Many European stock sectors have been feeling side effects from stiffly tightened regulation, a trend that traces back to the global financial crisis of 2008–’09.
Some national governments and central bank regulatory bodies are imposing their own detailed rules that have the effect of increasing banks’ capital requirements even beyond the strict requirements set out by international regulators. Examples include rules from the Norwegian Finance Ministry and the Bank of England.
In other sectors, such as utilities and telecommunications, politicians have been pressing companies more aggressively than before to keep prices low in response to the fall in household incomes in real terms. For example, in the U.K., the opposition Labour Party, which is leading in opinion pools, had pledged to freeze gas and electricity bills for 20 months if it wins the next election. The resulting political furor has put pressure on energy companies to keep prices low. EDF Energy, one of the big suppliers, has declared that it will hold energy prices unchanged for the rest of 2014.
And the costs have spilled over to investors, who note that regulatory expenses are becoming a key variable in calculating their strategies. “If you look at the top inputs to profits that investors in Europe have to look at, government intervention, including regulation, has escalated to become one of the two key drivers,” says Anne-Gaelle Pouille, managing director and partner at Pacific Alternative Asset Management Company (Paamco), an Irvine, California–based fund of hedge funds firm with $8.2 billion in assets under management. The other key driver, she says, is “competitive positioning.”
But although the impact of regulation must be considered, say some investors, its future course is much harder to predict in Europe than in some other parts of the world. “If something is going to be good for Chinese business, investors can count on it being done by the Chinese government,” says Pouille. “Europe, on the other hand, tends to be a lot less predictable. European governments make regulations that may be good for certain industries, but there are also other forces at play, including social forces.” She cites Germany’s 2011 decision to phase out nuclear power after the Fukushima disaster in Japan, a move that partly reflects the German public’s long-standing disquiet about nuclear energy.
Some investors in Europe see the increased importance of regulation as an opportunity, rather than as a threat.
Paamco, for example, is considering long and short opportunities in European telecoms. Specifically, French telecoms have become ultracompetitive because big incumbents, such as Bouygues Telecom, the country’s mobile service provider, have been forced by France’s telecom regulatory agency to open up their networks to smaller competitors that lack such extensive infrastructure, such as Paris-based telecom Iliad. The situation has fostered speculation about mergers and acquisitions within the sector to ensure survival. For starters, Bouygues’s failed bid for rival French telecom SFR has prompted speculation that Bouygues may itself be taken over by Iliad. Pouille sees investment opportunities in French telecoms coming out of potential industry consolidation.
How, exactly, can investors bolster their knowledge of the regulatory landscape to boost returns and minimize losses?
One method is to take an educated view about what might happen before the actual announcement of new regulations. Paul Vrouwes, a senior portfolio manager based in the Hague and specializing in financials at ING Investment Management, which has €174 billion ($240 billion) in assets under management, reduced his holdings last year and again this March in DNB, Norway’s largest financial services group, in response to speculation that the Norwegian central bank would continue imposing tougher capital requirements. The Norwegian government and central bank have imposed progressively stricter rules on banks in recent months. For example, in October 2013 the Finance Ministry said that Norwegian banks would have to assume bigger lending losses on residential mortgages that year, increasing the pressure on banks to bump up capital buffers.
It’s easier to make such wagers when they run in line with existing European trends, as was the case with DNB. Many scenarios are harder to predict, however.
Roland Vetter, head of research at CF Partners, a London–based energy trading house, says that much of the skill in earning positive returns on the back of regulation is “to understand as soon as you can the impact of regulatory announcements and to form, as quickly as possible, an opinion as to whether this is fully priced into the shares or not.”
Vetter cites as an example Red Eléctrica Corp., the operator of Spain’s national electricity grid, whose returns on capital are heavily regulated by the government. In December the company revealed the headline figures of the impact of newly instituted regulation. The numbers looked quite positive, prompting CF Partners to buy on that day. But most analysts were away on their end-year break, so they did not react right away. The company gave a more detailed presentation on January 9 in which executives asserted that they could generate higher-than-expected returns through efficient capital spending and cost controls. The stock has been trending upward ever since, save for a small drop the second week of April. As of market close April 28, Red Eléctrica is up 55.75 percent on the year at €58.61.
Another example is Spanish renewables operator EDP Renováveis, which fell last year on the back of a July government announcement that would cut €1.6 billion in renewables subsidies. CFP assessed that EDP’s exposure to the move would be relatively modest because of the way that the subsidy cuts affected its particular mix of renewable assets. The firm took advantage of the price fall to increase its position in the stock, and it has profited handsomely. As of market close April 28, EDP is up 23.8 percent on the year at €4.87 on the Lisbon Stock Exchange.
The EDP example underscores a point made by many investors in highly regulated European sectors: Invest based on bottom-up research of particular companies, rather than just taking broad bets on entire sectors based on the latest regulatory news. Specific regulations can have very different effects on different companies, analysts note. In addition, they say, it is extremely hard to have a better idea than the market of what big decisions governments and regulators will make. Pouille of Paamco says the firm avoids funds that make “big binary bets on regulatory decisions.” Her plea to fund managers: “Be macro aware, not macro obsessed.”
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