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European Investors Regain a Wary Confidence

Stocks of strong multinationals are seen as offering good value despite the region’s ongoing debt crisis. Bonds are another story.

LATE LAST YEAR IT WAS HARD FOR ANY INVESTOR in European equities not to feel like part of a dying breed. The sovereign debt crisis seemed to have everyone bracing for a market meltdown comparable to the turmoil that followed the collapse of Lehman Brothers Holdings. Conversations at holiday parties in London and across the Continent revolved around fears of defaults, recession and the breakup of the euro. The smart money was gearing up for fire sales on distressed debt and assets that cash-strapped banks would have to unload.  “It was unfashionable by the end of last year to say Europe might resolve its problems,” recalls Reade Griffith, the 45-year-old co-founder of Polygon Global Partners. Unfashionable, perhaps, but not unprofitable. While markets were swooning last year, Griffith, an American who manages his event-driven hedge fund firm from offices in London’s Knightsbridge neighborhood, was brashly buying European stocks. Where others saw little but political and economic risk, he noticed something rarely seen in the investment world: Europe’s growth stocks had price-earnings ratios that were very close to those of large-cap stocks. Griffith saw the multiples not as a sign of lowered expectations but as a chance to buy a lot of undervalued growth. Griffith isn’t the only investor wading into troubled waters. Mark Kopinski of American Century Investments, Nigel Bolton of BlackRock, James Rutherford of Hermes Sourcecap and Bradford Jones of Sagil Capital are also seeing opportunities in European equities. The region’s fixed-income market, meanwhile, is attracting interest from the likes of William Chepolis of Deutsche Asset Management, Mark Devonshire of MCapital Investment Management, Stephen King of C12 Capital Management and John Brynjolfsson of Armored Wolf. Not that any of these money managers are throwing caution to the wind. Indeed, more than a few are anticipating further distress and positioning themselves accordingly. Europe has not solved its problems, but policymakers have managed to avoid a doomsday scenario, at least for now. And that has been enough to turn the investment outlook on its head. Banks aren’t desperate to sell assets, because the European Central Bank has provided three years of easy financing. Corporations are showing little distress and little need to borrow because they have been hoarding cash to the tune of about $2.64 trillion in the euro zone and $1.19 trillion in the U.K. The equity market offers some compelling opportunities now — at least, it offers a select group of equities that have risen 10 to 20 percent or more this year in spite of a very volatile market. A wary confidence has returned. What is becoming clear to investors is that the best hopes for the next year or so lie in Europe’s multinational corporations and smaller-cap companies that know how to build market share abroad, especially in the rapidly growing emerging markets of Asia and Latin America, and to some extent Russia, Eastern Europe and Africa.
Griffith had been looking all along at a scenario that suggested there were opportunities for investors who held out. A November report from Goldman Sachs Group, for instance, found that the premium on stocks with projected earnings growth of 15 percent or more was close to an all-time low. Few investors were willing to commit money, however, until the ECB calmed nerves with its extraordinary long-term refinancing operations, or LTRO, in late December and at the end of February. The twin refinancings, which allowed European banks to borrow a little more than €1 trillion ($1.3 trillion) at an interest rate of only 1 percent for three years, averted the risk of a Europe-wide credit crunch. The Stoxx Europe 600 Index duly responded by rising nearly 12 percent in the first 11 weeks of this year before easing to about 257 late last month, up 5.32 percent from the start of the year. Just as important to investors is a big change in correlations: Stocks have begun to move on their own fundamentals again rather than sinking in unison as they did last year. The lower correlations make all the difference in the world to value investors like Griffith. The Polygon European Equity Opportunity Fund, with $300 million in assets, rose 2.34 percent in the first two months of this year after losing 7 percent in 2011. What is harder for Griffith now is finding the merger opportunities his fund seeks — one-off events that allow him to arbitrage the spread between the share price of a target company when a deal is first announced and the actual price paid by the acquirer. European companies also have been waiting to see if the investment climate is going to improve. Companies announced just $174.7 billion of mergers and acquisitions in the first quarter of 2012, down 21 percent from the first quarter of 2011, according to data from Dealogic; that figure includes the massive $48.4 billion offer by Swiss commodities trader Glencore International for Swiss mining conglomerate Xstrata. Several other big European deals are pending. GDF Suez, the second-largest power company in France, announced a $9.6 billion deal that will give it full ownership of the U.K.’s International Power, and in February, Deutsche Bank completed its purchase of a 39.5 percent stake in Deutsche Postbank for $5.1 billion. A few smaller deals are in the works; for example, Tata Communications and Vodafone Group have both expressed a desire to acquire Cable&Wireless Worldwide, which has a market value of $1.4 billion. Griffith looks for companies that export, as do nearly all equity investors in Europe. Euro-centric companies of all stripes face a slowdown in spending, and many portfolio managers cite industries such as telecommunications, retail and utilities, which tend to be geared to domestic markets, as areas to avoid or short because of their vulnerability to a regional slowdown. However, some 29 percent of the revenue of listed companies in Europe comes from selling to emerging markets, compared with only 20 percent of revenue for U.S. companies, according to estimates by Morgan Stanley. M&A deals on the horizon will be aimed at increasing that emerging-markets revenue. European exports should receive a boost from the LTRO because the central bank has flooded the market with euros, keeping the currency at a relatively low level of about 1.30 to the dollar. German companies stand to be among the prime beneficiaries because they are Europe’s largest exporters. Companies in other countries are also drawing investor interest. Mark Kopinski, senior vice president and CIO of global and non-U.S. equities at American Century Investments in New York, a $120 billion asset manager, has his eye on Italy, especially its largest tire maker, Pirelli & C. Kopinski kept his portfolio overweight in Europe last year and has continued to do so based on a positive view of a number of multinationals. He has homed in on several global growth themes and looks for companies that have figured out how to develop their own growth from those themes. Although Kopinski won’t disclose position sizes, Pirelli is a top holding. It beat the MSCI Italy Index by more than 60 percent for the 12-month period ended April 10, and even though the company makes tires, not windmills, Kopinski says it fits into his theme of environmental products and services. “It’s one of the best-positioned companies out there to supply tires that meet new environmental regulations,” he says. He also reasons that the cars and trucks now on the road in China — some 106 million as of the end of 2011, according to the National Bureau of Statistics of China — will need replacement tires in the years ahead. Pirelli has been aggressively pursuing market share there, partly through branding strategies that have included sponsoring the Chinese Super League football games as well as teams in Latin American growth markets. He also approved of Pirelli’s decision two years ago to stick to what it does best and spin off unprofitable lines of business in real estate and broadband hardware. Energy exploration is another of Kopinski’s growth themes. Among European companies he particularly likes French equipment and engineering business Technip and London-based Subsea 7, which makes equipment for oil rigs. Both outfits, he says, have a strong share of the oil exploration market, specializing in deep-sea drilling. Both are involved in building pipelines to the big oil fields now under development off the coast of Brazil. Another global growth theme, automation, has been good for such companies as Germany’s Dürr, Kuka and Siemens. All of these stocks are in Kopinski’s portfolio based on the businesses’ strength as makers of robotic devices for manufacturing. He sees a fast-growing market for such equipment, especially as China begins producing more value-added products instead of serving as the world’s center of low-cost, low-skilled labor. Kopinski also has holdings in Gemalto, the French encryption software maker that is a leader in technology for the mobile wallet, an instant cash transfer system that is expected to have a global market of $600 billion by next year, nearly twice what it was as of early 2011. Mobile payments are just beginning to catch on in the West but are used widely in emerging markets; the system has already revolutionized the way immigrants working in domestic jobs send remittances home to countries like Egypt, Nigeria and the Philippines. American Century’s analysts estimate that Gemalto’s earnings per share will grow 18 percent annually this year and next. The BlackRock European equity portfolio (a fund not open to U.S. investors) has Rolls-Royce Holdings among its top ten positions, with a weighting of 2.4 percent, part of a weighting of 36.7 percent in the U.K., followed by about 13 percent each in France and Germany. Portfolio manager Nigel Bolton, based in London, likes luxury goods and sees emerging-markets consumption as the main hope for European companies. The fund has assets of about $3.2 billion and was up 10.4 percent year-to-date at the end of February, 2 percentage points ahead of the MSCI Europe Index. Bolton’s top holding since January has been Xstrata, which owns some of the world’s largest copper mining assets. BlackRock’s World Mining Fund owns 5.8 percent of Xstrata, making the investment firm the second-largest shareholder in the company after Glencore, which owns 34 percent. Bolton says his investment in Xstrata is based largely on his conviction that China’s consumer spending will remain strong enough to keep the price of copper high. Also on the BlackRock fund’s top ten list is Danish pharmaceuticals maker Novo Nordisk, which has gained 23 percent since January 1. At a time when Europe’s drug companies are experiencing serious pricing pressures at home as a result of constraints on government financing, Novo Nordisk is the world’s leader in diabetes care, with products such as Levemir and Victoza. The company saw a 15 percent rise in sales last year from growth markets in Asia, Latin America and the Middle East. China has approximately 1 million new cases of diabetes a year thanks to the fast-food diets that come with growing affluence. Bolton favors companies that are using their cash for dividends. “The volatility is lower than that of traditional equity and the returns better than bonds right now,” says Bolton, who sees dividend payouts as an ideal use of corporate cash. Few portfolio managers are giving much weight to banks these days because of the sector’s continuing debt problems and dim growth outlook. Banks for the most part have not been using their LTRO capital to expand lending, according to ECB findings. A lot of the earnings growth in the banking sector over the past ten to 15 years was driven by leverage. “That is now being reversed, so there will be limited or negative earnings growth going forward as banks build capital ratios,” says James Rutherford, chief investment officer at Hermes Sourcecap in London, a European equity asset manager.  Financials are the biggest underweight in Hermes Sourcecap’s portfolios. “Besides the balance-sheet issues, the banks are in a very mature, very competitive market where there is limited demand for credit,” says Rutherford. But there are exceptions. The CIO’s Hermes Sourcecap European Alpha portfolio holds two banks, with a 2.3 percent weighting in DNB of Norway and an equal weighting in Swedbank, one of Sweden’s four largest banks. Both have healthy balance sheets, Rutherford says, at least in part because they never bought the debt of peripheral EU countries. Sweden is trying to impose higher capital requirements on its biggest lenders than the European Union’s minimum — a proposal that has banks grumbling but might be a way to keep up the Nordic banks’ track record of higher-quality assets and fewer nonperforming loans than most EU banks. And even in this beleaguered sector, a few multinational banks hold more promise than the banks with strictly domestic markets.  Bolton went overweight in bank stocks in early January but sold most of the holdings when the sector rallied in February as valuation gaps began to close on the strength of the LTRO. “The fall in banks in April is starting to reveal some value again,” he says, “but we really need to see loan growth picking up before we can become excited about banks for the longer term.” Since January, Bolton has kept one multinational financial services firm in his top ten: HSBC Holdings, weighted just above 2 percent. He likes HSBC’s global reach; the bank generated 78 percent of pretax income from Asia, the Middle East and Latin America last year. Spain’s Banco Santander has also been making productive use of its emerging-­markets presence. Pre-LTRO, European banks were expected to unload distressed assets at undesirable prices, but observers now predict they will sell top-of-the-line assets at prices they want over the next couple of years, with total sales likely to bring in as much as $30 trillion. Santander has already begun to raise low-cost capital in this fashion. In the past year the bank has offered investors stakes in some of its best-performing Latin American markets, with sell-offs of a minority stake in Banco Santander-Chile that raised $950 million, a full stake in Banco Santander Colombia for $1.2 billion and a 5.76 percent stake in Banco Santander (Brasil). “Santander Spain has been able to raise funds and improve its capital position through these asset sales, in most cases at very favorable prices and generating significant gains,” says Bradford Jones, a portfolio manager at Sagil Capital, a $75 million London-based hedge fund that invests in Latin American equities. A small amount of Santander’s capital has gone toward diversifying farther afield; early this year, for example, the bank spent about $50 million to acquire a 20 percent share of Bank of Beijing’s consumer financing unit.  Jones has long seen the value of overseas assets to European banks. For several years before last summer’s debt crisis, Sagil held long positions in both Santander and its Spanish rival Banco Bilbao Vizcaya Argentaria, hedging with short positions in Spanish banks that were focused on the domestic market. The firm closed out the trade in August 2011, however, after significant outperformance of BBVA and Santander relative to the domestic banks. Sagil had some luck on the timing: When the European crisis escalated, causing a panic among European banks, Belgium, France, Italy and Spain issued temporary bans on short-selling bank stocks. The short-selling ban in Spain has been lifted, and Sagil could put the trade back on, but Jones says borrowing costs are prohibitively high at the moment and margin is difficult to locate. He remains positive on Santander. The fund didn’t participate in the recent Santander sales but is watching a planned IPO for the bank’s Mexican operation, which is expected to happen in late 2012 or 2013. Though the equity market has a reasonable share of investor favorites, the fixed-income market is not generating anywhere near the same level of excitement. Hermes Sourcecap’s Rutherford sees his experience with French food services company Sodexo as a typical example of the lackluster returns on corporate bonds. The company fits squarely into the multinational profile, operating institutional catering services all over the world, a market that Rutherford projects should grow by more than 10 percent annually in the next few years. He notes that Sodexo has a free cash flow of about 8 percent and no outstanding bank debt. Its four-year bond yields early this year were only 1.6 percent, while the dividend yield was substantially higher than that at 2.4 percent. Rutherford terms this “an interesting anomaly” in many defensive stocks in Europe, and that leads him to think bonds may be overpriced and equity underpriced. The corporate bond market has not traditionally been as large in Europe as in the U.S., but it is growing, in part to compensate for the lack of bank lending. Strong demand has driven average yields down, to a record low of 2.59 percent as of early April, according to Bank of America Merrill Lynch’s EMU Corporates Non-Financial Index. In January and February spreads between credit default swaps and the investment-grade corporate bonds in the Markit ITraxx Europe Index were narrower than those between the bonds and sovereign debt, so many investors saw it as a good time to buy protection on investment-grade credit. Boaz Weinstein’s New York–based Saba Capital Management bet against investment-grade credit this way, according to an investor in the fund. This is a bet that paid off in April, when upcoming elections in France, Greece and the Netherlands brought renewed political uncertainty and CDS spreads were running between 26 and 40 basis points. William Chepolis, a fixed-income portfolio manager at Deutsche Asset Management in New York, holds out more hope for high-yield bonds than for investment-grade debt. The DWS Unconstrained Income Fund that he oversees has only a 6 percent weighting in European investment-grade debt, a long way down from as much as 25 percent over the past few years. “There are a lot of investment-grade companies in solid shape, but the spreads are so tight we think it makes sense to play in the higher beta space, meaning high-yield with wider spreads and muted delinquencies,” says Chepolis. He’s referring to high-yield bonds with credit ratings of about double-B and spurns the triple-C debt that some favor. “We’re nervous about some of the lower-rated credit. There’s too much that could potentially go wrong when it comes to European economies pulling through, especially with the spread-widening potential of continued turmoil in Europe,” he says. Six months ago almost any fixed-income portfolio manager contemplating Europe would have said that the big opportunities for 2012 were going to be in distressed debt. Many funds built up their distressed divisions and are still waiting for the opportunities to arrive. According to a report on distressed private equity funds released by Preqin in March, Europe-focused distressed private equity reached its peak in fundraising in 2011, when ten vehicles closed on an aggregate $7.7 billion. The Preqin report also cited a September 2011 study of limited-partner attitudes toward distressed private equity investment — undertaken at a time of particular concern over the sovereign debt crisis — in which 65 of the distressed-fund investors surveyed named Europe as a preferential focus. Instead, default rates have been low thanks to liquidity supplied by LTRO. Mark Devonshire, CEO and CIO of MCapital, which runs a $70 million hedge fund and expects to launch another with $50 million in June, is one of the investors waiting for the distressed opportunities to materialize. His fund specializes in distressed and rescue situations in Europe and Asia, and operates out of Hong Kong, London and Amsterdam. But he has another game plan for now. “There isn’t a lot of capital available for small and medium-size businesses,” he says. “As a small fund, we can be active in providing finance through equity or loans to SMEs and get reasonably significant returns.” He has seen some excellent SMEs that have been around for many decades, powerhouses in their respective industries, many of them family-owned and very stable, but they are having trouble getting financing in the current environment. Devonshire has a deal in the works with a 40-year-old German auto-component manufacturer. “They have an unbroken track record for profits, but they’ve had some hard times lately, and their revenue has dropped,” he says. “They used to get their funding from six local landesbanks, but three have pulled out.” He is finding similar opportunities all over northwestern Europe. “But not east of Germany, and the Mediterranean countries are a bit of an issue. Even France can be difficult,” he notes. “We stick to jurisdictions that have reliable bankruptcy codes and judicial systems that will uphold a contract.” Eventually, however, Devonshire anticipates richer hunting in distressed debt. Like most observers, he sees the liquidity from the LTRO as a temporary fix for deeper, structural problems. There are highly indebted companies in some industries — Spanish construction and real estate, for example. And there are lingering worries that if any one of a number of problematic scenarios comes to pass, the recession gripping many EU economies could deepen, triggering a wave of corporate defaults. The costs of hedging against more problems in the EU are an indication of how little has actually been resolved. “Investment-grade U.S. corporate spreads are now in the 80-basis-points range, while Italy and Spain sovereigns are trading at about 400 basis points. That doesn’t suggest that the crisis has passed,” says Stephen King, founder and CIO of C12 Capital in London, a $900 million hedge fund firm that trades liquid fixed-income, rates and credit markets. “It suggests a very high reluctance to hold sovereign risk.” King believes it’s a good idea to continue hedging against Europe, although he says it is neither necessary nor practical to hedge through a narrow market like sovereign credit default swaps. It is less expensive to get protection through a broad market such as options on a credit index or on the Standard & Poor’s 500 Index, he says. Others are taking advantage of the current respite from crisis mode by loading up on credit default swaps on German debt. The price has come down from a high of $109 in September, close to the price of some emerging-markets debt, to $71.50 for five-year German credit default swaps as of late March. But Germany remains vulnerable to any flare-up of the debt crisis, even though it is Europe’s largest economy and the bedrock of the euro zone. More than half of the Bundesbank’s balance-sheet assets are claims on other euro zone countries’ sovereign debt, according to a study published in January by Michael Hintze, CEO and founder of CQS Management, an $11.2 billion, London-based hedge fund  firm known for its successful bets in the U.S. subprime mortgage market. Germany itself has a national debt of about 84 percent of GDP and faces the possibility of having to dig into its pockets to rescue peripheral countries. If that were to happen, the price of protection could rise sharply. “We’ve been in and out of positions having to do with protection,” says John Brynjolfsson, CEO of Armored Wolf, a $700 million hedge fund firm in Aliso Viejo, California, that runs macro and high-yield strategies. He has shorted the euro through put options and bought credit default swaps against both German and French debt. “It’s going to be hard for Germany to maintain a strong sense of quality when the two roads forward are to either use their strong credit rating to provide stability for all of Europe or distance themselves from the other countries, in which case there will be mayhem,” says Brynjolfsson. “In either case it speaks to having protection against Germany.”

Such is the state of the European markets. Optimism may still be in short supply, but investment ideas remain plentiful.  •  •

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