Contributing editor Gavin Graham is with us today with some thoughts about the strong performance of the European stock market this year. Gavin has had a long and successful career in money management and is a specialist in international securities. He held senior positions in financial organizations in London, Hong Kong, and Toronto. He currently is chief strategy officer at Integris Pension Management, a provider of personal pension plans for incorporated individuals. He divides his time between Toronto and the U.K. Here is his report.
Gavin Graham writes:
The European stock markets have been on a roll for the last few months. The German DAX Index, which hit a low of 8,354 in mid-October 2014, was up a remarkable 47.5% to 12,312 six months later on April 15. That was a new all-time high. The DAX is up 25.5% year-to-date.
Germany isn’t alone. The French CAC 40 was up 38.7% to 5,257 over the same six-month period. The Spanish IBEX 35 was ahead 25.8% and the Italian FTSE/MIB gained 36.5%, although it hit its 52-week low at the end of December. The Euro Stoxx 50, which is comprised of the 50 largest stocks in the Eurozone, is up 36.6% from its October low and 21.9% year-to-date.
By contrast, the Britain’s FTSE 100 is only up 17% from its October lows and 9.6% year-to-date, although the 7,000 level is also a new record. The last time the FTSE was touching 7,000 was in early 2000, as is the case with Germany. So in real (inflation adjusted) terms, these new highs are still 30%-40% below their previous peaks.
Why have the Eurozone markets done so much better than the FTSE, or indeed the S&P/TSX over the last few months? One obvious answer is that both the U.K. and Canada have heavy weightings in resource stocks. While most Canadian investors know that approximately 21% of the TSX Composite Index is made up of energy companies and another 10.4% of materials, they may not be aware that 11.9% of the FTSE 100 is comprised of energy companies and another 6% of materials.
The underperformance of the FTSE compared to the Eurozone markets may be surprising when you consider the U.K. was the fastest growing major economy in 2014. But it becomes more comprehensible when you consider two key factors. First, the price of oil dropped 50% in the last six months of 2014 from over US$100 a barrel to US$50. Second, China’s economic slowdown led to sharp declines in other commodity prices, particularly bulk commodities such as iron ore and coal, to which FTSE listed companies have a high exposure.
Then there’s the political factor. The upcoming U.K. election has the ruling Conservative party running neck and neck with the perceived anti-business Labour party with three weeks until the polls. We have seen the pound sterling weaken against the U.S. dollar, hitting a five-year low of US$1.455=£1 on April 15, further reducing the returns for U.S. dollar based investors.
The other major difference between the U.K. and the other European markets is, of course, monetary policy. Mario Draghi, the President of the European Central Bank (ECB), finally announced his €1.1 trillion (US$1.2 trillion) Quantitative Easing (QE) program in January, with purchases of €65 billion a month of government bonds and other authorized securities starting in March. The program is due to continue until September 2016.
Mr. Draghi acted because of the lack of growth in the Eurozone and the fears that deflation (falling prices) was becoming established. That would make the enormous debts carried by European governments harder to service and raises the likelihood of a Greek exit (Grexit) from the Eurozone, with the possibility of other countries, like Portugal, following it.
While it is too early to say whether the program has been successful in averting deflation, the early evidence is encouraging. Eurozone inflation, which was -0.6% in January, improved to -0.3% in February and -0.1% in March. That was even before the ECB’s QE program actually started.
The European Purchasing Managers’ Index (PMI), compiled by Markit, hit a 46-month high of 54.1 in March (50 marks the boundary between expansion and contraction). That was up from 53.3 in February. In Germany, the PMI hit 55.3, up from 53.8 in February and the highest in nine months, since sanctions were imposed on Russia. In France, the PMI expanded for the second month in a row, although the 51.7 mark was below the 42-month high of 52.2 reached in February.
Chris Williamson, chief economist at Markit, said the data was “welcome news” for the Eurozone and anticipated that Eurozone GDP growth would reach 0.3% in the first quarter of 2015. Meanwhile, the European Commission survey of consumer confidence was near an eight-year high in March, the sharpest increase since April 2009. One of the drivers of the improvement has been the weakness of the euro itself. The prospect of quantitative easing by the ECB has seen the currency fall almost 25% against the U.S. dollar, from US$1.399 = €1 a year ago to US$1.059.
As with the FTSE 100, the Euro Stoxx 50 has a large weight in multinational businesses such as industrials, autos, aerospace, pharmaceuticals, and energy companies, which benefit twice over from a weaker domestic currency. First, their overseas earnings, whether from exports or from foreign subsidiaries, are worth more as the euro weakens against other currencies. Second, their exports become more competitive, with German exporters of capital equipment and autos particularly benefiting against their U.S., U.K., Chinese, and Korean rivals.
In this, the Eurozone is only following in the footsteps of Japan. At the behest of the Prime Minister Shinzo Abe, the Bank of Japan has pursued an aggressive QE policy aimed at generating positive inflation and GDP growth by weakening the currency to stimulate exports – the so-called “Abenomics”. The yen has weakened by over 17% against the U.S. dollar over the last year, from ¥100.8 = US$1 to ¥122. Almost all of the fall came between September and December 2014, as the initial weakening of the yen in 2013 from ¥80=US$1 to ¥100 failed to stimulate consistent growth.
With Japanese products more than one-third cheaper for U.S. buyers than two years ago, Japan’s rivals, China and South Korea are seeing their export growth decline sharply. In fact, China’s exports in March contracted 15%, much worse than any forecaster had expected. That was due in large part to the strength of the Chinese renminbi, which is effectively pegged to the U.S. dollar. China’s exports to the Eurozone and Japan fell 19.1% and 24.8% respectively. China’s slowdown, with GDP growth officially forecast to hit a six-year low of 7% this year, also saw imports plummet 12.7% in March, although most of this fall was due to lower demand for commodities, with coal imports down 40% in the first quarter.
The sharp fall in the euro over the last year means that returns for North American investors are less attractive than they appear in local currency terms. U.S. investors have been the hardest hit but Canadians have also been affected. The loonie’s 18% decline against the U.S. dollar since last July, from US$0.94 to US$0.80 today, offsets some of the euro’s weakness, but still knocks 8%-9% off the returns from Eurozone companies. Nonetheless, multinationals such as capital equipment makers Siemens, Philips, and Schneider Electric, auto-makers Daimler, VW, and BMW, pharmaceutical and chemical companies Sanofi, Bayer, and BASF, consumer products groups Anheuser Busch Inbev, LVMH, and Inditex (owner of Zara), and software group SAP should all benefit from the weaker euro and signs of recovery in their domestic European markets.
If investors are willing to put up with the uncertainty caused by the sharp moves in oil prices, Royal Dutch Shell’s US$70 billion takeover offer for smaller U.K. exploration and production company BG Group at a 50% premium last week shows that other European energy stocks may be targets for acquirers.
Nonetheless, the jury remains out on whether Eurozone economies are finally starting to show signs of a sustained domestic recovery. The sharp fall in oil prices, the weaker euro (which also helps tourism, a major industry) and Mr. Draghi’s QE program are undoubtedly helping. But Europe’s longer-term problems, such as high debt levels, an aging population, and the possibility of a Grexit remain unaddressed. Furthermore, the euro is likely to continue its decline, as the U.S. Fed has ended its QE program while the ECB’s still has 18 months to run.
Investors should be selective about which European stocks they purchase, as a market capitalization weighted vehicle such as an ETF will have big exposure to Eurozone banks, which still have major credit issues to address. If an ETF is chosen, then it should be hedged back into Canadian or U.S. dollars to offset the likely weakness in the euro. Amongst my European recommendations in The Income Investor and IWB are U.K. drinks group Diageo (NYSE: DEO), Anglo-Dutch consumer products maker Unilever (NYSE: UL), and Swiss drug group Novartis (NDQ: NVS), an update on which follows.
Novartis AG (NYSE: NVS)
Originally recommended on Dec. 1/14 at $96.65. Closed Friday at $102.46. (All figures in U.S. dollars.)
Swiss pharmaceutical giant Novartis has moved up by 6% since I recommended it in December last year. The most important development has been the completion of the sale of its Animal Health division to Eli Lilly (NYSE: LLY), which closed on Jan. 1. In another major deal, the company will purchase the cancer operations of GlaxoSmithKline (NYSE: GSK). Novartis and GSK’s consumer divisions will be merged into a joint venture of which Novartis will own 36.5%.
As noted at the time of recommendation, Novartis has also agreed to sell its influenza vaccines business to Australian healthcare company CSL. This resulted in it taking a $1.1 billion non-cash write-down on the value of the assets in 2014. This was effectively offset by the $0.9 billion it received from selling its blood transfusion division to Grifols SA in early 2014. Novartis also received $0.8 billion from selling its shares in Idenix Pharmaceuticals to Merck and $0.4 billion from its shares in LTS Lohman Therapie-Systeme AG.
In March Novartis invested $200 million in cancer specialist Aduro Biotech, with a potential $500 million to follow if certain milestones are met.
For the full year of 2014, Novartis saw sales and operating income grow 1% to $58 billion and $10.7 billion respectively (3% and 7% in constant currency terms). Net income grew 12% (17% in constant currency) to $10.3 billion. Core operating income was up 3% (8% in constant currency) to $14.6 billion (core EPS $5.23 vs. $5.01) driven by 120 basis points (1.2%) of margin expansion. Free cash flow was up 12% to $10.8 billion. Novartis’ growth products revenues grew 14% and now represent 32% of net sales while sales in emerging growth markets such as China and Russia grew 12% in constant currency terms.
New drugs Cosentyx for psoriasis and long acting Signifor for acromegaly were approved in the EU and U.S. First in class heart failure drug LCZ-696 has impressive clinical trials results and is forecast to gain U.S. FDA approval by August.
Novartis’ CEO Joseph Jimenez expects mid single digit growth in revenues and high single digit growth in core operating income for 2015 in constant currency terms, assuming the GSK deal closes before mid-year. The dividend, which is a single payment made in the second quarter, was raised 6% to CHF2.60 per share.
Action now: Novartis remains a Buy at 19.5 times 2015 earnings and a 2.67% yield.
Home Capital Group (TSX: HCG) (OTC: HMCBF)
Originally recommended on Aug. 19/13 (#21330) at C$31.35, US$31.76. Closed Friday at C$46.22, US$37.96.
The share price of specialist mortgage lender Home Capital has been depressed by investor concerns over its exposure to mortgages in the oil patch in Alberta and Saskatchewan. The shares are down 21% from a record high reached in November. Home Capital, through Home Trust, lends to non-compliant borrowers who do not meet the big banks’ criteria, owing to personal circumstances such as being recent immigrants, entrepreneurs, self-employed, or in professions regarded as higher risk.
CEO Gerald Soloway said: “We’re quite comfortable with the exposure we have to the Alberta market. We haven’t seen any arrears to date.” Alberta represents 5.1% of Home’s total mortgage book and a large portion is CMHC insured, he went on to say. “We are well insulated. We can withstand any type of a downturn even if it’s more severe. We think we’re in good shape there.”
Home Capital reported net income of $95.9 million ($1.36 per share) for the fourth quarter. That was up 39% from $68.8 million ($0.98 per share) in the previous year. The company earned $73.2 million ($1.04 per share) on an adjusted basis, after a $24 million ($0.34 per share) exceptional gain on the prepayment of its $234 million water-heater loan portfolio.
For 2014 as a whole, Home Capital had adjusted net income of $288.4 million ($4.09 per share), up from $257.7 million ($3.68 per share) in 2013. Total assets were $20 billion on which it earned 1.6% at a net interest margin of 2.25%, up from 2.17% in 2013. Tier 1 Capital was 18.3% and non-performing loans were 0.3% of assets, down from 0.35%. Book value (the most important metric for financials) was up 21.9% to $20.67 per share. The dividend was raised 10% to $0.22 a quarter.
Action now: The stock is a Buy at 1.77 times price/book, 10.4 price/earnings, and a 1.9% yield.
