What’s next for Europe? And where should investors look for profits? John Stepek finds out where our Roundtable panel of experts are putting their money now.
John Stepek: Investors no longer seem as afraid of Europe blowing up. Has the European Central Bank (ECB) succeeded?
Richard Webb: Yes, since the OMT [the ECB's sovereign-bond-buying programme] was announced last summer, tail risk' has been removed. We've had some testing periods with the Italian election and Cyprus, but bond-market spreads have narrowed.
Bertie Thomson: Yes, it's easy to get carried away about Cyprus, but in the end, only 4% of deposit holders were affected. I've recently been in Greece and the ECB's intervention is keeping the banking system alive. They understand that that's the oil that keeps the economic engine going.
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Greece won't be allowed to leave the euro it could ruin most of Germany's banks. You'd have a bank run in all the peripheral countries. What they need is a banking union and it will happen, slowly but surely.
John: Has Greece bottomed out?
Bertie: There are still too many vested interests. Tax evasion is rife. Professions are liberalising, but still very closed off. While the economy is coming back from the dead, it's still tough out there, and although unemployment is at 27%, we're only just starting to see wage deflation. But it was a lot more unstable last year with the elections. Now we're through that, the backstops seem to be working. Greece will live to fight another day.
John: Are any of you invested in Greece?
Everyone: No.
Richard: You've got to be certain of the recovery.
Bertie: There's a risk of further capital destruction. But they'll muddle through.
John: The German election in September looks like the next big hurdle.
Andrea Williams: Let's hope Angela Merkel gets re-elected. The peripheral countries have been through some very painful austerity. The risk is that they end up in a downward spiral. So they need some incentives: longer deadlines for balancing budgets, etc. But it's hard to see that happening ahead of the election because Merkel can't be seen to be letting the naughty' countries off the hook. But if she does get re-elected with a working majority, maybe we can see about finding stimulus for these economies.
Greg Bennett: Meanwhile, central bankers have become the king-makers rather than the politicians. They control the money they are the ones people look to. The economic data are weak as, in many cases, are corporate profits, yet still the stockmarket rises as central banks push people to take more and more risk. So regardless of the economy, equity markets could continue going higher.
John: Are markets betting that the ECB will eventually do quantitative easing?
Richard: No. It's more that we now have two big monetary bazookas from the US Fed and from Japan, and European markets are rising along with that. Even so, there's not much participation in European stocks, despite the gains. Sir John Templeton said that bull markets are born of pessimism and die on euphoria, but we haven't even got as far as enthusiasm yet this is very much a stealth bull market.
Andrea: The bigger problem is that companies are questioning their commitment to Europe. They've cut advertising in Spain because they see no point spending money when economies are this deep in recession. The risk is that they pull out of some markets altogether, which would not be great.
John: Which countries have the most promise?
Bertie: What's important is where and how a company makes its money, rather than where it's listed.
Andrea: Yes, the trouble with the Italian or Spanish index is that you are buying the banks, the utilities and the telecoms. With the utilities, often the balance sheets are stretched, there's no earnings growth, and the regulator's all over them. And I don't feel confident enough about those countries' banking sectors what with bad loans still going up.
Bad debt provisions started in the property sector, but then rolled into the small business sector. If things don't improve, they'll have to make even more provisions. It's hard to guess when that stops.
Greg: Yes, last year analysts expected bank earnings to rise 15%. Instead, they fell 35%. Earlier this year, analysts expected earnings to rise by 47%. A lot of this hoped-for improvement is about provisions normalising, but that's not going to happen. They've already had to cut their estimates. This is key.
The loose money we see on our Bloomberg screens can't be accessed by people in the real' economy, unless they work for very large, liquid German firms. Small Spanish businesses can't access it at all their cost of lending has actually gone up. So the transmission mechanism is what the ECB is trying to fix. But all the worry about regulation and capital ratios hardly gives the banks an incentive to lend.
Richard: It's about clearing the losses. In America the banks recognised their losses immediately. Citigroup has written off $140bn-$150bn no European bank has done that. But it's going to take a long time.
Andrea: Some Scandinavian banks are doing well, although that's partly a function of their economy. Some are making a 15% return on equity or more, and already have more than enough capital. Handelsbanken, for example, is making good inroads into Britain.
John: What other sectors do you like?
Richard: Given the low growth rate in European telecoms, we look for individual pockets of growth in the sector, such as the cable companies. Kabel Deutschland's (Germany: KD8) cable business is growing at about 8% a year by winning market share with faster speeds and better deals than its fixed-line rivals such as Deutsche Telecom.
Iliad (Paris: ILD) in France is also growing strongly as it has entered the mobile market with aggressive prices and a better cost structure, and so is eating into the market share of the three incumbents, which are too fat to compete.
John: One argument is to buy European companies that don't sell to Europe.
Richard: Really you just want companies with unique goods and services who are selling into unmet demand. But in many cases the markets have efficiently priced that in. For example, the fast-moving consumer goods stocks such as Diageo, Unilever and L'Oral have done incredibly well.
Bertie: We like Handelsbanken (Stockholm: SHBA). It's well capitalised, well run, and has a unique approach to banking, focusing on the top 15%-30% of customers in the credit spectrum. It pays a good dividend too. It may not be that exciting, but in this environment it can grind out double-digit earnings growth, and juice up the dividend over time.
We also like Novo Nordisk (Copenhagen: NOVOB), the world's leader in diabetes care. Diabetes is a growing problem worldwide and the market remains an oligopoly in terms of the providers. It's also a very sticky product: diabetics generally don't change their insulin provider for over a decade.
There's strong growth, good cash flow and production is not particularly capital intensive. The company has enough capacity to maintain double-digit growth over the next four years.
Then there's lift maker Schindler (Zurich: SCHP). It makes most of its money from servicing, rather than installing, equipment. So it has strong, predictable cash flow as each year management knows how many installed elevators it has, and what revenue they will generate.
Andrea: I like Handelsbanken too. We also hold Swedbank (Stockholm: SWEDA). Handelsbanken has grown its dividend by a 15% compound average growth rate over the last five years, and is pre-funded up to 2014. The bank also has more capital than it needs, so once the regulator has decided on various issues, it will raise its dividend payout close to 50% and may also buy shares back.
I've also got a drug stock, Novartis (Zurich: NOVN). It has lagged others in the sector, but it's managing its patent cliff (where products go off-patent and can be copied by generic drug makers) well. It's also talking about slashing the time it takes for certain products to get to market, because it can now target drug trials at specific sets of patients. Its pipeline of new products is full, growth is in double-digits, and it yields nearly 4%.
My third is lockmaker Assa Abloy (Stockholm: ASSAB). It's twice as big as its nearest rival. It has entered the security door market, which is ripe for consolidation. It has a broad geographic spread, with good exposure to the US economy, which is recovering with both the residential and commercial property sides improving. The yield is about 2.5%, but it generates plenty of cashS.
John: Greg?
Greg: Many large firms in Europe have interesting things going on. Sportswear specialist Adidas (Germany: ADS) is one. In 2010 it set itself targets for 2015, the main one being to raise margins from 7.5% to 11%. Analysts think it'll hit its sales growth target of 7%-8% a year. But they don't believe it'll hit the margin target. However, the numbers Adidas released recently suggest it might.
Meanwhile, it's generating cash at a phenomenal rate and could have e2bn in net cash two years from now. It's the global number two in footwear but number one in sports apparel. It's improving its margins partly by reducing its range and making distribution more efficient. But it's also sales-driven.
China and Russia are its two highest-margin markets. America is the lowest, but there it has only single-digit market share. If it can increase that, then economies of scale come into play. If you believe it can hit its 11% margin target then, adjusting for cash, you're looking at Adidas being on a single-digit price/earnings (p/e) ratio in three years' time.
On the low-cost airlines story, the most interesting is Norwegian Air Shuttle (Oslo: NAS). The company has a huge capital-spending programme it plans to double the size of its fleet over the next five years. But this year it will be Europe's second-cheapest airline in terms of average cost per available seat kilometre.
The key in terms of upside surprises is that while analysts assume decent single-digit ticket price rises for most low-cost airlines, Scandinavian analysts assume 0%-0.5%. So as long as ticket prices remain flat or go up, it can easily fund itself.
Marine Harvest (Oslo: MHG) is the world's biggest salmon farmer. Salmon prices have shot up from NOK25 in October, to NOK42 now. Demand is growing at 9% a year, but supply for this year and next is only likely to rise by 0%-3%. These price gains feed directly into MHG's profits, with the company seeing significant earnings upgrades.
Lastly, the Norwegian government has lifted restrictions on salmon farming market share, so MHG has begun consolidating. It has bought the world's largest value-added processing company and is bidding for Cermaq, the world's largest salmon feed company. This would give MHG a global market shares of 30% in salmon farming and salmon feed while also being number one in processing.
Richard: We like Eurofins Scientific (Paris: ERF), which tests products in the food, drug and environmental sectors. Organic growth is about 8% a year, with acquisitions accounting for another 4%. China and India haven't even started testing products, but right now the Chinese are buying up baby milk from around the world because of home-grown contamination scares. You can imagine what will happen to demand for testing once they work out just how unhealthy their food chain is.
We also like small engineering companies with specialist technology. Duerr (Germany: DUE) makes the paint shops at the end of car production lines. Global expansion by auto companies coupled with historic under-investment in the US has allowed Duerr to build a strong order book. Their customers, mainly auto manufacturers, will continue to reinvest in production plants.
Duerr's products allow significant cost savings for the car firms. So you have a company with good visibility of orders, compound annual growth rates of 20%-25% for the next two to three years, and a low valuation. You can say the same for KUKA (Germany: KU2), which makes robotics for factories.
John: What do you think will mark the turning point for Europe's economies?
Andrea: We need to help the unemployed. Youth unemployment at 50-odd per cent is frightening.
Bertie: I wonder if, after the German elections, we might see a deal done where reforms are pushed through peripheral economies in exchange for some debt being waived. The eurozone is very much a socialist organisation. It wants everyone to have the same standard of living, and the same approach to life.
We need to get to the point where the Germans are happy to say: "look, Greece doesn't have the money to live in the German way we have to help it out". And we need a banking system that is joined up across the countries involved.
John: Where does that leave Britain?
Bertie: The risk is that in these moments of extreme economic pressure, populism rears its head. Look what happened in Italy, look what Greece had with Golden Dawn it's scary stuff and I think Ukip's popularity is a small extension of that. It's what happens when political will meets economic reality. That is the risk when does political will start waning?
But you've also got to remember that politicians look after number one. The answer is always no' until it's yes'. They want to get re-elected and they'll keep moving the goalposts to do so.
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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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