What's really going on in Europe?
This is the question of the hour for advisors whose clients are wondering why lines at the teller windows in Greece – a country that makes up 0.165% of the global population and 0.478% of global GDP – cause their U.S.-centric portfolios to bounce around like an unbalanced gyroscope.
For astute professional investors, the question has another meaning. When was the last time we saw negative headlines drive valuations so low in such mature developed markets? Is there a significant opportunity to be found in Europe's economic mess? If so, how can we tell when it will be safe to get back in the water?
To get a better handle on the Eurozone's underlying dynamics, I asked David Marcus to serve as tour guide and translator. Marcus is manager of one of the newest mutual funds on the market – the Evermore Global Value Fund. Most people remember him as the person who succeeded Michael Price as manager of the Mutual European Fund, also serving as co-manager of Mutual Discovery and co-manager of the Mutual Shares fund. After leaving the Franklin-Templeton shop, before starting his own funds, Marcus co-managed the global empire of the Sweden-based Stenbeck family, a job which required him to engage in hands-on management of companies across Europe, in the Ukraine and Vietnam. (Price currently serves on Evermore's Board of Advisors.)
So what is going on in Europe? Marcus says the external dynamics are pretty obvious. "There is so much distress right now that investors are panicked," he says. "Everybody is running every which way. This is one of those markets where logic has departed and emotions are running things, which means that if you can keep your head, people will sell you things at crazy low prices."
However, Marcus is far more interested in what's going on under the hood. Behind the headlines, hidden from public view, he's watching the rebirth of huge sectors of Corporate Europe. As is often the case in investing, the darkest gloom tends to hide the most interesting opportunities.
Someday, he says, this period of obsession with Greek debt, bank restructuring and single-digit P/Es may be known as The Great Oversell.
Born-again competitiveness
The first Eurozone dynamic on the tour is widespread behind-the-scenes restructuring. "I think we all know that for the past 50 years, European companies have been hamstrung by rules, regulations, unions, and a lot of socialist government policies that favored employment over innovation and productivity," says Marcus. "Today, that is changing, and it is one of the biggest untold stories in Europe today."
Changing how? "With all the economic chaos, governments have realized that they have to take action," Marcus explains. "They realize that unless they help their companies, even more people will be out of a job. Governments in Spain, Italy, France before the elections, Germany and everywhere else are quietly revising all the stifling rules and regulations that held European companies back for decades."
In the U.S., government assistance might take the form of direct Fed intervention, loan guarantees or outright bailouts. In Europe, it means easing restrictions on laying off employees, allowing companies to pay smaller severance packages when they do shed unnecessary workers, and cutting red tape. "Severance packages that had to last three or four years are now just one year," says Marcus. "This chaotic environment represents an unprecedented opportunity for companies to restructure themselves, and become more competitive in the global economy."
Are there any concrete examples of this trend? "When Sergio Marchionne came in to run Fiat, his factories were running at 25% capacity," says Marcus. "Stop for a moment and imagine that – what a challenge it is to be profitable under those conditions," he says. "But before the debt crisis, there wasn't much he could do about it."
Today, says Marcus, Marchionne is taking full advantage of an easing of restrictions. He is refocusing his high-end (Fiat and Maserati) businesses, smashing factories together, selling off assets and embracing technology rather than fighting it. At the same time, he managed to execute a turnaround of Chrysler faster than the management teams at GM or Ford. This year, the U.S.-based division will contribute $5 billion to the company's total earnings.
Another poster child of this restructuring process is Siemens AG, the 165-year-old German company. "Peter Loescher, the CEO, has made a commitment that the company will either be number one or number two in any of its businesses or he will spin it off and sell it," says Marcus. "In just a couple of years, Siemens has gone from having the lowest margins among its competitors in every division to, in some cases, higher margins than GE, where they compete. He moved production to lower-cost countries, revamped technology and laid off thousands of workers who have been sitting on the payrolls collecting a paycheck because it would have been more expensive to fire them."
One cannot help but feel sympathy for the laid-off workers in these stories, and Marcus acknowledges that all this restructuring is adding to the painful unemployment situation. "I feel bad for those people," he admits. "But from a purely political point of view, the choice is pain, or more pain. They can cut the jobs of thousands of employees, or the company can be out of business and everybody is out of a job."
Looking at the situation purely as an investor, as a representative of his shareholders, Marcus sees a stronger, more profitable global competitor being created almost in secret, behind the mayhem of constant negative headlines. "You don't see public announcements of these layoffs," he says, "for obvious political reasons. Much of the restructuring is taking place outside the public view, and it is literally taking years for the process to complete itself."
Techno-industrial multiplier
In many of these restructuring stories, Marcus thinks that there may actually be a multiplier effect – and this is the second dynamic that people aren't seeing under the hood of the European mayhem. "Someday we're going to look back and realize that we just lived through another global industrial revolution, a technology/industrial revolution that changed how we make everything," he says. "Technology changes today are so transformative that we are literally seeing factories that used to have thousands of employees bring in this new equipment and operate more effectively with hundreds. You have robots doing everything."
During its first few decades, the benefits of this transformation were not evenly distributed across the globe. "European manufacturers were 15-20 years behind the U.S. in restructuring themselves and taking advantage of these technologies," says Marcus. But now, the fact that European companies were suppressed – and uncompetitive – for so long might actually prove to be an advantage for the management teams with the wit to jump through this restructuring window. "In some cases, these companies will be able to leapfrog the competition by going directly to the latest innovations," Marcus says, "much like African nations skipped the land-line stage with their phone systems."
But of course the situation is not quite as simple as this makes it sound. The complicating factor is that not everybody is taking advantage of the opportunity.
Marcus offers a simple analogy. If you put everybody in straightjackets for years, and then suddenly give everybody back the freedom to use their hands and arms, some people will be so used to having their arms folded across their chests that they won't have any idea how to use this new opportunity they've been given.
"What I like to tell people is that the rules across Europe created an environment that was so different from everybody else, that you hardly ever saw what I would call 'normal business practices,'" says Marcus. "Some companies are recognizing that now they can, for the first time, manage themselves the same way as their most competitive American and Asian rivals. But on the other side of the ledger, you literally have companies that are hundreds of years old, who have no intention of changing anything," he adds. "When you sift through the rubble over here," he says, "the most common thing you find is rubble – uncompetitive European companies that are doing nothing to improve their competitiveness."
Strategic consolidation
Selective restructuring is the first underlying dynamic on our tour behind the Eurozone headlines. The second, much simpler one is strategic consolidation. "You have strong, well-managed companies looking at these incredibly low share prices as a once-in-a-lifetime chance to buy their competitors, to buy growth at pennies on the dollar," says Marcus. "Every time you pick up a European paper, there's another story about somebody buying somebody else, sometimes at a significant premium to what the market is valuing these companies at."
As a dramatic recent example, he points to Swiss-based Transocean, the world's largest offshore drilling company with the clever website "deepwater.com," and even cleverer ticker symbol: "RIG." Last November, the company purchased a competitor called Aker Drilling – and paid a remarkable 98.5% above the stock's current market price.
EM growth at euro-prices
A third, very interesting stop on the tour is a group of companies that are headquartered in Europe, and as a result have been sold down to nominal P/E valuations, even though all of their revenues are derived from high-growth emerging and developing markets where there is no headline risk at all.
"Investors read the headlines and then they call their broker and dump all exposure to Europe," says Marcus. "Anybody with a European headquarters. There are some amazing stories about what they throw out as a result. The crisis is giving us opportunities to sneak into all these other markets on the cheap." Call it the "baby with the bathwater" syndrome.
As a prime example, Marcus points to Lonrho Plc, whose headquarters is based in London, whose stock has dropped like the proverbial stone during the Eurozone crisis. It's a European company, right?
"Lonrho trades on the London Stock Exchange," Marcus concedes, "but they have all their businesses in Africa, which I would characterize as a high-growth, emerging markets economic environment." The company owns one of the busiest oil and gas deepwater ports in Africa, located on Bioko Island in Equatorial Guinea – and the port enjoys tax-free status with regard to custom duties.
It has hotels in tourist destinations all over Africa, and owns the means to get tourists to these areas. "They're converting their airline from a normal carrier to what I would call a low-cost airline," says Marcus, "with ultra-cheap rates for small hops from one country to another." Lonrho also processes fish in Namibia and has other food-processing plants in Africa, and builds infrastructure, including schools, in small African villages as a contractor for African governments.
Another example? "Sevan Drilling is based in Norway, but their rigs are deployed in Brazil, and their biggest customer is Petrobras, Brazil's state oil company," says Marcus. "It's trading at European valuations with exposure to the emerging markets. Why? Because it got dumped with everything else in Europe."
Can Marcus identify a company that exhibits both trends: radical restructuring during this window of opportunity plus the baby-with-the-bathwater syndrome? Without hesitation he points to the Spanish media conglomerate Grupo Prisa, which publishes El Pais, the leading newspaper in Spain and read throughout the Spanish-speaking world.
A newspaper company? Really? Grupo Prisa is a somewhat longer story, but the gist of it is that, yes, the newspaper's European advertising revenues are down in this recessionary environment, but the company also owns broadcast TV, satellite and cable TV businesses, including pay-TV access to the soccer leagues. "They also have a company that produces textbooks in the emerging Latin American markets," adds Marcus. "It is one of the fastest-growing businesses in the education field."
The company's stock price recently dipped to 40 cents a share, partly because the company happens to be headquartered in Europe, partly because the company was, in the past, managed poorly and would have had trouble restructuring under the old rules even with astute leadership.
"They brought in the former CEO for Credit Suisse in Spain, who had previously restructured Telefonica, the government-controlled phone company," says Marcus. "They're restructuring their debt, selling off some of their real estate assets, changing how operations are run, and bringing in normal business practices. Last year," he adds, "they laid off 2,700 employees, which they could never have done before the crisis. This year, I expect them to do more."
So when is it safe...?
The final dynamic on our Eurozone tour is pretty obvious: markets tend to overshoot on the upside and downside, and the deep gloom in Europe today has all the earmarks of an oversold situation. "I remember when I worked with Michael [Price], and the Asian Contagion thing happened," says Marcus. "Everybody was saying that the Asian miracle was over, get out and never get back in again. It looked like the worst time to invest, and it turned out to be the best. When Russia blew up and defaulted, and everybody was running for the exits, in retrospect that was a perfect time to be buying."
Because of all these unusual, potentially positive underlying dynamics, Marcus is convinced that he's looking at one of those rare investment opportunities that come along once or twice in a career. "People are going to look back at today's valuations and wish they'd bought what everybody else is throwing away," he says.
At the same time, Marcus fully understands the dilemma faced by advisors: if you get your clients back into a gloomy market too long before a recovery, when prices are still trending down, you could lose client relationships and – temporarily, at least – look like a fool.
But of course it works both ways. Those same clients may someday wonder why their advisor avoided the cheapest market on the planet. "I hear people say they're waiting until it is safe to get back in the water, until they have clarity about the Eurozone," Marcus says, "but when do you ever have clarity? When you have clarity, stocks are not trading at 35 cents on the dollar anymore."
So how do you split the difference between taking a pure contrarian plunge and waiting for clarity and missing the bargains? Are there any clues or signals that investors might follow, that will help them at least anticipate the end of the Great Oversell?
Surprisingly, Marcus has a plausible answer to this eternal question. Distilling a long conversation down to its essence, he says that the market has a hierarchy of investors. At the top are the strategic buyers, the corporate managers and CEOs who know and understand their own business environment better than anybody, who know the value of their competition and recognize before anyone else exactly what kind of a bargain a low share price represents. These are the people who, today, are buying growth at pennies in the dollar.
One rung below are the superinvestors, the Warren Buffetts of the world who buy when everybody else is selling, but very selectively and with an eye to holding forever.
Below that: the legions of professional investors, hedge fund managers and mutual fund managers who have access to research and high-level contacts. When they decide to move into a market, its prices start to move visibly.
The next rung down are professional advisors, who boast to their clients that they are never the first ones in or the last ones out, who wait for signs and signals before committing client money.
There may be a variety of other rungs down the hierarchy, but at the bottom you have investors who wait for absolute clarity before they buy or sell. As a result, they always seem to sell at the bottom and buy with enthusiasm at or near the top. When these people are selling, you want to be a buyer, and vice versa.
This much you know. But if you topple this hierarchy to the left and lay it down on its side, it gives you an interesting way of evaluating when a market is starting to creep out of its oversold position. Are the strategic buyers making purchases yet? Are they buying at a premium to the market? If so, that would suggest that at least some of the more astute buyers don't expect share prices to fall much further.
Are the superinvestors moving in? Their participation may not move the market needle, but it suggests that some really thoughtful players think valuations are unlikely to get much better.
Are professional investors and hedge funds buying? When this cohort moves in, the needle begins to tick upward, and you see share prices rise even though there is no evidence of an economic turnaround yet. (Is this why the markets are a leading rather than a lagging economic indicator?)
And so forth.
With these rough guideposts in hand, Marcus gives us the last leg of the tour. Transocean's purchase of Aker is one example of an uptick in strategic purchases now taking place across the Euro-landscape. The M&A Index for the 4th quarter of 2011 lists 122 acquisitions in the UK, 36 in the Netherlands, 32 in Germany, 65 in France, 12 in Ireland, 14 in Spain, 34 in Switzerland, 26 in Sweden and 20 in Italy. Compare the total of 361 with 253 in the U.S. market, or 56 in China over the same time period.
What about the super-astute investors? We seem to be in the early stages of their entrance in the market. Marcus notes that both Nicolas Berggruen, the famed value investor, and Martin Franklin, chairman of Jardine (which owns Sunbeam, K2 Inc., Rawlings and Coleman) have both taken significant positions in Grupo Prisa, and currently sit on its board. More recently, Carlos Slim, who Forbes has anointed the richest man in the world, has bought 2.5% of the company. John Fredriksen, the richest man in Norway, has recently started buying shares of Sevan.
Marcus confesses that he doesn't know when the next group will move in. "All I know is that we're getting closer to it happening," he says. "When I see Seth Klarman, the legendary value investor, set up an office in London, and the private equity people with their own new offices popping up around Europe, I know that the smart guys are waking up to the opportunity."
Playing the turnaround
The tour over, guide and tourist have a few moments to talk about what we've seen. If an advisor were adventurous enough to put money back into Europe, what would be the best venue? Marcus acknowledges that an index investor would probably make good money on any turnaround, even though the portfolio would include a fair amount of what he calls "rubble" – companies that are not taking advantage of the restructuring opportunity.
Because of the uneven participation in restructuring and modernization – because not every CEO is taking this chance to adopt "normal" business practices – today's Eurozone might be one of those situations where you get an advantage by investing with somebody who has boots on the ground.
Marcus is aware of the conflict of interest in this opinion; he simply points to the unusual nature of today's European market, where some companies will leapfrog from uncompetitive to global player, and some will continue to fold their arms across their chests. If you can't tell the difference, if you don't know anybody who can, buy an index fund.
At the end of the conversation, the tourist invites him to talk about what it's like to be a value investor in this environment. He's living an unfortunate dynamic that is shared across the mutual fund industry, something that frustrates all true value fund managers.
"The times when you have the greatest opportunities are the times when you're begging people to invest in your fund, because they're afraid of all the headlines and they see everybody else selling and getting out," says Marcus. "I think every real value fund manager sees the same dynamic; you're most constrained at the times when you have the most opportunities, when the bargains are lying around waiting to be picked up, when the babies are being thrown out with the bathwater. You have the most cash flow at the times when the pendulum has swung in the other direction and you have trouble finding an occasional bargain in a generally overvalued environment, when your instincts and your valuation models are telling you to sit on the sidelines until the greater fools have had their day.
"If we could find a cure for that," he says, "it would be a tremendous benefit to all of us."
Bob Veres is editor and publisher of the Inside Information service for investment advisors and a new client articles service that creates topical investment articles that advisors can send to their clients.
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