François Gobron, fund manager of the recently launched Generali IS European Recovery Equity Fund, expains in this interview with Funds Society that there is a lot to earn in Greece and Portugal as these markets were the most impacted by the financial crisis.
Although the fund intended to play the current economic recovery, is it a good idea in the long term, although countries may not always be in “recovery” mode? Why?
The recovery theme we are managing with our fund is focused on Southern Europe, on the peripheral countries, that is Italy, Spain, Portugal and Greece. Indeed, we see lots of opportunities in Southern Europe, mainly in companies with a large domestic exposure.
We are taking into account three major drivers which will have a strong positive impact on South European companies. These are: firstly, the economic recovery itself of these countries, with a focus on leading private companies focused on their domestic markets; secondly, the re-rating by major rating agencies, which will reduce the cost of these companies’ debt and facilitate their access to the debt markets; and thirdly the ongoing restructuring of many public or para-public companies and new regulations, in many cases imposed by the Troika (IMF, ECB and EC), especially in Greece.
We are convinced there is a lot to earn in Greece and Portugal as these markets were the most impacted by the financial crisis. We have thus a stronger focus on these two countries. It is also a bit unfair, from my point of view, to put Italy and Spain in the same bag of Portugal and Greece. Although it is true that some of these countries will not always be in “recovery” mode, there are always good opportunities and special situations that can make good investment cases, especially by capable stock-pickers with a clear focus on strategic analysis.
It is true that the peripheral economies’ recovery it is not priced in their respective stock markets? How do you see the current valuations? Is it currently a good entry point?
If you only look to P/E 2014, it is correct that valuations in Southern Europe do not look particularly attractive: at around 15x they are on line with the rest of Europe. But if you do a strategic analysis, trying to understand what could be normalized margins once volumes are going back to normal (or even just increasing a bit), you will see that you have a lot of opportunities in some companies with a large, underutilized asset base.
On top of that, there’s a huge variance in stocks performance and valuation, so there’s a need to be particularly selective and cautious on stocks we include in our portfolio. As an example, we are not exposed to the Spanish media market as the media stocks (TVs…) look too expensive to us given the kind of recovery we can expect in the short to medium term in this industry. For this fund, we avoid companies not enough focused on their home markets, meaning we prefer to not invest in companies with a strong international presence (large blue chips); we also avoid regulated business when regulation can be at risk, like energy in Spain; and finally we try to stay away from value traps like companies with overvalued assets, such as the Spanish real estate sector, in our opinion.
What kind of opportunities in the periphery still have an interesting potential?
We see a lot of opportunities in companies listed in Southern Europe, as all these countries will benefit from re-rating from the major rating agencies. We usually prefer companies having a strong footprint on their local market, that will benefit the most from the local recovery; still having a potential to restructure (para-public companies pushed to make strong cost cutting by the Troika); in the near future, we believe there will be interesting opportunities in the Italian financial sector.
Which recovering country could provide more benefits to investors? Spain / Italy / Portugal / Greece?
The recovery theme is more present in Portugal and Greece than in Spain and Italy. We chose not to include Ireland in our fund because the Irish stock market has already more than doubled since the 2009 lows.
In which sectors can there be the greatest recovery? What about the financial sector?
Heavy industries (cement metal), infrastructures (water, energy, telecom). The financial sector has a huge leverage on activity, with ROTE that could go as high as 15% in the long run in Greece and Portugal (on a normalized 9% CT1). In Italy ROTE could normalize from 7% today to 10% in a few years and we expect some sort of consolidation in the coming quarters/years in the Italian banking sector.
Is the recovery fully on the way? What risks do you see that could affect economic recovery in southern Europe ? How could these risks impact your portfolio?
Recovery is now a reality, at least we can now see that the worst is behind us, but it is still a very early phase of economic recovery in South European markets. The main risk I would like to underline is not an exit of Greece from the eurozone. Instead it is more a slower recovery than expected that could take 5 years instead of 3 to materialize.
Do you believe that deflation will occur ?
We think we are not in a deflation mode and that political institutions will take measures to avoid it. We are quite immune from deflation coming from emerging countries, as stocks included in the European Recovery Equity Fund are not exposed to anything else then their domestic market. For instance, the crisis of emerging currencies back in January had no specific impact on our fund.
It is true that with the euro area headline inflation marking a new cyclical low of 0.5% yoy in March and Spain even recording falling prices by -0.2% yoy, deflation concerns have heightened recently. However, deflation is a situation in which prices fall on a broad scale and consumers as well as firms believe that this situation will continue. This is to be distinguished from disinflation where price increases come down but there is no wide-spread expectation regarding falling prices on a sustained basis. In the euro area disinflation is the name of the game. Looking ahead, we do not expect the euro area falling into deflation for the following reasons: First, the latest data were strongly influenced by technical factors. Base effects from energy prices and an early Easter compared to this year turned to be substantially disinflationary. Second, the economic recovery is on track. Output has started to expand in most of the Southern countries. This should at least stabilize price increases. Moreover, also in these economies the price pressure excluding volatile goods and government effects (tax hikes, administered prices etc.) has stabilized. Third, inflation expectations have come down over the last months but are still at reasonably high levels.
All in all, while low inflation rates will persist for the time being, we do not see the euro area falling into deflation. That said, deflation is a risk that has to be closely watched. For instance, a geopolitically induced negative supply shock has the potential to initiate a process that in the end pushes the euro area into a deflationary environment.
Should the ECB do more … or is it enough?
The ECB has brought down its policy rate close to zero already and implemented a number of unconventional policy options in order to stimulate activity and cushion risks. Most importantly, the OMT program and the forward guidance to “leave interest rates at present or lower levels for an extended period of time” is a clear signal that monetary policy will continue to support activity. However, the major problem of the current recovery is missing credit growth. For instance, loans to the private sector continued to shrink at an unabated pace of slightly above two percent year-on-year. Here, tailored measures to facilitate credit creation especially in the peripheral economies are likely to be adopted. The acceptance of Asset Backed Securities based on credit given to small and medium sized firms or the creation of a Funding for Lending Scheme à la Bank of England are promising possibilities in our view. We do not expect the euro area to fall into deflation. However, a clear and credible emergency plan would help to stabilize expectations. In this respect, it helps that the chorus of policy makers are loudly thinking about quantitative easing, including the President of the Bundesbank. Moreover, should the euro continue to strengthen and become a threat to the recovery we think the ECB will not hesitate to introduce a negative deposit rate.