Bad press has dogged most of Europe’s major economies for the past two years but, argues Fidelity’s Tim McCarron, GDP figures are a poor barometer of stockmarket performance.
Italy’s economy is flat on its back and the country has slipped into political turmoil. French workers strike at the slightest threat to their terms and conditions. German consumers seem unable to stir from their decade-long slumber. Europe is the place to invest, then?
Yes is the answer, according to Fidelity’s Tim McCarron, who is tired of the “sick man of Europe” tag applied to any major continental country when there is a temporary crisis.
“It has been frustrating over the past two years given the press these countries have had,” he says. “It has come at the same time that equity markets in Europe have risen more strongly than in any other developed area. For a stockpicking fund, I find that opportunities are much better in Europe, as individual stocks are not so efficiently priced as in the UK or the US.”
The trick is to ignore GDP figures, which McCarron says have only a limited correlation with stockmarket performance, especially over the short and medium term.
“Top down, it is true that Europe has slow growth compared with areas where the demographics are better,” he says. “In Germany and Italy the population is falling. You don’t have demographics on your side, so you are not going to achieve the sort of GDP growth that you see in the US. But I am not interested in GDP. The correlation between GDP and performance is very low.”
That said, he is comforted that in recent months the consensus forecasts for GDP growth in Europe have been moving upwards, while in America and Britain they have been flat or falling. “Only a few months ago the forecasters were saying 1.7% GDP growth in Europe this year, but it has already moved up to 2.2%,” McCarron says. “Germany is seeing an improvement, while Italy has gone from being extremely bad to not so bad.”
Perhaps not surprisingly, there is not a unit trust investing in Italy that is targeted at British investors. But Fidelity does have a Luxembourg-listed Italy sub-fund, managed by Mario Frontini, who when I spoke to him last week was upbeat on the country’s prospects despite the electoral gloom. He says that Italian companies have restructured markedly under the impact of competition from China and that they will share in the export-led economic upswing coming out of Germany.
When the euro started strengthening against the dollar a few years ago, McCarron says he was concerned about the impact on exporters, but they turned out to be more robust than expected. Now that trend has accelerated, and Germany in particular is exporting again on a gigantic scale. Its net trade balance over the past 12 months has been $200bn (114bn), more than that of China and Japan put together. Meanwhile, Britain’s trade deficit has escalated to $120bn and the American trade gap is an extraordinary $800bn.
Europe is home to an astonishing number of world-class companies, especially exporters. “What people miss is that when you invest in European stockmarkets, you are not investing domestically in the way you do in the US,” McCarron says. “Quoted US companies make around 25% of their sales outside of the US, while the figure for Germany is 40%.”
And do not believe the hype about unreconstructed, sclerotic economies. “It appears on the surface that it is difficult to get changes through, but that is not quite the case,” he adds. “In France, the labour market is not as totally inflexible as it is sometimes portrayed. The percentage of people who are on temporary contracts is quite high. In Germany, it was until recently very low – less than 0.5% of the labour force – but the rules were changed in 2003 and it is moving quickly up to the European average of around 3-4%.” The fear is that these sort of changes are already in the price. After all, now that stockmarkets around Europe have soared, isn’t it time to bale out? McCarron’s fund is up 34.6% over the past 12 months and is ahead 128% over three years, which are terrific numbers but not ones many expect to be maintained.
“Shares in Europe are up because earnings are up,” McCarron says. “There has not been a major re-rating of the market, so valuations are not that forbidding. What I find remarkable is the number of companies that seem to be on the same rating – about 15 times earnings. If your concern is how far markets have risen, then the place to be is Europe, not the UK or the US.”
So where does this take his portfolio? McCarron has been topping up his holdings in pharmaceutical companies and financial services. Indeed, if a typical British equity portfolio is pharmaceuticals, oil and banks, then in Europe it is even more concentrated – there is no oil.
His biggest holding in what has become a 4bn fund is Novartis, but his top 10 also includes Sanofi-Aventis and Roche Holdings. “I have historically never held pharmaceuticals in this fund,” McCarron says. “But in the past three years, as you’ve seen everything move on to the same multiple, pharmaceuticals have started looking more attractive. And the stocks I hold are high quality.”
Financials in his top 10 holdings include ING, BNP Paribas, Allianz, Axa and Soc Gen. He is a big fan. “Financials are a big sector in Europe, bigger even than in the UK or US,” McCarron says. “On the whole, I do not feel negative about valuations. We are at the early stages of the rate rising cycle, and the early stages are usually good for earnings. Provisions are benign and bad debts are unbelievably good at the moment.”
ING is McCarron’s single biggest financial holding. “People have been sceptical about the ability of the ING retail deposit model to make money,” he says. “They have to work on a much lower net interest margin spread, but the costs they run on are also extremely low.”
But while last year was good – 34.6% is acceptable by any standards – it only managed to match the sector average, which is not what investors expect from the redoutable Fidelity European.
“In general, when markets are going up very strongly my style tends not to do so well,” McCarron says. “In 2003, I was ahead of the market, but only just. When the market is in the 10% to 15% range is when I perform best. The worst I ever performed was in 1999 when I was not buying companies that did not have earnings. I never do particularly well if the market is full of super-bulls.”