While investor sentiment regarding European equities has been generally negative, demonstrating pronounced levels of risk aversion, we believe the economic and corporate fundamentals for Germany - the continent’s biggest economy - are broadly encouraging and supportive for its equity market in the coming months.
As a result of the perceived risk of an intensification of the eurozone crisis, German equities have seen some selling pressure along with the rest of the European equity markets, especially since the end of March. However in recent weeks, there has been evidence of a partial switch in sentiment, with the DAX 30 Index up 5% over one month to July 11 2012 in euro terms against 4.9% for the MSCI Europe ex index over the same investment period in euro terms*.
We believe several conditions are in place in Germany for a recovery. Firstly there is an underlying positive trend especially for German exporters as they continue to see strong order flows and strong results. Exports increased by 3.9% in May compared to the previous year and reversed a 1.7% decline in April, according to official figures. From the companies we have met and the earnings statements we have analysed, this turnaround is not unsurprising. LPKF Laser & Electronics AG is a good example of a specialist company with a healthy pipeline of orders but operating in a challenging environment for the sector. The company has won major orders and strong demand for its laser systems which cut printed circuit boards. SAP, the business management software firm, has also just announced strong second quarter results based on robust sales of its newest products, in spite of the gloom within the global technology sector.
Again, we argue that recent economic data releases reveal a divergence between investor sentiment, which continues to be below par, and reality. The balance sheets of both German corporates and households remain healthy, new figures suggest. According to the Federal Statistics Office’s published figures on July 9 2012, there was a 0.5% decline in the number of business insolvencies in April, compared to the same period last year, with a 4.5% decrease in the number of consumers declaring bankruptcy over the same period.
With reference to the Baring German Growth Trust, we continue to favour small and medium-sized companies and areas such as exports. We have also moved away from a concentrated portfolio where we favoured the very largest companies. We believe this demonstrates the flexibility of having an all-cap investment strategy and the portfolio is more diversified as a result as we continue to build from the bottom-up, using stock liquidity as an important portfolio construction parameter.
Looking at share price valuations versus earnings, we continue to witness a superior earnings environment in Germany as the chart below demonstrates, yet this is not necessarily being translated into higher equity valuations. In this regard we believe this presents an attractive opportunity for investors especially given the valuation of the German market relative to European peers.
Source: Thomson Reuters Datastream and IBES as at 4th July, 2012
Everything else being equal, superior earnings growth should translate into higher share price valuations over time, as investors are prepared to pay more for future cashflow. We believe the same is true for the German equity market, yet as the following chart shows, it trades at the same valuation level as its European peers, where earnings growth prospects are in our view much lower.
Source: Thomson Reuters Datastream as at 4th July, 2012
In the medium to longer term, however, if German companies continue to deliver strong earnings results as we expect, we believe the fundamentals will reassert themselves, to the benefit of investors.
While we are aware that global economic growth rates could still disappoint, interest rate cuts in China (in both June and July) and the potential for US efforts to further stimulate its economy should generally help support the consumer, which in turn should benefit German companies. Those with a solid export base, many of which are in our portfolio, thrive on strong consumption from the likes of China, emerging markets and the US.
*Source: Thomson Reuters Datastream, as at 11th July 2012, in euro terms.
Rob Smith Investment manager, Baring German Growth Trust Baring Asset Management, London
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