… if you can wait a decade for active risk to pay off.  Joseph Mariathasan finds managers enjoying rich pickings for the long term, by taking account of - but also looking through - the dominant macro themes

Over the past decade, a global convergence of interest rates, accounting standards and corporate tax rates has led to a convergence of valuations: country effects - outside of Japan - became less significant in equity markets. Even in emerging markets, the last decade has seen companies increasingly correlated to their global sectors rather than their local country indices.

“This was massively true in the euro-zone, where countries converged to Germanic levels of prosperity,” observes Andrew Parry, CEO of Hermes Sourcecap, the high-alpha European equities boutique within Hermes Fund Managers, which is owned by the BT Pension Scheme.

But 2008 proved to be a watershed for Europe, with European countries diverging and country risk at times seeming to overwhelm company and sector risk: “In 2006, Portugal and Germany both had 10-year bond yields of 4%,” says Parry. “In January 2012, the Portuguese yield was 11.85% and Germany’s was 1.8%.”

Andrew King, head of European equities at BNP Paribas Investment Partners, says his impression is that the European market has become more top-down, with less emphasis on stock-specific risk. “When we look at the statistics, we find that the correlations between companies and sectors is increasing and the dispersions between stock returns is decreasing,” he says.

For both investors and fund managers, this leads to philosophical and practical issues whose resolution is ultimately tied to the future of the euro-zone itself. Will these dominating country effects persist, or are they just a temporary aberration?

While the country effects have tended to overwhelm company specifics in the peripheral countries of the euro-zone, the story within Europe as a whole is much more complex. Many companies listed on European markets have little to do with their domestic economies. “In the FTSE 100, the top 15 companies only have a 10% exposure to the UK,” says King.

Elsewhere in Europe, the story might not be so pronounced, but it is still true that the prospects for many companies listed on European exchanges are far more tied to foreign than domestic markets. “One reason auto stocks did so badly in Germany in the second half of 2011 was because China’s economy was looking weaker,” notes Paul Doyle, manager of the newly launched European Absolute Alpha fund at Threadneedle Investments. “That gave us an opportunity to buy BMW and Daimler.”

This is not merely about growth from emerging markets; Doyle cites Swedish medical instrument manufacturer Elekta, which pioneered significant innovations and clinical solutions for treating cancer and brain disorders. Its key market is the US, where it has secured 20% of new orders despite having only 10% of the existing market, helping it to grow its margins from 13% up into the mid-20s. “Elekta, like a lot of European companies, has invested much more in R&D than its domestic competitors in the US,” says Doyle.

Even in the struggling economies of the euro-zone’s peripheral countries, there are many examples of companies whose local listings belie their economic exposures. Doyle is happy to hold Ireland’s Kerry Group and Ryanair, for example. King sees Portuguese retailer Jerónimo Martins as a case in point, with its success due to dominance of the retail market in Poland where it was one of the first foreign entrants in 1995. “In Greece, the biggest stock is the Coca-Cola Hellenic Bottling Company, the world’s second-largest Coca-Cola anchor bottler,” says Raj Shant, head of European equities at Newton Investment Management. “Greece accounts for only 7% of its revenues and it has a presence in 28 countries, including Russia and Nigeria.” Parry says that he is sceptical on Spain because of its deep housing market problems: “But you cannot tar every stock in a country with its national brush. We hold Inditex in Spain, the owner of retail chain Zara, a great company that has its manufacturing in Spain.”

Macro cannot be ignored…
Nonetheless, while there are many successful companies in the struggling peripheral economies, it is clear the headwinds are against them. Hermes Sourcecap, a pure stockpicker, less than five years ago had positions in Greece, Italy, Spain, Portugal and Ireland as well as Russia, Hungary, the Czech Republic and Cyprus. Today, it has no exposure to any of these countries - despite taking no explicit macro decisions. Even a comparison between German BMW and French Peugeot is stark: “BMW is able to undertake bond issues at tight prices and accelerated their investments,” says Parry. “Peugeot is still dependent on state aid.” The firm is overweight Germany, Scandinavia and the UK. As Parry argues, the euro-zone is signing up to German austerity and by so doing, voting for massive domestic deflation. Germany went through such a period after reunification.

“German productivity went through the roof,” he says. “The country’s goods were made more competitive by the euro being relatively weak. But are other European countries willing to go through austerity like Germany did?”

Whether it falls out from bottom-up decision marking or an explicit top-down strategy, managers are being forced to become more cognisant of macro factors. “We, as a house, are bottom-up stock pickers, but we recognise that macro themes have become very important,” as Doyle puts it at Threadneedle.

And it is the banking sector, of course, that dominates the macro environment - not least because many have balance sheets comparable to the GDP of the countries they are domiciled in and much current public policy is directed towards keeping the sector stable.
As Parry points out, there are no overnight solutions. Debt funding for companies, particularly smaller ones unable to issue bonds, are dependent on their local banks. This gives a real advantage to the stronger companies in the core euro-zone countries that are able to borrow from those banks at cheaper rates. Smaller companies - which dominate the peripheral countries - face a big challenge.

Ironically, the sector that has managed to avoid the problems of local country credit ratings is the banking sector itself. For Doyle, last December’s ECB decision to provide €489bn of three-year loans at 1% to 523 European banks was a macro event that could turn out to have been the game changer - he began buying aggressively and is now overweight.

“It was very important as, until then, there was a stigma to borrowing from the ECB,” he says. “That stigma has now gone. Collateral requirements were also eased so medium sized banks were able to use lower quality collateral. The effect of this is that the wall of refinancing that is coming in 2013 has begun to ease. The important point is that is it an invitation not only for banks to get liquidity, but to use that liquidity to manage their own balance sheets by, for example, buying back their own bonds in the marketplace at a discount.”

Not everyone agrees. Shant is more cautious: “Longer term, the banking sector will struggle,” he argues. “They have to shrink their balance sheets and deleverage, and may have to replace the system of risk-weighted assets with total assets. The return on capital for banks will never be high again.” Parry concurs, noting that even in the boom periods, geared 40-times, the European banking industry did not outperform: “If you calculate it as return on total capital, it was just ridiculously low. Goldman Sachs earned less than 1% return on total capital employed.” Nonetheless, Shant has built a short-term position in Italian banks, given the absence of a local property bubble and the market pricing in substantially higher funding costs than those implied by the ECB’s liquidity provision; and Parry holds Scandinavian names DnB and Swedbank.

.… but company specifics remain key
When one speaks to a multi-manager like Altis Investment Management the message is that European managers, as a whole, have been reducing the total amount of active risk they take in the face of this uncertainty.

“A lot of fund managers now use risk-management tools such as BARRA and have a good control of how much and where they are taking risk - and what is clear, is that a lot of active risk is off the table,” says portfolio manager Bram Bikker.

This move might suggest that the managers have more concerns about hedging against the business risk of short-term underperformance than focusing on maximising their convictions. But Bikker cautions against jumping to that conclusion. “It is always difficult to ascertain whether a manager is doing something to reduce his own career risk, or whether he is trying to act prudently in the client’s interest,” he says.

“The fact that active risk is down has, first of all, a technical reason in that correlations have gone up, while the cross-sectional dispersion of stock price returns have come down. This results in lower calculated ex-ante tracking error numbers. In Europe, we give managers the benefit of the doubt as, over the past three years, managers on our shortlist did well by being underweight financials and underweight companies exposed to southern Europe. The fact that active risk is down may be just a technical effect, in that managers may be aware that the market will rebound but do not want to dive into riskier stocks too early.”

Few would disagree with Parry when he suggests that diverging performance between core and periphery will last for the next decade at least. But he argues that means 10 years of a rich environment for good stock pickers.

“The strong companies will get stronger, with low discount rates and better cashflows, and they are infinitely better positioned than the weaker players and can therefore maintain a competitive advantage for a longer period and through the business cycles,” he says. Large companies with strong brands and pricing power have the ability to generate cash and have flexibility over price, making it a tough environment for smaller companies, he suggests.

Shant says something similar: in an environment of low growth and stagnant or falling asset prices, the margin for error for companies is reduced and it is likely that there will be more company failures. “The issues are not simple, so the solutions are not simple,” he says. “But that is what underlies the investment opportunities.”

King concedes that stock correlations are very high, but he argues that it has less and less justification. “In the tougher environment that we are going to be seeing, companies with strong market positioning will benefit at the expense of their weaker competitors, so the earnings will diverge and ultimately drive the stock prices,” he says. “It is possible to generate outperformance in a wide variety of ways, from taking top-down macro views on countries, to momentum trading, sector positioning, stock selection and so on. The mistake most managers make, is that they try and do everything.”

Indeed, he goes further than those bottom-up strategists who have focused more on top-down risk management when he argues the case for stock-specific decisions. His strategy is to ignore the problem of forecasting economic scenarios and, instead, find companies that are best positioned to manage their earnings risk - “we look for pricing power, which means limited competition and high barriers to entry” - ensuring that other risks relative to benchmarks are eliminated, either through adjusting weights of stocks or by replacing lower conviction bets altogether with other choices that reduce unwanted common-factor risks.

What other managers might see as an opportunity, King sees as a common-factor risk. Exposure to domestic growth in emerging markets is an example. “It is easy to see higher demand there, but the actual issue is how much of that the market has priced in,” he says. “Emerging market exposure by itself is not necessarily a good thing.” He gives the example of Dutch supermarket Ahold: “It trades at a discount to its peers, as it does not have any emerging markets exposure: but I would rather have the market leader in the Dutch market than the fifth or sixth-placed player with no competitive advantage in a rapidly growing emerging market.”

Understanding the interplay of domestic markets versus other European markets, the US and emerging markets; the regulatory pressures in areas such as energy and telecoms; and the funding environment with a heavily weakened banking sector; all provide a rich environment for longer-term stockpicking strategies. The interplay has become more complex, with some companies able to borrow cheaper than their governments while they are physically, legally and economically wedded to the local economy. Others such as utilities and telecoms may be defensive in nature, but if a government needs money and taxes them more, they are unable to leave the country.

Understanding the macro environment might have become more important in Europe than it has been in the past, but it is understanding the details of a company’s revenue streams and how they are likely to be affected in the face of changing economic and market conditions across the globe that will still separate the winners from the losers among the investment managers.