European volatility masks opportunity

Since news of Europe’s banking and sovereign debt crisis broke in the latter part of 2009, sales of European equity funds have been in continuous decline, while the volatility of the MSCI Europe index has increased.

Given the impact of Europe’s woes on both the economy and corporate profits, investors may want to avoid the continent altogether. But a zero-allocation would leave investors with no exposure to the eventual recovery.

So, how do investors maintain exposure without getting burned? One of the options is to get into an actively managed global equity fund that has flexibility to deviate from the MSCI World Index. While top-down funds and closet-index mutual funds may track the lagging index, active global fund managers can implement their views to mix things up and flex their stock-picking muscle to beat the benchmark.

For David Fingold, lead portfolio manager of the Dynamic Global Discovery Fund, navigating through the European crisis means keeping exposure to a minimum. He has scaled back his European holdings, believing the investment risk has increased as the debt crisis remains unresolved. The current credit spread, which remains wider than it was in depths of 2008, is a testimony of the heightened risk. Also, given the current global economic slowdown, there are better growth prospects in the U.S., he says.

“Just because MSCI Europe is whatever percentage it is to MSCI World, doesn’t mean that you have to put the money into it,” he says. “I’ve spoken at conferences this year about investing in Europe and the recommendation I’ve given is: Don’t do it; put your money in the U.S.

“That’s my number one recommendation for anyone looking at Europe.”

As a global equity fund manager Fingold has to maintain some European holdings, but with an active mandate, he’s able to act on his current views that U.S. is in a better financial position than Europe. For him, America is a safer bet because its market is inherently defensive and U.S. companies tend to have healthier balance sheets than their global peers. Also, most U.S. companies will use the bond markets as a primary source of financing, whereas most major European companies will turn to the banks. Not only will U.S. companies likely out-perform European rivals, but they’re also safer.

“Obviously, I have very high convictions in the (European) companies that I own, but they’re not going to out-perform American peers until such a time as the credit risk in Europe abates,” he says. “So this is part of the reason we were so aggressive in taking down our Europe weight, because you only need to be in the markets for a few years to understand that if the French banks are being destroyed, then Danone (the French food products multinational) is going to under-perform its American comparable.”

In the last year General Mills advanced approximately 7%, while Danone increased by 5%, in U.S. dollars term. The French company’s relative underperformance is largely the result of being on the European index, says Fingold. That means that every time someone shorts the euro stock future it puts pressure on the stock.

“The problem is that if you’re a good European company, you’re the best house on a bad block And that’s not a good investment, to be the best house on a bad block. You’re still in a bad neighborhood.”

Focus on company, not economy

Chris Ryder, vice-president and investment specialist for Capital Group Institutional Investment Services, is less bearish on Europe. Ryder believes the silver lining amid the increased market volatility in Europe is that there are opportunities through the volatility to buy stocks at a discount.

While the daily headlines continue to feed investors’ fears of investing in Europe, one approach advisors can take to help maintain perspective is to tell the stock story as opposed to talking about the economy, says Ryder.

“Obviously we’re happy to discuss the European situation, but it’s not what’s driving the portfolio,” he says. “What were spending our time doing is finding companies that are at the best valuation, which we think that irrespective of the macroeconomic uncertainties are companies that going to thrive and prosper over the long term.”

As the Capital International Global Equity Fund employs bottom-up research, whether the company is domiciled in Europe is less important than other factors such as its client base and market capitalization.

The European companies that have an international export business base will have greater staying power. And the increasing middle class in China and India will play a big part in this consumption story.

“Irrespective of how the European economy is doing, a lot of the investment thesis behind BMW and Daimler is based on the growth of the Chinese and U.S. market. So just because it shows up as a European holding, doesn’t necessarily mean that its dependant on Europe for its growth.”

Defensive companies that fulfill basic needs are also common characteristics of the holdings in their global equity fund. A case in point is Novo Nordisk, a Netherlands-based pharmaceuticals company that focuses on diabetes care. “You’re not going to stop taking those drugs because the European economy is good or bad,” says Ryder.

A focus on strong balance sheets and market share will help a company through tepid global economic growth.

Emerging markets to the rescue?

Whether the emerging markets play will be profitable for European companies is a question of whether the glass is half full or empty. Fingold, does not believe emerging markets will provide a big boost to export-based European businesses, as growth has cooled in China and demand has waned. A case in point is the 20% price incentives BWM and Daimler have started to offer in China. In part, this is the result of the appreciation of the euro, which will hurt many European companies.

Fingold says most people don’t take into consideration that as European banks are big lenders to Asian markets, evaporating liquidity will leave them unable to provide these loans, and demand for European goods will shrink.

“The big number that nobody’s talking about that I think is the 800lb gorilla in the room is the magnitude of European lending to Asia,” he says, referring to a recent Merrill Lynch report. “Asian corporations have borrowed approximately $1.4 trillion from European banks. If European banks are going to shrink and deny credit to Asia, Asia will slow. And I know people are convinced that Asia has a savings glut, but if Asia has a savings glut, why does it borrow more from Europe than from any other region?”

Although market conditions vary across Europe and some are in better shape than others, Fingold believes there is no safe haven in the region. Even non-EU countries such as Norway and Switzerland are not immune to contagion. That leaves only the U.S. as a safe haven, he says.

“In Switzerland they have Dutch disease,” he explains. “Because they’ve done such a good job at managing their financial system and their banks are solvent, they have to fight an appreciating currency and that really hurts their corporate profits.”

While some active managers see opportunities to scoop up discounted stocks, he’s staying away. The signal to start investing in Europe will be when the credit spreads collapse and banks recapitalize. When that occurs, he plans to add companies that are not dependant on the European economy for growth.

As he sees it, whatever the outcome in Europe it will likely experience a lost decade as Japan did. Growth in Europe will be lost largely as a result of austerity programs and deleveraging. As with Japan, its aging population will also be a headwind to growth.

Fingold believes his fund will benefit by avoiding the companies that will suffer from the crisis, specifically the financials that make up a large component of the European index.

“The benefit of active management is that we don’t care what the weight of the zombie banks are within the index. We will own none of them,” he says. “But we will take advantage of companies that are growing and that are attractively valued. When you buy index funds, you are buying zombie banks and when you invest in a manager who has low active shares, and that is almost every manager, then they will give some exposure to those zombie banks and that will be an overhang on your portfolio.”

This article was originally published on capitalmagazine.ca.