German equities: now even cheaper

New measures announced by Chancellor Gerhard Schröder will boost after-tax profits in Germany this year. James Ferguson goes bargain-hunting

Last week in MoneyWeek, Euan Stuart and Sven Lorenz argued that Germany was "the best buy in Europe". Their argument was twofold: that slow-growth economies have historically made for the best investment returns, and that Germany is "one of the cheapest stockmarkets in the Western hemisphere". To these two attributes, we can now add another: the boost to net profits to come from Chancellor Gerhard Schroder's corporate tax cuts.

Stuart and Lorenz, citing the ABN Amro and London Business School analysis of the last 105 years of equity and bond prices, argued that there are several reasons why a slow-growth economy's stockmarket outperforms, such as high pay-outs, pressure for corporate restructuring and cheapness. But I'd say government hand-outs are just as important. Last week, in response to a 72-year high unemployment rate of 12.6%, Chancellor Schroder initiated what Kate Connolly, writing in The Daily Telegraph, called "an emergency raft of reforms aimed at boosting growth".

Critics remained unimpressed, which implies that Schroder may yet be forced to come up with even more goodies later. However, for now I'm pretty impressed with one of the measures that did go through: a cut in corporate tax from 25% to 19%. All other things being equal, this will boost profits by 8% this year, on top of any other growth that companies can achieve. With eurozone interest rates so low (though they'd be lower still if they were being set purely with Germany's plight in mind), this extra 8% of profits is enough to boost equities to their cheapest relative to bonds for two decades. To see the historic relationship between bonds and equities and compare the two, we need first to look at equities as we might a bond: in yield terms. We could look at dividend yields, but because profits that aren't paid out as dividends are reinvested for future growth (ie, future dividends) it is more normal to look at the yield implied by the whole earnings per share (EPS). To get this figure, we divide the EPS by the share price, or alternatively invert the price earnings ratio (1/p/e). Germany's p/e is about 13 times, so the earnings yield is 7.7% (1/13), more than twice the bond yield.

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While equity investors are expected to get some additional reward for the risk they're taking, in reality the yields from bonds and equities are on average around the same. This is not to say they don't swing about a bit, but the historic range for most markets, including Germany's, is usually not more than about 0.75 (expensive) to 1.5 times (cheap). An earnings yield ratio of twice the yield from bonds is therefore considered very cheap, as cheap, for example, as it was in 1988, just after share prices had been hammered down by the 1987 crash. Then Germany's benchmark index, the Dax100, doubled in just two years (1988-1990). However, Schroder's tax rebate will boost Germany's earnings yield to 8.3%, which is a huge 2.22 times the bond yield. This means that on this measure, German equities have never been so relatively attractive compared to bonds. Ever. To give you an idea of just how cheap this is, consider that only five years ago, at the height of the dotcom bubble, the earnings yield ratio was just 0.6 times. Relative to bond yields, equities are now about a quarter of the price they were back then.

The five best German stocks to buy now

Stuart and Lorenz highlighted some very attractive stocks, like ThyssenKrupp, which has a dividend that yields more than bonds; MunichRe and Volkswagen, which both have p/e ratios of just about ten times; and Suedzucker, Europe's number-one sugar company, and as such a play on both the sugar and oil prices.

However, one stock I hold, which I think offers excellent value amid exciting earnings-growth prospects, is the giant chemical and household care products company, Henkel. Henkel, famous for such brands as Persil and Loctite glue, trades on a 15-year low prospective p/e of just 12.5 times, even though, with bond yields so low, there should be scope for the p/e to be up nearer the all-time highs of 30 times. This low p/e, you might think, implies a low, or even zero growth, outlook, yet analysts' consensus earnings forecasts are for e5.2 per share this year - a good 30% better than a year ago, with further double-digit growth pencilled in for next year. If Henkel's share price, already very cheap, should continue to track its earnings-per-share outlook, that outlook implies a very exciting share-price jump.