Europe on the cheap

By Bryan Borzykowski, Canadian Business | October 24, 2011 | Last updated on October 24, 2011
6 min read

Paul Ehrlichman can’t wait to see Greece finally default. “The country’s a fraud,” he says. “There is no hope.” With a one-year government bond yielding more than 100%, it’s as if the country has already defaulted, explains the head of global equity for Delaware-based Global Currents Investment Management. The sooner it goes under, the sooner Europe can start healing. But until the region works out its myriad problems – there’s also Italy, which was recently downgraded by S&P from A to A–, not to mention Spain and Portugal – people will continue to run from Europe’s markets.

Ehrlichman, though, isn’t going anywhere. There are plenty of opportunities, he says. People just need to make sure they’re investing in the right countries, instead of the region as a whole. “We used to look at the world as one big happy place,” he says. “But now we’re starting to talk about countries again because not everyone is getting access to capital at the same price.”

Because of the worries around sovereign debt, all of Europe, from Finland to Poland, has never been cheaper. Parus Shah, a London- based portfolio manager with Fidelity Investments, says that, in general, companies are trading at a 20% discount from the depths of the recession. Yet, having cleaned up their balance sheets since 2008, businesses are in better shape. Compared to the S&P 500, which is trading at about 14 times earnings, Germany’s DAX Index is trading at 9.9 times earnings; France’s CAC is trading at 8.5; most of the eurozone is trading at 10 times or below. Shah thinks people are overreacting to Europe’s economic woes. “There are so many global funds not invested in a single European company,” he says. “That’s strange.” The longer people stay away, though, the better stocks look to value investors.

The rule of thumb is to buy blue-chip, dividend-paying multinationals that sell to fast-growing emerging markets. That way, you aren’t exposed to country risk and don’t have to worry as much about slowdowns in consumer spending. But with the gap between healthy and weak European countries widening, investors can’t simply ignore where a company is based anymore. A weak country could raise corporate taxes as a way to increase revenues and pay down debt, says Shah. It could levy fees on utilities or telecoms. While higher taxes won’t kill a strong business, a 5% tax increase could destroy some of a company’s value.

Shah also warns that companies in weaker countries may also find borrowing more expensive. The longer the turmoil continues, the more investors will want a premium from corporate bonds. If a business has to pay a 6% yield instead of 3%, it could eat into profits or make it difficult to pay the higher coupon back.

Germany tops most people’s list of places to invest because its debt-to-GDP ratio is low, at least compared to other eurozone countries, at 83%. It’s also competitive, explains Ed Devlin, an executive vice-president at Pacific Investment Management, with the price of products increasing more than wages. It’s got a skilled workforce, and exports are still strong. Its main risk, says Devlin, is that it, along with France, has put its balance sheet at risk by propping up struggling countries.

Opinion is mixed on France, because its banks have more sovereign debt exposure than Italy. But, says Ehrlichman, Italian banks are in worse shape than French ones, and the French are more productive, so GDP is likely to grow faster. France’s government also directly or indirectly employs about 35% of the workforce, says Shah. As long as the country’s finances stay stable, these people aren’t going to lose their jobs. Investors should consider telecoms, infrastructure companies and, though they’re riskier, banks.

If investors want to buy companies in the weaker countries, such as Spain and Portugal, it would be wise to stick to more international operations as it’s likely the domestic market will continue to face downward pressure. Shah says that governments may be less likely to tax multinationals since they can move their head office if there’s a threat to their profits. However, Ehrlichman says there are a lot of good opportunities in Ireland. That country has already faced the worst of its problems and, he says, is beginning to heal. Two years ago Irish bonds were yielding about 20%; today rates are closer to 9%. “The credit markets have been telling an accurate story,” he says. Besides buying bonds which, Ehrlichman says, “looks like money,” a basket of contrarian and quality stocks—including Bank of Ireland for the former and airline Ryanair for the latter—is the way to go.

Countries outside the eurozone, like the U.K., Switzerland, the Scandinavian countries and some Baltic states, are also worth a look. Their banks don’t have the same sovereign debt exposure as Germany and France and, since they have their own currencies, they have more options to deal with financial crises.

After deciding which countries to focus on, you’ll want to find companies with low debt, especially in the weaker countries. If a business is too leveraged, and interest costs rise, then there will a massive drop in earning power, Shah explains. Also make sure that more than half of revenues come from international sources.

Price-to-earnings and price-to-book ratios don’t matter as much in Europe because everything looks cheap. Dividends, though, are important as they speak to a company’s health. Don Reed, president and CEO of Franklin Templeton Investments, likes companies that can grow earnings and pay dividends higher than 3.5%, which is what the MSCI EAFE Index, a benchmark that tracks Europe, Australasia and the Far East, pays.

Ehrlichman wants companies that have lowered their earnings expectations for 2012 and 2013. He says a lot of businesses, especially in the industrial sector, haven’t yet adjusted their projections to the global economic slowdown. “We know the forecast will be wrong,” he says. “And would you rather be on the side of a positive surprise or a negative one?”

Ultimately, investors need to be patient. Valuations could still drop as the region works out its economic issues, and there are still uncertainties around who will be using the euro in the future. But hold on for the long term and you won’t go wrong. “What will happen in Europe over the next 10 years?” asks Shah. “I think the next 10 years will be a lot better than the last 10.”

Top picks

  • BNP Paribas SA (EPA: BNP) While many investors still consider Europe’s financial sector risky, fund manager Paul Ehrlichman is happy to take a chance on Paris-based BNP Paribas. The European Central Bank has demonstrated that it won’t let large banks fail, “so there won’t be a Lehman-like event,” he says. And, with a strong consumer banking business, a near-7% yield and a price of about five times earnings, it’s got a lot of upside.
  • Marks & Spencer Group PLC (LON: MKS) Despite living in what Ehrlichman says is “the worst consumer environment since 1870,” Britain’s retail stores are doing surprisingly well. In May, Marks & Spencer, which has more than 700 stores across the U.K., reported a 13% increase in profits over the year before. Its shares jumped 7% in September after it announced it was revamping its stores. Private equity investors are reportedly interested in buying the company. Its price-to-earnings is 8.6 and it pays a 5.1% dividend yield.
  • Novartis AG (NYSE: NVS) Switzerland-based Novartis is a favourite of Don Reed, CEO of Franklin Templeton Investments. He likes the pharmaceutical giant because it’s a global company in a non-cyclical sector. The company produces some of the world’s leading drugs, including Excedrin and Ritalin. Because a large portion of its business is outside of Europe, it has less exposure to the region’s economic risks. It’s not as cheap as some other companies—it trades at about 13 times earnings—but it does pay a 4.2% yield.
  • Bank of Ireland (NYSE: IRE) Dublin’s Bank of Ireland is a contrarian play, says Ehrlichman. Most investors still think it could fail, but with Ireland’s fortunes improving—it’s already implemented its austerity measures— he thinks the bank’s shares should start climbing soon. In a sign of confidence, the bank has raised US$3.9 billion of term debt since June, despite not being able to access the public debt market. Another private bond sale worth $1.6 billion is reportedly on the horizon.
  • Telefonica SA (NYSE: TEF) Reed likes this Madrid-based telecom company because of its high dividend—about 9%—and its international exposure. The company’s stock is down 15% year-to-date because of fears over Spain’s public debt load, but only onethird of its business is done in its home country. A big piece of its business comes from Latin America, where GDP growth is still robust. Its P/E is about eight times.
  • This article was originally published in Canadian Business.

Bryan Borzykowski, Canadian Business