Germany: bad economy, good shares

Germany: bad economy, good shares - at - the best of the week's international financial media.

Wherever you look around the world, you'd be hard pushed to find a more rubbish economy than Germany's. The days of its industrial supremacy are a distant memory, its economy is mired in incomprehensible bureaucracy, domestic demand is weak and unemployment hit a 72-year high in February. What Germany is going through right now can no longer be classed as merely a recession: it's more like a depression. GDP fell by 0.2% in the last quarter of last year. And on the face of it, there's little reason to think things will improve anytime soon. Any reform of its bureaucracy is nigh on impossible, thanks to the fact that civil servants effectively have their jobs for life; the ageing population combined with public hostility to immigration suggests ongoing budget deficits; and finally, the rise of global low-cost competitor economies, such as China and India, is turning out to be the last straw for high-cost manufacturing all over Europe.

Given all this, it's hardly a surprise to find that retail investors aren't showing much enthusiasm for the German market. But perhaps they should be. Last month, ABN Amro and the London Business School produced research that show there has never been a statistically significant link between a country's GDP growth and its future investment returns. It's the other way around: slow growth countries consistently deliver better performance.

First, there is the fact that in high growth economies, cash flow is likely to be poured into capital investment and expansion. In slow growth economies it is more likely to be paid out in dividends - and over the long term, high yielders always outperform so-called growth stocks. Second, periods of low growth very often force companies to change the way they operate (for the better).

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Finally - and most importantly - low-growth markets that investors don't expect much from tend to be cheaper than those operating in the world's go-go economies. And if you buy cheap assets over time, you do tend to make more money than if you buy expensive ones.

So are German firms cheap? China seems to think so. As its hungry economy grows, it has started to look around the world for acquisitions that will feed its commodity and manufacturing needs, and increasingly its eye has been falling on Germany. High-tech German steel plants are, for example, of great interest to the waking giant economy of China, whose own steel mills can barely keep up with demand. Three years ago, German steel giant ThyssenKrupp sold an entire steel plant near Dortmund, in the heart of what used to be Germany's largest industrial region, to a Chinese steel firm. Expect deals like this to come thick and fast from now on: the Chinese are no longer just low-cost manufacturers, they're moving up the value chain and they need the kind of industrial expertise found in Germany to do it. Private-equity buyers have been having a field day in Germany too as suffering conglomerates have been putting anything that is outside their core activity on the market. Recent deals have included the sale of chemicals firm Celanese to Blackstone for $3.1bn, the sale of WET Automotive (the world's leading supplier of in-seat heating for cars) to UK-based HG Capital, and the sale of Dynamit Nobel (the explosives company whose founder set up the Nobel Prize) to legendary American private equity group, KKR Kohlberg.

Private-equity buyers only buy anything if they think they are getting a bargain, and in many cases, they very probably are. Just as the ABN Amro year book suggests should be the case, years of low growth have forced change on German corporates. As Dirk Schumacher of Goldman Sachs points out, thanks to intense restructuring efforts - balance sheet strengthening, real-wage cuts helped along by labour reform, and so on - there has now been improvement in profitability across the corporate sector. So much so that Germany can now be said to have regained its competitive position with the rest of Euroland, says Schumacher. The German economy even seems relatively well placed for recovery, with many analysts expecting its marked underperformance soon to come to an end with household income and consumption growth showing signs of recovery later this year.

Yet despite this potential, Germany remains one of cheapest stockmarkets in the Western hemisphere. The profits of the 30 companies contained in the Dax index rose 40% in 2004, but valuations only rose 7%. The Dax is now valued at just 13.5 times 2005 earnings and there are plenty of companies trading at single-digit p/e ratios. ThyssenKrupp now offers a 4.3% dividend yield. MunichRe, the world's largest reinsurance company, is trading at a p/e of just about ten. Volkswagen, still Europe's largest car manufacturer, can also be had for just ten times earnings. Then there are less obvious plays, such as Suedzucker - with a 22% market share it's the leading sugar producer in Europe. Sugar is a tricky business to be in due to the World Trade Organisation's (WTO) ruling that sugar subsidies must go. But what with the oil price back over $50 a barrel, there's great potential for producing bio-ethanol fuels based on sugar. Suedzucker could be one of the surprise investment opportunities of the next few years.

We are not suggesting that Germany is out of the woods completely. It isn't. However, we need to put the bad news coming out of it into perspective. The country is still Europe's largest economy with 80 million people, all of whom need to be fed, housed and entertained. At the same time, the vigorous restructuring seen in recent years suggests there is huge potential for individual firms to prosper, regardless of slow growth - something that the market appears to be underpricing. The smart investor will find plenty of opportunity to profit from restructurings, takeovers and rising profits. It's a stockpicker's paradise.

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