Still A Lot to Like in Europe
11/09/2011 12:04 pm EST
According to a fund manager who specializes in European equities, there are plenty of opportunities in the Old World for the patient, quality-oriented investor, says Ben Shepherd of Investing Daily.
With all the structural problems plaguing European economies, most investors now take a dim view toward the continent.
But Matthew Benkendorf, manager of Virtus Greater European Opportunities (VGEAX), has successfully navigated these treacherous markets. His fund ranks among the top 1% of European equity funds, according to Morningstar.
We recently spoke with Benkendorf about his outlook for the region.
Ben Shepherd: What is your outlook for Europe?
Matthew Benkendorf: Europe made a critical error with its response to the 2008 credit crisis.
During that crisis, the US initiated programs such as the Troubled Asset Relief Program (TARP), which it used to infuse banks with capital. Although that may not have been the intended purpose of TARP, injecting banks with capital and then forcing them to raise additional capital turned out to be the right course of action.
European banks did raise some capital at that point in time, but they didn’t do so to the fullest extent necessary. Instead they took a piecemeal approach, with the hope that the resulting growth from an eventual economic recovery would obviate the need for additional borrowing.
Even after the equity markets finally rallied off their lows, European regulators failed to push the banks to strengthen their balance sheets by raising additional capital.
One can draw a simple contrast between the relative strength of US and European banks with basic metrics. In terms of tangible common equity (TCE), US banks are roughly twice as capitalized as European banks. On average, European banks are at 3% TCE to assets, while US banks are at about 6%.
It’s difficult to know the right level of capitalization, but the market’s action suggests that European banks need more capital. Unfortunately, it’s far more difficult for banks to raise capital from exiting shareholders after the market sell-off.
Beyond that, most entities take a risk-weighted approach to judging a bank’s capital needs. That risk-weighted methodology examines a bank’s asset base and discounts its assets according to their perceived risk levels.
Under that system, sovereign debt isn’t discounted—it’s considered sacrosanct, because it is theoretically redeemable with no risk. Of course, those assets do carry risk and, considering the risk to certain sovereign bonds such as those issued by Greece, the banks probably aren’t sufficiently capitalized to endure losses on those bonds.
Many politicians in Europe are being disingenuous when they say Greece won’t default on its bonds. Greece has over $300 billion in outstanding debt, and there’s no way the country can continue to make payments on it.
You can’t expect an economy or a population to shoulder that burden, and the Greek population isn’t going to struggle for the next 100 years to pay back Europe for its folly in offering them cheap financing for so many years. There will be social revolt before that happens, and we’re already seeing signs of unrest.
Although most politicians would likely deny it, default is obviously the endgame. For now, politicians are simply trying to buy some time and hoping for the situation to improve. They’re just delaying the inevitable.|pagebreak|
Ben: What is the most likely resolution to Europe’s debt crisis?
Matthew Benkendorf: The problem with many of the solutions offered thus far is that they involve raising additional debt to deal with an already unsustainable debt burden.
This approach doesn’t make sense. Nations with stronger economies such as Germany simply can’t shoulder the whole load, and it wouldn’t be prudent for them to try.
The other problem with raising additional debt is that it would be done on a European-wide basis, with every nation contributing proportionately. It’s perverse that some of the weaker nations would be contributing to a vehicle that quite possibly will have to bail them out as well.
The cold, hard reality comes down to Europe either printing money to inflate away its debt or deflating its debt by allowing debtors to default. Because nobody likes the risk involved in deflating debt, Europe is more likely to print money.
But for that solution to work over the long term, they’ll have to create greater fiscal integration in the groin, which will raise a lot of philosophical questions for the Europeans. For example, how much of their sovereignty and national identity are the individual nations willing to concede?
Ben: Are there any bright spots on the continent?
Matthew Benkendorf: This is an exciting time because investors ultimately produce their best returns by buying stocks during such crises. Of course, investors must still do their research to find the best risk-reward scenarios.
Our concentrated portfolio focuses on high-quality companies that have proven track records of profitability and operate in markets with high barriers to entry. I won’t buy a stock simply because it’s been beaten down. I only buy the best, most stable stocks when the prices are right.
At the moment, multinational consumer-staples companies in Europe offer especially attractive valuations. They’ve been consistently profitable and they do a strong business in emerging markets.
Philip Morris is a Swiss-based business that owns all the international rights to a portfolio of popular brands such as Marlboro cigarettes. It’s a very predictable and stable business that gives all of its excess capital back to shareholders.
The food space also offers a number of opportunities, including Nestle (NSRGY).
In the spirits space, Anheuser-Busch InBev (BUD) throws off a lot of cash, and is very attractive to investors. In addition to its US business, a high proportion of its earnings come from emerging markets. For instance, it has a huge share of the beer market in Brazil.
Diageo (DEO) is the world’s largest spirits maker, boasting a portfolio of some of the best-known brands, including Johnnie Walker and Smirnoff. Similar to Anheuser-Busch InBev, it’s generating significant growth from emerging markets.
There are also some compelling health-care names. Although most pharmaceutical companies have pipeline issues with their portfolios of drugs, there are some opportunities.
Novo Nordisk (NVO) offers the world’s best insulin franchise. Because of this focus, it differs from the typical pharmaceutical company that tries to compete in five or six different therapeutic areas. As an increasing portion of the global population becomes diabetic, Novo Nordisk has great structural long-term business drivers which aren’t going to change any time soon.
Both are global testing and inspection companies. They inspect everything from testing batches of toys exported from China, the soundness of the construction of commercial buildings in France to the quality of grains being exported from Africa.
All those operations capitalize on continued long-term global growth within a highly consolidated industry while maintaining high margins and returns.