For three years the German stock market has posted strong returns. Will it lose its appeal following September’s unsettling election?
Probably not, suggest observers like Ronan Carr, a Morgan Stanley European equity analyst based in London. This is not because the macroeconomic picture has suddenly turned rosy. Rather, investors are taking a micro view of German equities: For the most part they like what they see.
It helps, of course, that the favorite of most investors, the center-right opposition candidate Angela Merkel, finally prevailed over Chancellor Gerhard Schršder, the center-left incumbent, after the September 18 election failed to produce a clear winner. In mid-October, Schršder agreed to step aside, allowing Merkel to form a coalition government: Her cabinet will include an equal number of center-right and center-left ministers.
Though the economy remains anemic, with GDP expected to grow 0.9 percent this year and 1.3 percent next and the unemployment rate exceeding 10 percent, many investors are looking at stocks one by one. They’re searching for inherently strong companies that have responded to Germany’s four straight years of zero growth by successfully restructuring themselves. Many companies are poised to enjoy continued growth and margin expansion -- whatever happens to the GDP and whatever direction the next administration’s economic policies take the country. Investors are also focused on the fact that German stocks are, by many measures, relatively cheap: On a price-to-book valuation, Germany trades at a 27 percent discount to the MSCI Europe index.
“Germany is a play on micro restructuring, not on macro reform,” says Morgan Stanley’s Carr.
For this reason investors were unfazed by the initial election fallout. The DAX index, which had risen about 14 percent since the election was called this summer, fell by a modest 1.2 percent the day after the election. By October 19 the index was down a further 3.2 percent.
The market’s past performance will be a hard act to follow. The MSCI Germany index was up 29.3 percent in dollar terms in the 12 months through August. That’s nearly 15 percentage points better than the Standard & Poor’s 500 index. And for the three years ended August 31, the German index returned an annualized 18.1 percent. That’s nearly 6 percentage points better annually than the S&P 500. One-year returns were minimally affected by currency values; three-year returns, though, reflect the euro’s rally, which basically doubled dollar returns over local-currency returns.
“Germany is my favorite market, and it has been so for over a year,” says David Abramson, European investment strategist for Montreal-based investment firm BCA Research. “Though profits are surging, price-earnings ratios have not risen from their low levels of recent years.”
The experience of Heidelberger Druck-maschinen, the world’s oldest maker of printing presses, explains some of that enthusiasm. Since 2003, Heidelberger has been restructuring operations, cutting staff and extending work hours in exchange for greater job security. This has produced a 10 percent cost savings. As is typical of many increasingly profitable German companies, Heidelberger’s growth has been driven by thriving exports, which account for 85 percent of its sales. Since the beginning of 2003, its shares have more than doubled. In late October they traded at E26.4 ($32).
Restructuring is taking place across much of corporate Germany. Siemens, the nation’s biggest engineering company, made that clear just one day after the election, announcing that it will eliminate 2,400 jobs at home as it looks to reduce costs by $2 billion over the next several years.
Says Morgan Stanley’s Carr, “We are seeing restructuring driven by a pickup in private equity, mergers and acquisitions and the unwinding of long-term cross-shareholdings among the country’s largest firms.” For many years billions of euros of corporate assets were tied up in noncore holdings. Tax law changes in 2003 permitted the sale of these shares -- whose ownership, in many cases, dates back to the end of World War II -- without triggering capital gains taxes.
The German equity market also benefits from having a relatively high proportion of the cyclical stocks (materials, industrials and consumer-discretionary) that investors currently favor. Such industries constitute 28 percent of European but 47 percent of German stocks, according to MSCI.
Multiples also look attractive. IBES reports that German earnings increased 38 percent in 2004 and are poised for 10.3 and 15.0 percent expansion in 2005 and 2006. European profits are moving along much more slowly: They were up 23.6 percent in 2004 and are projected to rise 9.7 and 8.6 percent this year and next. Despite this edge, Germany’s forward P/Es are the same as Europe’s, with both projected at 13.8.
On the other hand, German companies lag their European counterparts in several key financial measures. German corporations have posted average margins of 5 percent, versus 8.4 percent for the typical European company, according to Carr. And although European return on equity is near its historical peak of 15.7 percent, Germany’s ROE of 9.2 percent is 5.4 percentage points off its high. BCA’s Abramson notes that Germany’s ROE is beginning to pick up; he expects levels to rise sharply as corporate profits continue to surge and unit labor costs fall relative to those of the rest of Europe.
Like many portfolio managers, Henry D’Auria, who comanages the $1.3 billion large-cap focused AXP Partners ?International Select Value Fund in New York, looks for German companies that are major exporters. “Global economic growth, not the domestic economy, is driving my German investments,” he says. His portfolio significantly overweights Germany, at 11.2 percent of ?total assets, versus 7.1 percent for the MSCI EAFE benchmark. This exposure has helped him achieve a 12-month gain of 26.8 percent and a three-year annualized return of 23.6 percent through September 7, 2005, topping EAFE dollar- based returns of 26.4 percent and 21.2 percent, respectively.
At 2 percent of his portfolio, tire manufacturer Continental is one of D’Auria’s biggest holdings. Two thirds of the company’s sales and profits come from abroad, and earnings doubled between January 2002 and year-end 2004. D’Auria’s fund started accumulating shares in late 2003 at an average cost of E30. With the shares trading at E67 as of early September, the fund has more than doubled its investment.
Starting in mid-2003 the fund began building a position in electric and water utility E.On. That holding was up more than 30 percent through September. After a string of acquisitions in the Czech Republic, Hungary, Sweden, the U.K. and the U.S., the company now generates half its sales and profits from markets outside Germany. With a price-to-book-value ratio of 1.5, E.On is the least expensive of all developed-market utilities, whose average price-to-book is 2.2.
Performance of German small-cap shares helped the $201 million American Century International Opportunities Fund soar 47.4 percent over the 12 months through the end of August, versus 31.2 percent for its benchmark, the S&P/Citigroup EMI growth world ex-U.S. index. Three-year annualized returns topped 36 percent, compared with 25.3 percent for the benchmark. Fund managers Trevor Gurwich and Federico Laffan keep 8.4 percent of their assets in German shares; their benchmark, the S&P/Citigroup EMI growth world, weights German shares at just 7 percent.
One of the fund’s recent stock picks: real estate developer Vivacon. The Plauen, Germanybased company buys residential properties primarily from the government and from nonprofits that are looking to raise capital. Supported by favorable tax laws and low lending rates, Vivacon then rehabilitates and resells the properties. Earnings grew 67 percent in 2004 and are projected to climb 73 percent in 2005. Gurwich started purchasing the company’s shares in April 2005; by early September the stock had soared 77 percent.
Labor flexibility is a positive development. Gurwich sees significant expansion ahead for Germany’s temporary workforce -- now just 1 percent of all laborers -- as unions agree to a shift in status for those workers whose jobs are at risk. “Companies like Volkswagen and Infineon Technologies have forced such changes,” he says, “shifting such workers over to staffing agencies like Deutscher Industrie Service.”
DIS’s own earnings per share rocketed 114 percent in 2004, as the company reaped the benefits of smart acquisitions and major deals with large multinational clients. DIS is expected to grow at a more sustainable rate of 25 to 30 percent this year and currently trades at a projected 2005 P/E of 30. Gurwich saw the position he established in the stock in April appreciate by 126 percent through September 9.
Can Germany’s stock market continue to outperform? Valuations remain attractive, and corporate restructuring is moving ahead at a steady pace. Investors worry, though, about a global economic slowdown. Germany’s exporters would be hurt, and that would not be good news for German equities.
