A “crowded trade” is the term we use for a too-popular investment, the idea being that once too many investors are already invested in a particular stock, sector, region, etc., there is almost no one left to buy. When there’s no one still clamoring to buy, who will provide the upward pressure on stock prices? Indeed, when the current holders need to sell to raise capital or simply become bored and want to move along, there are more sellers than buyers, leading to a stagnant, or worse, a declining market.
Even though a number of portfolio managers have recently begun redeploying a good percentage of capital in Europe, I believe there is more room to run there than there is in the USA right now. Why? Two reasons: valuations and earnings.
As I have written on many prior occasions, it matters less where a multinational is headquartered than where they derive the bulk of their earnings. Of course we want our selected companies to be domiciled in nations that respect the rule of law, that insist upon transparency in corporate and political governance, and that treat shareholders as owners whose rights will be honored. We are fortunate to find these conditions in most of Europe. On this continent we also find some of the biggest, most secure, and best-run companies on the planet.
Belgium-based AB InBev (NYSE:BUD) is the brewing company that counts among its brands the “All-American” Budweiser beer. Those Shell gas stations in every American town? Incorporated in the UK and headquartered in The Netherlands (NYSE:RDSa). Those VWs, Audis, Porsches and Mercedes cars and SUVs may enjoy international management and US and Mexican factories, but the decisions on how to make, sell and distribute them all come from headquarters in Germany. Chrysler is a subsidiary of Fiat in Italy, Dannon yogurt is owned by Danone (OTC:DANOY) in France, and on and on it goes.
Many of our most consumed brands like Dove, Hellman’s, and Lipton are owned by Europe’s Unilever (NYSE:UN). And the largest food company in the world? Nestle (OTC:NSRGY), HQ’d in Switzerland, brings us Stouffer’s, Nescafe and numerous candy confections. That has always been the case, so why is our firm moving more of our clients’ investments into European companies now?
Earnings. With the strong US dollar, US goods are more expensive to our trading partners. With the strong US dollar, their products are relatively cheaper for us than they were just 6 months ago, when we started buying our first European companies. Consumers in which nation have recovered the most from the recent unpleasantness? The USA. So the multinationals selling to the US consumer are likely to increase their sales and earnings. US companies? Not so much.
Could the US dollar plunge from here? Well, in currency dealings, anything can happen. Beggar thy neighbor is a well-worn mantra at many of the world’s central banks. But such a decline is unlikely. If you are a central banker or sovereign wealth fund or fixed income manager you’re going to go where you can enjoy the highest return and the greatest safety of return. That, today, is the USA and it will take time for that situation to change.
Earnings and/or the expectation of increasing earnings are ultimately what drive stock prices. I still want to believe that US firms will do well in this arena, but if wishes were horses we’d all be riders. I believe European multinationals, and to a slightly lesser degree, Aussie and Japanese multinationals, have the edge in likelihood of increasing earnings, so that’s where our dollars are going as our US companies and ETFs hit their trailing stop levels.
Valuation. It isn’t just the P/E ratio, which has been cited by many money managers as their reason for selecting European investments over US. It’s true that European stocks recently had a “forward” price-to-earnings ratio of 15.1, compared with 17.5 for the U.S. But European companies are more widely dispersed along the bell curve that defines their mean value. So many more of them trade at valuations one or two sigma from the mean on both sides of the central point. Those most undervalued are where we seek to find the best value. And on a book value, price/sales, cash flow and weighted cost of capital vs. return on (this newly-invested) capital basis, the valuations in Europe become even more compelling.
In addition, the recent stimulus program that the EU has now embarked upon will create even greater valuation disparity from US stocks. QE has certainly benefited American stock investors over the past few years. It is logical to expect that Europe’s new-found admiration for QE will have a similar effect, especially on the more economic cyclical companies and those in the consumer discretionary sector. $60 billion euros a month of economic stimulus means the likelihood of cheap, sometimes effectively free, money for companies to streamline, modernize and expand at least into 2016.
European banks that have been wary of lending have already begun to loosen up so that businesses both large and small can now get the credit they need to expand. Lending to non-financial companies recently posted its first gain since November 2011and mortgage lending rose the most since June 2011.
In making this recommendation for your due diligence, I am not wearing rose-colored glasses. Europe faces a number of problems the USA does not, from worsening demographics to deflationary pressure; from armed conflict in Ukraine to Greece’s ruling party believing they are owed debt forgiveness simply because, well, “we already spent all our money and we don’t have any more to pay back our debts with.” None of these problems are likely to derail the earnings train. Indeed, I would guess that as Greece recognizes it must sell off a number of inefficiently-run state enterprises, they will enjoy far better cash flow from those assets once they are privatized and taxed than they are today as untaxed entities or unprofitable symbols of Greek statehood. It is in such times of short-term volatility that we find our best opportunity to add to our positions.
I also see individual countries in the Eurozone finally taking economic reform seriously. Ireland certainly takes the lead in making itself more business-friendly by lowering corporate taxes, lifting the regulatory burden and easing onerous job market rules and regulations. But France, Italy and even Spain and Portugal are beginning to follow suit. As a result, jobs are being created, wages are beginning to rise, factory orders are increasing and business sentiment is improving markedly.
How have we chosen to invest to take best advantage of our belief that European companies will reward us well this year? We own a few Euro-stocks outright but mostly we want our investments there hedged against any further rise in the dollar, like our current position in the Wisdom Tree Europe Hedged Equity ETF (NYSE:HEDJ) is. We are now buying for ourselves and our clients two more that also hedge the dollar: Wisdom Tree Germany Hedged (NYSE:DXGE) and Wisdom Tree Europe Hedged Small Cap (NYSE:EUSC) The former holds the giants we know and buy from every day, the latter lesser known but still high quality firms.
We’ve been moving steadily offshore as we find fewer and fewer value stocks in the US. Europe has been our primary venue for finding undervalued equities. While our international investing is focused primarily on Europe right now, I must say that I think the Japanese are finally coming to grips with their economic issues, if not their demographic ones. Certainly the soaring US dollar has helped this export-driven nation markedly, as has the low price of oil and gas, which Japan must import from elsewhere. But if “Abenomics” takes hold as it seems to be, you can expect that we will consider Japan as part of our international portfolio as well.
Among emerging nations, I can really only suggest one right now. India, for all its problems, still looks able to surpass China in growth rate this year. Speaking of China, I continue to resist all the entreaties to buy this “cheap” market. Cheap relative to what? To where they once were? China has enough problems to occupy an entire 'nuther article — just not this one!
Disclosure: As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.
Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year.
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