Buying Into the German Miracle

02/23/2011 1:53 pm EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Europe’s strongest economy is accessible to US investors via a proven and inexpensive ETF, write Paul Justice and Patricia Oey of Morningstar ETFInvestor.

With an annual gross domestic product of $3.3 trillion, Germany is the fourth-largest economy in the world.

However, Germany accounts for only 8% of the MSCI EAFE global equity index, which is low relative to its global economic standing. This is because corporate Germany has traditionally relied on banks, rather than capital markets, for funding.

Many large-cap German stocks are very successful global multinationals, such as Siemens (NYSE: SI), BASF (OTC: BASFY) and Daimler (OTC: DDAIF), whose shares have performed strongly over the last two years. Germany’s large-cap multinationals are well positioned to continue to benefit from strong growth in the emerging markets.

Investors using a fund such as iShares MSCI EAFE Index (NYSEArca: EFA) for their international exposure can consider iShares MSCI Germany Index (NYSEArca: EWG) to increase their exposure to German companies.

This exchange-traded fund provides broad exposure to German equities.

The diversification benefits of holding this fund are not significant. Many of Germany’s large-cap companies are global players that compete directly with their US counterparts in industries such as financial services, pharmaceuticals, and automobile manufacturing. On the other hand, like most ETFs that hold foreign stocks, EWG does not hedge its currency risk, so this fund does provide some diversification benefits through currency effects.

Currency effects do result in higher volatility for EWG, which is about 56% more volatile than the S&P 500.

Germany is Europe’s largest economy and is home to many large multinationals, such as Allianz (Frankfurt: ALV), Bayer (OTC: BAYRY), Daimler, and Deutsche Telekom (OTC: DTEGY) (known as T-Mobile in the US), all of which are top holdings in EWG. This fund also has significant holdings in high-quality, narrow-moat companies such as Siemens and SAP (NYSE: SAP)—companies with strong business models and sticky customer relationships.

Exports Uber Alles
Germany’s well-known global brands are a product of the government’s focus on promoting exports. Exports account for about a third of Germany’s GDP, and, currently, Germany is the world’s second-largest exporter after China. Over the past few years, this export model has benefited from the consumer boom in the US and strong economic growth in a number of emerging markets, resulting in stable employment levels and strong corporate-profit growth.

Between 2004 and 2007, net exports accounted for 60% of Germany’s economic growth, and in 2008, its current account surplus reached 6% of GDP. In the near and medium term, growth in emerging markets is expected to benefit Germany’s auto, machinery, and chemicals companies, whose products account for nearly two thirds of exports.

No Home-Field Advantage
However, the domestic outlook is not very bright. Germany has a rapidly aging population and has one of the lowest birthrates in the European Union. In addition, Germans are also famously frugal—consumer spending accounts for about 56% of Germany’s GDP, whereas in the US this figure is closer to 70%.

Starting in 2011, Germany plans to implement a four-year package of budget cuts in order to meet domestic constitutional requirements as well as European Union budget rules. The plan includes welfare reductions and cuts in defense spending, as well as additional taxes on banks (which account for 20% of the EWG portfolio) and nuclear-power plants (utilities account for more than 10% of the portfolio).

While German officials are optimistic that spending cuts aren’t deep enough to threaten a recovery, there is a possibility the austerity measures could weigh on growth.

The fund is top-heavy, with the top 10 stocks comprising more than 60% of the portfolio. The fund’s sector weightings reflect the key drivers of the German economy, with consumer discretionary (primarily auto manufacturers), financials, and industrial firms leading the way, accounting for 17%, 17%, and 16% of the portfolio, respectively. EWG’s expense ratio of 0.53% is reasonable.

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