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If there is one catchphrase to amplify the Lord Abbett International Equity team's view of Europe, it is that the so-called PIIGS (i.e., Portugal, Italy, Ireland, Greece, and Spain) won't fly anytime soon. (See Chart 1.) Deleveraging, austerity, and structural reforms will take years to implement in the peripheral countries. As a result, the team's investment focus is more on opportunities within northern Europe and the United Kingdom, particularly on healthy multinationals and exporters that proved they could perform well in previous recessions. The challenge is to gauge whether all the bad news is reflected in the prices of such companies. A world-class auto manufacturing company selling at six times earnings? A global pharmaceutical company selling at half its valuation of 10–12 years ago? In the following roundtable discussion, Lord Abbett Partners and Directors of International Equity Harold Sharon and Vincent McBride and Portfolio Managers Yarek Aranowicz and Todd Jacobson share their perspectives on the region that accounts for nearly one-third of the world's gross domestic product.1
Source: Haver Analytics and The Economist online.
Q. Harold, some international investors may be leery of Europe given the long-running sovereign debt crisis and the painful deleveraging that is expected to throw the Continent into recession this year. What opportunities are they missing?
HAROLD SHARON: Certainly, there are some economies that are indebted, but not all of Europe is in a deflating mode. Much like the Asian crisis of 1997 and the Latin America crisis of 1980 [see sidebar], careful analysis that looks beyond the macro arguments will actually reveal that some economies are in relatively good shape and have world-class companies whose returns are not inordinately dependent on what's happening in the peripheral countries of southern Europe. In other words, you can still find some compelling investment opportunities in Europe, particularly in countries that chose not to use the euro as their official currency, and are, therefore, not beholden to European Central Bank policy.
Q. Vincent, if you had to draw a picture of the current investment landscape in Europe, what would it look like?
VINCENT MCBRIDE: Our friends at GaveKal Research put together a great chart that essentially depicts some of the good, bad, and ugly investment options in Europe [from the period January 2009 through January 2012]. [See Chart 2.] The best performers by far were Europe's "export champions," that is, eurozone companies making at least 50% of their sales outside Europe [see Table 1], followed by European companies with at least 25% of their sales in North America, which avoided a double-dip recession. Lagging behind were pan-European companies making at least half of their sales in Europe, but not primarily in their home countries, and "national victims," that is, companies making at least two-thirds of their sales in their home countries and particularly vulnerable to government austerity programs.
Source: GaveKal Research.
Past performance is no guarantee of future results.
Note: Export champions: eurozone companies making at least 50% of their sales outside Europe. Pan-European companies: companies making at least half of their sales in Europe, but not primarily in their home countries. U.S. exposed: companies with at least 25% of their sales in North America. National victims: companies making at least two-thirds of their sales in their home countries.
Source: GaveKal Research.
Note: “Goods export champions” refers to industrial companies in the STOXX® Europe 600 Index that make at least 50% of their business outside Europe. “Service export champions” refers to companies in the STOXX® Europe 600 Index that work in the consumer service sector (retailers, media, advertising companies, telecoms), or service companies and institutions (business support, IT services, software, telecoms, catering, deliveries, utilities, etc.) that make at least 50% of their business outside of Europe.
Q. Didn't some of the companies categorized as "national victims" today used to be called "national champions" in better economic times?
YAREK ARANOWICZ: Unfortunately, yes. Historically, investing in certain countries was about finding "national champions," companies that typically enjoyed oligopolistic or monopolistic positions in their respective markets thanks to great relationships with the government. They really didn't have to compete much because they were so big and well connected. Now austerity is putting lucrative government contracts under the microscope.
Q. When did Lord Abbett sense a shift in the outlook for Europe, and how did that change your investment focus?
ARANOWICZ: That happened quite some time ago, when we realized that Greece's debt problems were just the tip of the iceberg and that most of the euro nations would struggle with high indebtedness and would be forced to implement austerity measures and deleveraging. Instead, we looked at multinationals with healthy balance sheets and strong, innovative management teams and with a very good presence in northern European markets, but also strong in emerging markets and North America, where growth should continue this year.
Q. Vincent, which sectors have been beaten down the most and, in your view, represent the most attractive opportunities from a dividend standpoint?
MCBRIDE: One of our favorite screens is the current dividend yield2 being higher than the current P/E [price-to-earnings] ratio.3 It's a fairly long list; within Europe, it's populated most frequently by insurance companies, banks, media companies, utilities, and telecoms. While we own two banks on that list, there are a number of banks we don't own, primarily because we don't believe the dividends will be paid out to us. As we know, a lot of these European banks need additional capital. One way to raise that capital is to lower dividends.
We expect to see reductions from some of the telecom companies, but they are at such high levels today—9%-plus—that if they come down to a lower level, they should still be of significant interest to us.
We also continue to add to European insurance, media, and utility companies, integrated oil, and defense.
Q. What kind of dividends are we talking about?
MCBRIDE: The dividend yields for insurance companies average approximately 7%. The telecom range is more like 7–11%, while utilities range 7–10% [as of January 19, 2012].
Q. Are those yields based on trailing 12 months or on consensus forecasts?
MCBRIDE: They're based on consensus forecast dividends, many of which (excluding the banks) are as much as 30% lower than the dividends they paid last year. We have no illusions that such dividends are as sustainable as they were last year. They're not.
Q. Yarek, which sectors do you focus on?
ARANOWICZ: As the global economic outlook deteriorated last year, the traditionally defensive healthcare sector became rather cheap based on price-to-next-12-months-earnings multiples4 in the high single digits to low double digits—valuations we haven't seen since the early 1990s, when President Clinton was trying to introduce healthcare reform. All of which helps explain why the healthcare sector outperformed all others. One European pharmaceutical company, for example, finished up 24% in 2011 (including dividends in U.S. dollars), while the MSCI EAFE Index5 declined 11.9% (including dividends in U.S. dollars).
Q. Is there more upside potential for the healthcare sector?
ARANOWICZ: The industry could benefit from much greater demand once healthcare reform begins to affect at least 30 million uninsured people. Considering that the average individual fills five prescriptions, this could translate to 150 million prescriptions a year for pharmaceutical companies. So even if there is no pickup in growth among existing patients, and prices remain flat or slightly down, that enormous influx of new patients should boost their top-line growth. Even if healthcare reform is modified, drug manufacturers would no longer have to make billions of dollars' worth of special tax payments over the next several years, thereby improving their bottom lines.
Q. What about industrials?
ARANOWICZ: We can still find very good opportunities here. While earnings estimates have been cut amid fears of a significant drop in global demand, we believe the shares of some companies have been overpunished. In some cases, valuations were even below the trough of the last cycle, which seemed exaggerated for companies with diverse global businesses and strong market penetration in regions that should continue to grow, albeit at a slower pace. Case in point: a major European engineering company that has undertaken a huge cost-savings program and become more competitive in the energy transmission and distribution business and industrial automation. With 35% of its business in developing countries and very good exposure to North American markets ripe for expansion, this company appears poised for a significant turnaround.
Q. Turning to small caps, which parts of Europe appeal to you, Todd?
TODD JACOBSON: The Lord Abbett International Small Cap Core Strategy has been overweight northern Europe and the United Kingdom, where we're finding a number of competitive companies that are trading at cheaper prices than other places in the world, even though they have great cost structures and can benefit from robust exports.
Q. Which countries stand out?
JACOBSON: The International Small Cap Core Strategy has been overweight Germany for more than three years, and we’ve done it through exporters and through companies with strong technology, research, and development that is much more difficult to replicate in countries with lower costs of capital. If the euro continues to depreciate, the profitability of these companies should continue to improve. In Scandinavia, one of our biggest holdings has been a credit management services company that has actually benefited from Europe's malaise by helping clients collect written-off receivables and purchase outstanding receivables from banks under mounting pressure to raise capital amid tightening liquidity. Then there’s the United Kingdom, where we've actually been overweight versus our benchmark, the S&P Developed Ex-U.S. Small Cap® Index.7
Q. Why overweight the United Kingdom?
JACOBSON: While 80% of the listed market is basically non-U.K.-oriented companies, we've found there are companies that tend to trade more cheaply than comparable companies around the world, particularly those in the United States, in part because the shareholder base tends to be concentrated among U.K. institutions. As a result, some companies in the energy, industrials, and financial sectors have been bought out at significant premiums.
Q. Harold, does the United Kingdom have any other bright spots?
SHARON: Some of the best-performing stocks in Europe have been in the United Kingdom, thanks to global leaders in the consumer staples (namely tobacco, alcohol, and beer), home care products, and pharmaceutical sectors. These companies have been able to sell into an expanding global market, and turmoil in Europe doesn’t completely derail their prospects.
Q. How concerned are you about such turmoil?
SHARON: We see enormous challenges to a deleveraging Europe; by definition, you're talking slow growth that could last a number of years. [See Chart 3.] So it's going to be volatile, but such volatility may generate opportunities to earn some attractive returns on underpriced companies, especially when you factor in dividends.
Been There, Done That
Nothing concentrates the mind like a full-blown financial crisis, and Lord Abbett's International Equity managers have certainly seen their share over the last three decades. Can some of the lessons be applied to Europe today?
In the 1980s, it was the Latin American debt crisis and the Japanese stock market crash. In the early 1990s, Norway, Finland, and Sweden all experienced severe banking difficulties. Then came the Asian debt crisis of 1997 and Russia’s default in 1998—all of which led to prolonged slow growth, recession, or, in some cases, deflation—environments in which active managers tend to prove their mettle before indexes rebalance.
Through it all, the key lesson derived for active managers is that crisis can also generate opportunity.
Take Japan, for example. While the confluence of an aging population, soaring debt, unfavorable currency, declining exports, and Chinese competition have taken their toll on Japan's economy, Todd Jacobson, Lord Abbett Portfolio Manager of International Equity, has identified companies that have been able to adapt and succeed.
"The consumer environment in Japan has been horrible for the better part of 20 years, but there are a handful of companies that have ultimately dominated certain segments, such as retail," said Jacobson. "We still own them because they just continue to win market share, and they’re taking that market share from structurally impaired operations like department stores with perennial cost issues."
In the case of the Asian debt crisis, the financial system deteriorated so quickly that companies scrambled to restructure their businesses, realign strategies, and clean up their balance sheets. While that was a long, painful adjustment for countries like the Philippines and Indonesia, a weak currency in South Korea made its exports super-competitive, giving rise to a world-leading company like Samsung.
From a macro perspective, the team has also seen entire nations learn from their past mistakes and come out of their bad experiences much stronger.
Thirty years ago, Poland, for example, was in sharp decline—but between 2006 and 2010, its gross domestic product (GDP) growth averaged 4.7%. Twenty years ago, Germany was riddled with inefficiency; but industry and labor eventually built a powerful export machine. Between 1990 and 1992, Scandinavian economies practically imploded; now profit growth is expected to exceed the euro region for a third straight year.1 Asia struggled long after its 1997 debt crisis, but Singapore did quite well during that time frame, as did Taiwan and, in the Pacific region, Australia.
"It's easy to lump regions together, but we've seen a number of sick economies emulate their neighbors and nurse themselves back to health," said Harold Sharon, Lord Abbett Partner & Director of International Equity. "Look at the differences among Brazil, Argentina, and Peru. Peru once had hyperinflation, but officials brought it under control through a combination of policy reforms, including improved rule of law and deregulation, which helped tame inflation and fuel growth. Of course, Peru was helped by the commodities boom, which drove up prices of its biggest mineral exports. But the point is that the political will to change went a long way toward attracting investment."
That being said, a solution to Europe's deep-seated economic problems may be much more difficult. As Yarek Aranowicz, Lord Abbett Portfolio Manager of International Equity, put it, "Europe will basically have to become more like the United States. They are a little bit closer than they were last summer, but they still have much farther to go. In addition to all the fiscal challenges they have, eurozone nations, especially southern Europe, have a major problem with lack of competitiveness [see Chart 1], rigid labor markets, inefficient tax regimes, and lack of infrastructure, which would give them access to export markets."
Source: World Bank staff calculations.
Note: Averages computed using principal component analysis, EFTA here comprises Iceland, Norway, and Switzerland. The EU15 comprises Denmark, Finland, Ireland, Sweden, and the United Kingdom (North); Austria, Belgium, France, Germany, Luxembourg, and the Netherlands (Continental); and Greece, Italy, Portugal, and Spain (South). EU12 comprises Estonia, Latvia, and Lithuania (North); Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia (Continental); and Bulgaria, Cyprus, and Romania (South).
Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in small and mid-sized companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations, and illiquidity. Investing in international and multinational companies generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments. No investing strategy can overcome all market volatility or guarantee future results.
Each portfolio is actively managed and may change significantly over time.
Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.