Sector Watch: Less pessimism about Europe

“We can expect the situation to continue for some time because the issues that need to be fixed need time to be worked out,” says Michael Hatcher, head of global equities with Toronto-based Invesco Canada Ltd. and lead manager of Trimark Europlus Fund.

“Unlike a fiscal union,” he continues, “it is more cumbersome to get the related parties to agree to a solution. Getting things on the right path will evolve over time. We won’t wake up one morning and read a headline saying, ‘We have solved the problems.’ There’s no magic bullet.”

From another perspective, Hatcher argues that the crisis is forcing EU members to get serious about a stronger fiscal union.

“Believe it or not, this was not only necessary but it is all good,” Hatcher says. “Without the crisis, they would have kept the status quo and stayed separate on a fiscal level. You need to have tighter fiscal integration for Europe to be strong over the next few decades. This is a positive evolution in terms of how Europe will become stronger.”

Meanwhile, the shorter-term macroeconomic outlook is mixed. Peripheral European countries, such as Spain and Greece, are in recession, but northern Europe is still growing, albeit slowly.

“Britain is moving into more moderate times, but France and Germany are OK,” Hatcher says, “although we’re in a period of very low growth, with people saying, ‘Let’s just slog it out until better times will evolve’.”

Compared with 2010 from a securities perspective, says Hatcher, “Most parts of the market are fairly valued. There are certain pockets that are overvalued and based on very rosy scenarios, especially some of the cyclical stocks that are pricing in higher margins. Having said that, I don’t pick markets or sectors. There are opportunities, but you want to pick stocks carefully.”

Managing a concentrated portfolio of about 25 companies for the Trimark fund, Hatcher seeks firms that have high returns on invested capital and strong cash flow. On a geographical basis, about 20.6% of the Trimark fund’s assets under management (AUM) is in Switzerland, 16.6% is in Germany and 13% is in Britain, with smaller holdings in countries such as France.

One representative holding is Ipsos SA, a France-based brand and market research firm that has grown organically over the past decade at a compound rate of 9% annually.

“You can cut down on your advertising budget in a downturn, but not on your market research,” Hatcher says, “because [that’s] what gives you visibility. Ipsos’ revenue is very stable.”

Ipsos’ shares are trading at about 24.40 euros ($30) each and have a dividend yield of 2.6%. There is no stated price target.

Similarly, Hatcher likes Vicat SA, a leading France-based cement maker that is making inroads into Asia. Vicat’s shares are trading at about 42.25 euros ($52) each and have a dividend yield of 3.6%.

other portfolio man- agers have a more jaundiced view of Europe’s latest attempt to steer toward a better outlook.

“It depends on what you mean by ‘outlook’,” says Paul Musson, team leader, Ivy Funds investment team, with Toronto-based Mackenzie Financial Corp. and co-manager of Mackenzie Ivy European Class Fund. “If you’re talking about the next few months, then maybe it’s better. But if you’re talking longer term, then I don’t think [the ECB’s bond-buying program] changes anything.

“Mario Draghi [president of the ECB] hasn’t promised to start buying bonds,” Musson adds. “He’s said he will buy them as long as a country asks for aid and agrees to strict criteria – and if it agrees, the ECB will buy [the bonds] for a period of three years.”

Although Musson and portfolio co-manager Matt Moody are primarily bottom-up managers who focus on companies that are efficient at capital allocation, the Mackenzie team maintains that the cause of Europe’s crisis is moral hazard.

“And it continues,” says Musson. “The more central banks get involved and buy debt, the more [that strategy] delays the necessary action of government.”

Countries in bad fiscal shape are clamouring for a reduction in interest rates, Moody notes, rather than addressing the underlying debt problem.

“Rates are rising because they have too much debt,” he says. “But they think it’s unnatural that rates should rise. The push is to get interest rates to fall through central bank intervention rather than tackle the high debt load. The ECB action takes the pressure off. It’s not getting at the cause.”

Referring to the ECB’s goal to drive interest rates lower, Musson adds: “The justification is that this is just a momentary thing. But it’s been going on for a while. That was the justification with Greece, with its continuous bail-outs. Maybe [the situation] will change [for the better] this time, but we’ve seen plenty of examples of this kind of thing in the past.”

Although Musson and Moody argue that the market’s latest upward move is fuelled by monetary stimulus, these portfolio managers have been finding stocks and reduced the Mackenzie fund’s cash holdings to 10% of AUM from 17% a year ago.

From a geographical standpoint, about 23% of the Mackenzie fund’s AUM is in Britain, 17% is in Switzerland, 15% is in France, with smaller holdings in markets such as Germany.

One of the recent acquisitions in the 20-name Mackenzie fund is Publicis SA, a France-based advertising and marketing services firm that operates globally. “It is a conservatively managed, cash-generating business with a strong balance sheet,” says Moody. “Despite the bad economic news – or maybe because of it – you can find good investment opportunities.”

Publicis’ shares are trading at 43.20 euros ($53.20) each, have a price/earnings ratio of 11.5 with a dividend yield of 1.6%. There is no stated price target.

In a similar vein, the Mackenzie fund has added Partners Group Holding AG, a Switzerland-based private asset manager. “We like [its] corporate culture,” says Moody. “It has a strong balance sheet and no debt.”

The shares are trading at 194.50 Swiss francs ($240) each, have a dividend yield of 2.8% and trade at 20 times current earnings.

Simone Loke, vice president and director of Toronto-based TD Asset Management Inc. and lead manager of TD European Growth Fund, says she is less pessimistic than in the past. “I’m not saying that the Draghi plan is a final solution,” she says, “But it is quite a breakthrough in many ways, in terms of ring-fencing a lot of the risks.”

One of the chief benefits of the ECB’s three-year plan, adds Loke, is its open-endedness: “It gives a good impression that the ECB is becoming a real central bank, supporting what is happening in the eurozone. The so-called ‘tail’ risk of a EU breakup has been minimized. This is buying more time so they can work through the issues. I’m less pessimistic than before.”

Meanwhile, the European Stability Mechanism (ESM), a 500-billion euro bailout fund that was supposed to take effect in July 2013, was to be up and running by October.

Another positive step was the recent approval by Germany’s constitutional court that limited Germany’s exposure to 190 billion euros, although that threshold can be raised with approval by the German parliament.

“This proves that the ESM is definitely on board,” Loke says. “At the same time, the language and willingness to participate by Germany is definitely very positive.”

Yet, the big challenge is that austerity measures will be in place in peripheral Europe for several years and are subject to political will.

“Any day we read about demonstrations and politicians back-tracking on promises – that’s a risk. On top of that, the austerity is quite severe, so economic growth is curtailed substantially,” says Loke, noting that there are risks in macroeconomic assumptions going awry.

A bottom-up investor, Loke is slightly more aggressive lately. “We are slightly overweighted in the cyclical sectors and underweighted in the defensive sectors. But we focus on high-quality companies,” says Loke, adding that she favours firms with strong balance sheets and management that can take advantage of the dislocation in the economy.

From a geographical perspective, about 40% of the TD fund’s AUM is in Britain, 11.5% is in Germany, 11% is in Switzerland, with smaller positions in Italy and Spain.

One top holding in the 70-stock TD fund is Prysmian SpA, an Italy-based company in the global cable-manufacturing industry.

“Companies are switching from copper to fibre. That’s a secular growth story,” says Loke, who notes Prysmian also is a dominant maker of high-voltage cable for power transmission. “And emerging markets are upgrading their infrastructure. They are still using copper, but down the road they will also switch to fibre optics.”

Prysmian’s shares are trading at 14.3 euros ($17.60) each and have a dividend yield of 1.4%. Loke’s price target is about 18 euros ($22.10) within 12 to 18 months.

Another favourite is Amadeus IT Holding SA, a Spain-based technology firm that specializes in global distribution systems that centralize airline and hotel reservations for price-conscious business travellers.

“Things are changing so quickly that we as individuals can’t handle it,” says Loke. “But everything is centralized through Amadeus’s system.”

Amadeus’ shares are trading at about 18.40 euros ($22.65) each, about 15 times earnings. Loke’s target is about 21 euros ($25.85) within 12 to 18 months.

© 2012 Investment Executive. All rights reserved.