Wariness is the word in Europe

Although media reports tend to be dominated with stories on Greece’s sovereign-debt crisis, Scullion notes that corporations also remain downbeat: “It is tough, and will be tough going forward. From an individual perspective, if your family has too much debt, there are few options. Either you restructure your debt or consolidate your personal loans so your monthly payments are lower. It’s the same with Greece: it will have to take a cut on its debt. It’s impossible to take all these austerity measures and think that revenue will go up.”

Scullion believes that the European Union will work out a package to backstop the banks but push the sovereign-debt problem into the future: “[The EU is] not solving the root problem. Greece is rotten in the way it functions. It has costly social benefits, but no revenue to support the benefits. At the end of the day, it needs to restructure. But it won’t do it in a few months. It’s a long, long process.”

Although Scullion is a stock-picker and reluctant to make any economic forecasts, he notes that many companies are saying it will be a long time before Europe recovers from its current sluggish state. “Our companies are growing their operating profits around 8%-10%,” he adds. “But they are working extremely hard to achieve that, protecting their margins and even growing them.”

Running a portfolio with about 44 names, Scullion favours well-managed companies that tend to be non-cyclical in nature, increase revenue by 5%-7% a year and rack up 10%-12% profit growth.

One holding in the CIBC fund is Tesco PLC, a leading supermarket chain in based Britain. “It is the most international grocery company in the world,” says Scullion, “and has the highest exposure to emerging markets.” Moreover, he adds, the stock is cheap, trading at 9.5 to 10 times 2012 earnings. Tesco shares are trading at about 372 pence ($5.90) a share; Scullion has no stated target.

Another favourite is ABB Ltd., the Switzerland-based engineering services and power systems firm. “Not only is the electrical infrastructure growing very fast in the emerging markets,” says Scullion, “but ABB is No. 1 [as a supplier], by far.” ABB stock is trading at about 15.5 Swiss francs ($17.50) a share, roughly 11 times 2012 earnings.

“There is a lot of risk out there,” says Paul Musson, senior vice president with Toronto-based Mackenzie Financial Corp. and lead manager of Mackenzie Ivy European Class fund. “In the past number of years, policy-makers’ responses to difficult times have exacerbated the problems, and they continue to do so.”

Musson, who shares fund-management duties with associate manager Matt Moody, points to a number of indicators of a worsening situation: “There is a lot more sovereign debt outstanding than a year ago, and consumer debt is still high So, we’re asking ourselves, ‘Why? How did we end up here?’ Our view is that it’s the result of 30 years of moral hazard. There is a bailout mentality, and we’ve seen the politicization of the central banks and other organizations. Politicians are more concerned with getting re-elected and, therefore, influence the central banks.”

The bailouts may have seemed the right thing to do — at the time. “But it’s the wrong decision,” Musson argues, “because governments should not decide who the winners and losers should be. It’s up to us, as investors.”

Musson and Moody seek companies that make prudent use of capital, have sustainable competitive advantages and strong balance sheets. “It keeps those companies honest,” Musson says, “because they know if they have a risky balance sheet and can’t compete very well, we won’t buy them.”

In today’s environment, about 17% of the Mackenzie fund’s assets under management is in cash. Musson admits that most of the companies whose shares the fund holds are defensive, largely because of the portfolio managers’ view of stock valuations.

“If economies get weak, our companies will be impacted, although less so than cyclicals or even financials — and we haven’t had a financial stock since 2005,” Musson says. “There will be a time to have some industrials or financial stocks. But we will only do so when we are more comfortable with the economic fundamentals in Europe. Or the valuations of the industrials and financials have to reflect some of our concerns.”

One top holding in the 20-name Mackenzie fund is Unilever NV, the Netherlands-based personal-care and food products maker. It had gone through a necessary restructuring under new CEO Paul Polman when it caught the managers’ attention. Says Moody: “The price did not reflect the potential that the CEO would succeed.”

The turnaround has paid off. Acquired in May 2010, Unilever’s stock is up by around 14% and trading at 23.57 euros ($32.90) a share, which is 14 times 2012 earnings. There is no stated target.

Another favourite is Colruyt SA, a Belgium-based supermarket chain. “It is the lowest-price supermarket in the country, and advertises that fact heavily,” says Moody, noting that Colruyt’s cost-cutting focus results in 7%-8% profit margins. The stock, which has a 2.9% dividend yield, is trading at about 30.95 euros ($43.35) a share.

The European malaise appears to be worse than it is, says Simone Loke, thanks to slowing growth in the rest of the world.

“Emerging markets are slowing — and, in particular, China because it’s regarded as an engine of growth,” says Loke, vice president with Toronto-based TD Asset Management Inc. and manager of TD European Growth Fund. “China has raised interest rates to institute a gradual slowdown, and that is beginning to filter into the economic data. People are getting spooked, especially as economies and trade are so closely correlated.”

Although the market has a jaundiced view of European policy-makers, in Loke’s view, they have accomplished much and introduced one fiscal package after another, including the European Financial Stability Facility, which is designed to help weaker countries and was enlarged recently to 780 billion euros (which requires approval by all EU members, some of which have expressed disfavour) from 440 billion euros. “With the economy in its present shape,” Loke says, “it’s very difficult to come up with more money. The market is asking for multiples of what is offered. So, it is more difficult to respond, even if policy-makers might want to. “

It’s anybody’s guess when the situation may be resolved, says Loke: “It’s a very fluid situation.”

A lot depends on three core issues: credibility, solvency and structural reform. Referring to the first issue, Loke, who works alongside Carrie Yakimovich, another TDAM vice president, says Greece is the prime culprit and must reform its taxation system. Second, solvency is a medium-term issue, wherein weaker countries may have challenges rolling over their debt within two or three years. Third, countries such as Italy and Greece must become much more competitive in the long term. “Germany has done a very good job at it,” Loke says. “But it will take years for the others to implement the necessary reforms.”

In an environment of indiscriminate selling, Loke has become more defensive and has increased the TD fund’s exposure to names that can withstand the current extreme volatility. One favourite holding in the 70-name fund is British Sky Broadcasting Group PLC (a.k.a. BSkyB).

Although hurt by the scandal surrounding News Corp.’s British newspapers, Loke says, BSkyB has had nothing to do with the tainted part of the empire controlled by media magnate Rupert Murdoch. “It’s the satellite pay-TV company in Britain,” says Loke, noting that BSkyB relies on subscriptions and not advertising.

“The business case is the same as it was when we initiated it in March 2009. And in this downturn, people are spending less money outside the home and more watching TV.”

BSkyB stock is trading at about 657 pence ($10.20) a share and has a 3.4% dividend yield. Loke believes the shares could hit 800 pence in a year. IE