From afar, modern Europe seems as foreboding as J. R. R. Tolkien’s Mordor, that volcanic wasteland populated entirely by quarrelsome creatures suffering from a nameless but universal necrotic skin disorder. Britain, Italy, Spain, France, Portugal, Greece—so much of it is already in recession. A great many of the continent’s banks have similarly been zombified, existing only at the pleasure of their respective national governments. Meanwhile, depositors scramble to find safer places to stash their money—the pitiful little of it that remains, anyway. Some governments have themselves been broken on the wheel of fiscal realism, while others stand in line waiting their turn for bailout negotiations. Things have become so grim for the continent, in fact, that drumbeating trolls might lighten the mood. Mordor had one important advantage over today’s Europe: a zero unemployment rate, thanks the Dark Lord Sauron’s insatiable military ambitions and macabre infrastructure projects.
Even mighty Germany, until lately a stalwart, has begun to show signs of decrepitude, prompting speculation that it, too, is now in recession. “Such an outcome would kill any hopes of Europe’s biggest economy dragging the rest to safety,” wrote Charles Gave, a French economist known in hedge fund circles. “So the central question for every Europe-focused investor is: Will Germany also enter a recession?” The OECD thinks it already has. In its latest forecast, it predicted the German economy will shrink at an annualized rate of 0.5% in the third quarter, and by another 0.8% in the fourth.
Absent a miracle, there’s little reason to suppose Europe’s fires will soon burn out. “Fiscal consolidation efforts, high unemployment, tight credit conditions and private deleveraging in peripheral countries will put a low cap on economic growth this year and next,” predicted TD economists in their latest outlook. Policy-makers will remain preoccupied with reacting clumsily to the latest misfortunes. In the months ahead, they must figure out how to respond as Greece misses yet another batch of bailout targets. More disturbing is the prospect that Spain’s recession will turn uglier, forcing it to request its own financial assistance.
So investors should stay clear of this foul wasteland, right? Not so fast. As manager of the Mawer International Equity Fund, David Ragan has a mandate to shop for equities outside North America. His fund has long been heavily invested in the United Kingdom and on the continent. “The macroeconomic environment really has nothing to do with what equity markets are going to do,” he says. “Europe has been underperforming. Nobody’s expecting any growth from most of its companies. But there are a number of companies in this whole area that, for various reasons, will do much better than expectations.”
This theory held so far in 2012. Indeed, while volatility on equity markets has been severe, most European equity indexes rose strongly over the balance of this year. (The MSCI Euro index was up more than 13% as of late September.) “You’ve been able to find pockets of strength even this year,” says Bruce Cooper, who heads all equity teams at TD Asset Management and manages a global dividend fund. “And it wouldn’t surprise us if there were opportunities in Europe again next year.”
Both men espouse a similar philosophy. Their targets include well-managed global companies that, while headquartered in Europe, do much of their business elsewhere. “That’s different from a domestic-facing business like a Spanish bank,” Cooper elaborates. “Deposits are fleeing. Loan growth is going to be negative, and credit quality is poor. That’s pretty tough.” Both men also insist on companies with strong balance sheets and high returns on capital. “You don’t go out of business if you have no debt,” Ragan says. “You can survive the downturn and rebound when it comes back.”
Although both favour a bottom- up approach when selecting stock (rather than, say, trolling a specific sector or region), Cooper and Ragan agree that it’s becoming increasingly difficult to find European blue-chip companies at discount prices. “The stocks that are high-quality and cheap right now are few and far between,” Ragan says. “We have a lot of weird little names.” Cooper notes Europe’s utilities and consumer staples stocks are generally expensive today, but sees better valuations among health care and energy listings. Europe likely still offers opportunities for those prepared to be greedy when others are fearful, provided they can endure the foul stench of scorched sulphur.
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