Research & Advice

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All Things Foreign

March 1, 2007

Given that the foreign markets were blamed for the shellacking the domestic markets received a couple days ago, it’s probably appropriate to share some of my thoughts regarding the foreign markets – in particular Europe and China.  But first, a warning:  I’m probably going to come off as a Pollyanna, especially compared to my tireless “short-term bullish/long-term bearish” comments on the domestic equity market. 

But please don’t think me as one of those other so-called professional investors that are continuously rah-rah even in the face of a declining market. Yesterday was a painful down-day for the market, and that feeling was magnified because it has been about four years since we have had to endure that type of experience.  But nonetheless, it was just one day – and not only does one day not a trend make, but with the exception of the last four years these days are not all that uncommon. 

Bloomberg reported that since 1985 seventy percent of the calendar years that experienced a three-percent loss in the US markets day ended up for the major averages. I don’t necessarily believe one way or another that Tuesday’s plunge was good or bad news for the rest of the year, but that’s my point – one day does not trend make.

Anyhow, I have successfully digressed and managed to ramble on about the U.S. markets when my intent was to ramble on about foreign markets.  And since I lack the proper ability to cleverly segue, let me awkwardly jump into some good news.

Europe

There is opportunity for investors in Europe.  The good news is that after about a half-decade of just barely chugging along, Eurozone growth in 2006 is the strongest it has been since 2000.  True, with every good growth story there is the bad news of potential interest rate hikes by a central bank.  That’s what has happened in the U.S., but even during/after 17 rate hikes by the Fed the market and the economy had continued to do well, so let’s not dwell on that too much right now.   Instead we should focus on things like Germany, the largest member of the Eurozone, dropping its unemployment rate below ten percent for the first time in a half-decade as well as their successful campaign to control labor costs.  Furthermore, productivity as measures by output-per-hour-worked in the 27 European Union member states was actually better in 2006 than in the U.S.  (albeit ever-so-slightly at 1.5% vs. 1.4%)

Some investors tend to shudder at the thought of international equities, even developed regions like the Eurozone.  I guess it is because they feel that they go down as much as they go up.  However, the Dow Jones Stoxx index of 600 European companies has only been down for four calendar years since the index was started in 1990.

However, those aforementioned “some investors” do have a good point in terms of risk because Europe, in one way, is much more leveraged than America.  European firms are more dependent upon international trade than American firms.  As a result, a one percentage point change in global GDP will affect a 15% difference in European profits compared to a 10% difference for U.S. companies. So, if you think global economic growth will be positive then European exposure seems to make a lot of sense.  Currently the consensus estimates for 2007 global growth is about four percent.

Let’s get into valuation.  After the other day’s little crash, all of the year-to-date gains of the European markets were pretty much evaporated.   That brings us right back to the same numbers as we started the year.  Currently, as was also true, on New Year’s Day, European stocks trade at about 13.3 times 2007 consensus earnings per share (EPS) estimates.  That’s below the long-term average of 14.5 times EPS.  So while Europe’s bull market has been pretty long (about five years – but unlike the US markets it has had its share of healthy corrections over that time), stock prices have really only risen as profit margins and profits have risen, as opposed to prices rising so fast as to create multiple expansion (i.e. higher P/Es); think the U.S. stock market in 2004 and 2005. 

Bull markets tend to fail due to many factors, but not typically because the rate of earnings growth slows (assuming that there is actually still growth, as opposed to a deceleration leading to profit contraction).

Circling back to the “bad news” prospect of higher interest rates, so long as interest rates stay low the helpful pace of mergers and acquisitions that occurred in 2006 should continue – if not at the same pace, at least at a helpful pace.  With European companies pumping out a healthy free cash flow yield of 6.5% (and return on equity of 18%), a 5% cost of capital is pretty darn attractive to both private equity firms and competing companies to snap up the shares of public stock (and that is without the usual nifty M&A benefits of economies of scale, reducing competition, etc.).

Even considering the possibility of higher interest rates, like the U.S. stock market my greatest concern for the European stock market is that there are not a lot of contrary opinions.  From the standpoint of supply vs. demand (the only thing that moves prices) I would prefer to see more pessimism abound by European investors.  Pessimistic investors have not (yet?) purchased equities, thus leaving room for growing demand.  Right now everyone seems to believe the same positive things (as well as understand the few potential negatives).  As a result, compared to 2005 and 2006, 2007’s gains could be far more muted.

China

Bubble?  Is it or isn’t it?  Not in the economy – you could cut economic growth in half and China would still be growing at a faster clip than developed nations.  The bubbliness of the stock

market, however, is up for debate.  And if it is a bubble, is that so terrible?  Nope, not when you can invest in bonds, convertible securities, or even companies that sell to China (well, it’s still not great, but it’s not as terrible as the “B” word implies).

I don’t want to get bogged down in semantics, but technically speaking (in industry jargon) a bubble is not an expensive stock market, but rather a psychology behind the buying.  A bubble occurs when investors buy into something not because of future prospects, but solely because the price is rising (think tulips).  In China, while valuations are certainly high (but not crazily so), economic growth is still in the double-digit range! Buying stocks that have gone up a lot can be a rational thing if an investor believes (rightly or wrongly) that for some reason what is being purchased is a good value relative to what he might expect later.  

Also, it may be a matter of options.  In China investors are pretty good savers, but where are they to put their money?  The bank is not an attractive option because rates are so low.   Capital controls restrict cash flows outside the country.  The government still owns a lot of the economy, so many would-be entrepreneurs are left clutching their money.  The reasonable, rational option becomes to put money into the stock market. 

All that being said, if the Chinese stock market is not yet a bubble then I am greatly concerned that investors will start acting irrationally, making it a bubble.  But that’s just in terms of behavior, not valuations.   The P/E ratio for companies listed on the Hong Kong market is close to 18, and the P/E ratio for the same companies in Shanghai is 33.  That leaves the Shanghai market more vulnerable (as we saw a couple days ago), but even at those ratios you have to consider a few things.  First, China’s low interest rates.  Second, China’s 10% GDP growth. Third, China’s P/E ratios should not be compared directly to those of the US because the ratios for developing nations trade higher than the U.S. market (it’s not exactly apples and orange, but it’s definitely Granny Smith and Red Delicious).

Also of importance is the recently leaked draft of Chinese tax legislation that phases out most tax breaks and applies a uniform 25% tax rate to company profits.  If passed this year, companies will begin to see the affect in 2008.  The consensus estimate for 2008 earnings growth for Chinese companies is 13%; the tax change would increase that growth rate by about 5.5 percentage points.  That earnings boost would certainly make valuations more appealing.  Granted, it is not reason enough for another type of doubling surge, but it helps explain away the idea of a bubble.

Lastly, from a fiscal perspective, China has a stockpile of currency totaling $1.07 trillion dollars.  I could elaborate on that, but instead let me just clarify that that figure is not a typo.  Trillion.  With a “T.”  As in about seven-and-half percent of US GDP.