Managers must help clients maximise their gains from the new financial landscape, says Sandy Black from Morgan Grenfell
The advent of a European region unified from January 1999 by a single currency and monetary policy creates important challenges for asset managers, for pension plan sponsors and for the companies in which they invest.
From the perspective of euro-based pension funds, the spectrum of assets whose currency matches that of the liabilities is extended beyond the home country into the rest of the euro zone. The erosion of national barriers to entry and the improvement in price visibility afforded by a single currency will cause Europe's companies increasingly to think Europe-wide rather than nationally.
For asset managers, these factors will combine to justify a pan-European approach to stock selection and portfolio construction in which it matters less and less whether a company's shares are quoted in Frankfurt, Milan or Helsinki.
Some large European companies have operated regionally, and indeed globally, for decades but for many companies and for certain nationally regulated industries, the primary focus has been on the national market. This in turn has meant that a significant part of share price performance can be accounted for by national, not sectoral or company-specific factors.
However, as the regulations governing industries such as power and telecommunications have in-creasingly fallen under regional influence and as product offerings and services have become more global, the country-specific factor in share price performance has declined.
The increase in merger and acquisition activity in Europe provides some evidence for this. According to material from various sources collated by Goldman Sachs, the value of M&A deals in Europe has risen from $51bn in 1993 to $250bn in 1997, representing a compound annual growth rate of 49%. Last year, 48% of the $250bn total was accounted for by deals where bidder and target were from the same country; this subset also accounts for the fastest growth rate, averaging 60% annually.
It is reasonable to assume that the process of national consolidation is a natural precursor to the drive for regional dominance. While some industries remain fragmented, even at a national level, and others are already characterised by Europe-wide dynamics, the consolidation trend brings significant advantages for both categories; namely, economies of scale, margin improvement, focus on core business and, ultimately, shareholder value creation.
Following Allianz's acquisition of AGF earlier this year, Henning Schulte-Noelle, Allianz CEO said: The partnership with AGF brings us a giant step forward. This means, in practice, that Europe has become our home country". Schulte-Noelle's opinion emphasises how important it will be for asset managers to 'pick the winners'. Companies should be rewarded, through superior share price performance, for regional dominance, irrespective of their domicile.
The potential rewards for companies which can dominate Europe are indicated by some interesting comparisons between the 'vital statistics' of the US and the 11 countries making up the euro zone on January 1 1999. The estimated population of Euro-11 is 290m, slightly above America's 267m, and the estimated GDP is slightly lower at $6,300bn against $7,800bn in the US. More interesting is the fact that the euro zone's market capitalisation is only around $2,712bn, compared with $11,500bn in the US.
The gap is likely to be closed from two directions. First, the average corporate return on equity in Europe is lower than in the US; a drive for higher profitability and ROE will tend to boost Europe's market capitalisation even if valuations remain static. Second, euro zone economies are poorly represented in the quoted corporate sector due to a still relatively high level of state involvement and family ownership of key companies.
Privatisation of state enterprises and the flotation of family-run companies will result in an increase in share issuance in the coming years but will also broaden the range of publicly quoted companies in the investment universe. Both of these factors are common to Europe as a whole and, as such, present exciting investment opportunities for asset managers with the resources to make comparisons within industries across the region.
Further, the extent to which investors already view national markets in Europe as anachronistic is illustrated by the dominance of companies like Nokia, which makes up 44% of its local market index, and Telefonica, which accounts for 17% of the local market index in Spain.
It is becoming clearer and clearer that the ambition and ability to dominate the 'euro zone', and indeed Europe as a whole, will confer significant rewards. As a result, it makes sense for fund managers to organise their research so that they can identify, for example, the best insurance companies or pharmaceuticals companies in the region, not just the best in Germany or Italy alone. This is a challenge that Morgan Grenfell has fully embraced.
The move in fund management towards sector analysis and a sectoral bias in portfolio construction should be accompanied by an expansion of our clients' horizons from their home country to the euro zone as a whole.
This is already being facilitated by a change in investment regulations allowing higher 'non-domestic' equity allocations and by a shift in actuarial assumptions, recognising that the currency risk in investing across the 'euro zone' will disappear on January 1 1999.
In response to this, some European companies from outside the euro zone will almost certainly seek listings within the single currency area.
The organisation of euro-based companies' pension assets along regional lines may well take some time, reflecting trustees' natural caution and the belief that superior knowledge of local investment opportunities may persist, but the trend is clear.
An examination of share price performance correlations provides evidence that the country influence is declining in importance. However, some sectors show much greater regionalisation than others. A small number of companies active in industries where pricing and regulation are truly global are beginning to show greater correlation with their global industry sector than with either the regional sector or with their country of domicile. Industries such as airlines, steel, energy sources, autos, utilities and healthcare are already showing higher industry correlations. Further, share price correlations with the regional sector or industry have increased during the period from late 1989 to early 1998. Industries which have recently dominated the headlines by virtue of merger and acquisition activity, such as banking and financial services, still show stronger country influences during the period under review; this is consistent with the fact that much of the consolidation in these industries has been local in nature.
The strongest trends towards globalisation are seen in utilities, telecommunications, electronic components and airlines. In industries demonstrating accelerating regional and global correlation, a number of key themes are evident.
Privatisations and subsequent cross-border shareholdings have facilitated the regionalisation process in the utility and telecom sectors; although the fixed telecom market was deregulated in 1998 in Europe, operators had been preparing themselves for this by forming alliances.
Airlines are finding that entry barriers are falling; the result has been a pick-up in regional and international alliances. Insurance has also seen an erosion of entry barriers in Europe. In addition to regional consolidation, the interest rate sensitivity of insurers, in a world where rates have tended to converge, has increased regional and global stock correlation within the sector. In many of the sectors mentioned, regulatory change constitutes a powerful force. The advent of the euro will act in the same direction, leading to a regional share market in Europe where decisions about companies and sectors will play a larger role than country decisions.
The financial landscape in the euro zone, and in Europe as a whole, is changing rapidly, with far-reaching consequences for financial markets and those who invest in them. Focus on sectoral trends both regionally and by extension, globally, will put asset managers in a strong position to maximise their clients' gains in this changing environment.
Sandy Black is a fund manager with Morgan Grenfell Asset Management in London"