be, turning government statistics and isolated facts into headline material does not always make for useful analysis. For investors, the path to profit more often lies in analysing the fine print and questioning the figures put out by the authorities. And you also need to bear in mind that Germany is a vast country of 80 million people, with regions and industries about as different from each other as the Hebrides are from the City of London.
For example, the unemployment figures might make Germany look like a stellar performer in generating jobs. However, the German system of "short-hours work" (Kurzarbeit) needs to be taken into account. Thanks to changes in labour laws, many companies nowadays opt to keep workers employed during weak periods, but on fewer hours and lower pay. This reduces the official unemployment figure, but it doesn't make for successfully employed workers with disposable income.
Such quirks have given rise to the multi-tier economy that Germany has had for a number of years now. The export industry is booming, with Germany still the second-largest exporter after China. However, the German consumer industry has never recovered from the collapse in confidence of the early 1990s. The retail industry remains weak and many Germans prefer to put their savings into ultra-conservative savings accounts with state-owned banks, rather than to spend or to invest.
The starkest example of such trends is probably the performance of the Munich property market compared to some locations in Eastern Germany. Munich looks on course to see a price level for residential property that can rival other major European capitals. Previously unheard-of prices per square metre of more than €10,000 have become common. In Eastern Germany, on the other hand, large areas are depopulating, and there are plans to raze entire villages. Between those two extremes are a wide range of individual markets. So what, specifically, should investors interested in Germany currently be looking at?
The single currency is key
Any analysis of German investments must start with the euro including a critical analysis of whether the single currency is here to stay. For a start, the success of the German export economy (as the key pillar on which the German economy now stands), hinges to some degree on the fluctuations of the euro versus other currencies. German products are in demand globally for their quality and longevity. However, an overly strong euro hurts the sale of German products abroad because it makes them horrendously expensive. A weak euro, on the other hand, can fuel the German export economy like no other single factor.
The debt crisis has already led to some serious fluctuations in the euro exchange rate. For example, it plunged against the US dollar from $1.50 to just $1.19 in a mere six months between December 2009 and June 2010. The big question now is whether more such fluctuations are on the cards, and whether there is a risk that the euro will collapse.
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A euro collapse could be caused by Germany going back to its former national currency, the deutschmark, and leaving the eurozone. Unthinkable? Maybe not. Financial markets are in entirely uncharted waters. The European Central Bank, for example, has published a paper called Some Reflections on Withdrawal and Expulsion from the EU and European Monetary Union. That alone tells you that such a drastic possibility needs to be taken into account.
A group of German professors has already taken the government to court, claiming that the bailout of Greece was against the German constitution. They are effectively trying to force the government to leave the euro. Such legal tussles aside, not only in Germany but elsewhere too there are those who see such a development on the horizon. British fund management group Schroders recently published an analysis claiming that it is "highly likely" Germany will leave the monetary union in the medium term. But is it that simple? And where does this leave investors?
The euro: tougher than it looks
For a start, it's not a given that the majority of Germans want to leave the euro. In a recent poll, 66% of the population was in favour of sticking with it. Germans are well aware that the return of the deutschmark would undo decades of European integration. To a nation that is still wary about its own past, this is quite a major factor. And as the pace of the country's economic reforms since the early 1990s has shown, Germany tends not to enact reforms quickly, even in times of economic pain.
Of course, the break-up of the euro needn't necessarily be driven by Germany. Other countries could well beat Germany to it. Since 1829, Greece has been in default on some of its debt for more than 50% of the time. The country has defaulted no fewer than 12 times.
Given its history, Greece looks a more likely candidate to refuse to put up with a fair bit of economic pain.Portugal and Spain would be potential candidates to follow. A euro unburdened of these weak members would return to being a strong currency, so Germany would have no reason to leave. A strong euro would hurt Germany's export industry, but it would be likely to boost consumer confidence and increase internal demand.
On the other hand, if Germany became proactive about leaving the single currency, it would be likely to find itself with an ber-strong deutschmark. Again, while this would leave Germany with fewer costs for bailing out weaker partners, Germany would also be left with less income from its export industry. But foreigners owning German assets would benefit from strong currency gains.
And there's a third scenario. This consists of Europe doing what it has always done best namely, dragging out problems and not making any tough decisions.
If the southern European countries refuse to reform their economies in the way that its northern partners believe they should be reformed, a sustained banking crisis with more bailouts and ongoing monetary moves to revive them could follow. The likely consequence? A weak euro, which would make it more expensive for Germans to holiday abroad, yet at the same time send their export industry through the roof. If Germany's export businesses are successful even at a dollar exchange rate of between $1.20 and $1.30, then an exchange rate of $1.0 or even $0.84 (as seen back in 2000) could lead to an export boom of unheard-of proportions.
So how do you play Germany?
The recent renewed strength of the euro, which has rallied back to $1.32, doesn't seem to be signalling that Germany will leave the euro any time soon. Then again, markets can always be distorted in the short term, not least because of all the interventions that have been going on latterly.
This reliance on the euro makes it hard to know the best way to play the German market. Unusually, the immediate future seems to hinge to a large degree on the path of the single currency. Stock pickers can easily find value, but their bets are now at the mercy of what could be a future of extreme currency fluctuations. And right now, whether the Greeks or the Germans will be the first to decide to call a halt to being part of Europe's biggest-ever monetary experiment, is anyone's guess. We might even simply see a persistent crisis with no clear solution it wouldn't be ideal, but it certainly wouldn't be a first for the eurozone.
How do you prepare for this uncertainty? We do what investors have always done when faced with an uncertain future diversify and stick to good, old-fashioned value. And what makes it a bit easier for investors to make decisions is the fact that there are some truths about the German market that are less subject to varying opinions and controversial debates.
For once, the market itself is quite cheap. Even at its current near-record level, the DAX index is only trading at a p/e of 10.6 based on expected 2011 earnings. And set within the complex German economy are some companies that have inherent, proven strengths, and which investors can currently buy into on the cheap. We look at some of these promising stocks below.
The best investment options in Germany
Munich Re (MUVG:DE; ISIN DE0008430026) is still the world's leading reinsurance company. The conservatively managed company is expected to achieve earnings per share of €11.30 in 2010, followed by a rise to €13.40 in 2011, and €14.80 in 2012. Last trading at €109, you won't be able to find many global market leaders at such a low valuation and with an easily sustainable dividend yield of more than 5% on top.
If you believe Europe will suffer an ongoing malaise and see a weaker euro (and to be fair, even if Germany decides to quit, things will get worse before they get better), you should invest in export-orientated German firms. Foremost among them are German carmakers. Only 18 months ago, these were written off as has-beens, kept afloat by government subsidies for wrecking old cars. What investors underestimated at the time was the strength of demand from emerging markets, coupled with a seemingly global penchant for old-style "Made in Germany" brands. Global car production is now expected to reach 68.7 million units this year, up from a previous estimate of 65 million and well ahead of the 2008 record of 66 million.
In China, the sale of automobiles grew by 50% during the first five months of 2010 to 5.8 million cars. Volkswagen preference shares (VLKPYISIN DE0007664039) are trading at just 3.2 times cash flow and 0.12 times revenue. There are question marks over its expected merger with Porsche, but these will eventually be resolved. In the meantime, BMW (BMW.DE) ordinary shares are trading at a p/e of ten. The firm is profiting even more than Mercedes from the developing world's thirst for such status symbols. Thriving even at the current exchange rates, these firms would turn into minting machines if the euro were seriously to weaken.
The same holds true for some of the lesser-known names in the German economy, such as Krones (KRN.DE). The world market leader for bottling plants suffered its first-ever loss in 2009, but is already expecting 10%-15% revenue growth to €2.1bn this year. Profits are expected to come out at €40m. Any euro weakness would add tremendously to the bottom line, given that the company is exporting more than 90% of its production. China and Africa now each account for a fifth of the company's sales. The shares recently had a run-up to €44 and should be bought if they fall below €40.
The other obvious route to investing in Germany is property. Prices have risen 10% over the last year, but compared to other European countries are still cheap. Berlin offers 8%-10% rental yields for low-income housing outside the trendy city centre. Prices of less than €1,000 per square meter are even running below replacement costs.
Those seeking a reliable income stream can do well with carefully chosen Berlin property. The use of leverage, combined with currency fluctuations, has the potential to lead to spectacular gains. However, the latter can, of course, backfire, as the poor performance of many Aim-listed German property funds shows. Develica Deutschland (Aim: DDE) currently has a negative net asset value, and its shares are more roulette chips than anything else. A host of other such funds have recently been struggling with refinancing issues. Speymill Deutsche (Aim: SDIC) is an interesting bet, given the involvement of City financier Jim Mellon as a major shareholder.
Those looking for a less high-octane play on German property could also be well advised to consider conservatively managed German property companies, such as Hamborner REIT AG (HAB:DE). This remnant of a former industrial firm nowadays manages a conservative portfolio of rental properties, as well as 4.5m square metres of land, and features a low loan-to-value ratio of 34%. It sports a dividend yield of close to 5% and is suitable for those looking to diversify into euro-denominated assets without taking overly large risks or dealing with the hassle of looking after tenants.
Swen Lorenz is a private investor, entrepreneur and author. For more see, www.undervalued-shares.com .
This article was originally published in MoneyWeek magazine issue number 499 on 13 August 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.
