Investor strategy: M&A outlook

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Jonathan Stubbs, managing director and head of UK and European equity strategy at Citi Investment Research will answer your questions in a live online debate on Monday from 3-4pm BST.

Mr Stubbs answers readers’ questions on issues such as whether European equities are on track to hit 2007 return targets, the outlook for the global economy, the maturing equity bull market, where we are in the corporate profit cycle and whether the M&A boom is set to continue.


Several European countries have experienced very strong growth in property markets in the last few years. In particular I am thinking of Ireland and Spain. How do you think that any slow down in these markets will effect the local equities markets and would it be best to avoid these local markets?
Alan Spencer, Dublin

Jonathan Stubbs: Low interest rates have fuelled property booms around the world. Periperal European countries have enjoyed some of the most explosive price gains. What now? Well, the pressure on European interest rates remains upwards with futures markets pricing in two more 25 bps hikes from the ECB.

Negative real interest rates have turned positive and the cheap money is unlikely to return in a hurry. The pace of mortgage loan growth in markets such as Spain and Ireland has already started to decelerate pretty fast. With the risk of interest rates over-shooting on the upside this presents a greater local risk to equity markets than elsewhere in Europe.

It makes sense, therefore, to have more balanced equity exposure to countries which have less property risk; and also to sectors that have less interest rate risk. Rising interest rates also makes cash a more competitive asset, although we think that European equity returns will still beat cash handsomely over the coming 12-18 months.


To what extent will a slowdown in the US (lower GDP and housing bubble) affect European equity markets 2008?
Gekho, France

Jonathan Stubbs: If the slowdown in US housing is moderate, and does not extend into US consumption, we believe the impact on the European stock market will also be moderate. European companies have about 20 per cent sales exposure to the US. Much of this exposure is to industries which are not related to housing like Pharmaceuticals.

However, if the downturn in housing becomes significant and seriously weighs on US consumption and US economic growth, we are likely to see downgrades to European economic growth and European company earnings.

Our economists believe the downturn in US housing will be moderate and not have serious implications for consumption or broader economic growth in the US. While this outlook should have moderate implications for the European stock market, the weakness in housing could be a more serious headwind for specific European companies with significant exposure to US housing.


Some forecasts have called for the increasing equitisation of the European market, in which equities represent a growing proportion of household investment portfolios. What’s the status of Europe vis a vis the US in this regard, what’s the trend if there is one and what are the implications?
Neil Gluckin

Jonathan Stubbs: European investors have not been that keen on pure equity exposure since the TMT bubble burst. In fact, European retail investors put more capital into equity in 2000 than they have done since. But, we would expect exposure to this long-term asset class to rise in Europe over the coming 10-20 years, just as it has in the US over the past 50-60.

The UK would be different to the rest of Europe, with the UK’s equity culture already well developed. As an aside, it is interesting to see that 80-90 per cent of the capital going into US mutual funds has been channelled into non-US equities over the past one or two years.


Will European equities continue to outperform the US equities? If so, why?
Oskar Stachowiak, Canada

Jonathan Stubbs: We believe Europe equity market performance has already shown some tendency to decouple from the rest of the world. Since the start of 2002 European equities have provided a total return of more than 120 per cent. Over the same period the US equity market has provided investors with a total return of about 90 per cent. We believe this outperformance by Europe is due to a number of reasons including cheaper starting valuation, solid earnings and cheaper debt financing for LBO’s and M&A.

These positives still exists and supports further outperformance by Europe. European companies trade at a discount to their peers in the US. The outlook for earnings remains solid with European GDP growth being upgraded. In addition, the cost of credit in Europe remains lower than the US, so LBOs and M&A make more financial sense in Europe.

As the European economy becomes more integrated we are likely to see more significant productivity gains. Also, greater financial market integration is likely to make cross border acquisitions more likely. Both are positive for further outperformance by European companies.


Despite dire predictions of several experts since last March that markets are ripe for a correction there are no signs of this as yet. So what will be your advice for equity investors, wait for a correction then invest and if so which world region should one invest?
Marylene Dean, Birmingham, UK

Jonathan Stubbs: Over the past four to five years there have been too many bears. Analysts, companies, fund managers, retail investors and strategists have been too cautious. Still scarred by the 2000-03 bear market, it has been difficult for many to forget the pain of UK equities falling 50 per cent in value (80 per cent in Germany). We continue to see decent value in UK/European equities over the coming 12-18 months - global economic growth looks robust, the profit cycle looks under-pinned and valuations are not so excessive.

Having said that, the risk-reward balance is less attractive now compared to one or two years ago. In particular, this is a result of higher interest rates. This removes some (not all) of the relative attraction for equities.


Different asset classes used to move in different directions but now it seems that they all move together (apart from bond volatility recently). Certainly last year when oil rallied, stocks in UK would fall. What has brought on this and will it continue? Does it signal a very strong bull run that isn’t running out of steam?
Adrian Kidd, London

Jonathan Stubbs: Rarely have different asset classes performed in such a correlated fashion. There seem to be few assets that have not enjoyed a strong return environment over the past few years - think real estate, emerging market debt, equities, stamps, horses, fine wine and art etc.

We think that the common link is cheap money and surplus liquidity. The monetary response post-TMT bubble was aggressive; US Fed funds were cut to 1 per cent to try and reflate the global economy. Real rates (ie interest rates less inflation) were negative in many countries, especially in Europe. This capital has been channelled into a variety of asset markets over the past few years and resulted in these abnormally high levels of correlation. Low volatility across macro factors such as inflation and economic growth has also fuelled this.

Now, this may be changing. We have started to see some divergence in returns between bonds and equity over the past year or so. Perhaps it is time to dust off some of those old relationships.


What are your thoughts on European energy equities? How do you view them in comparison with US energy investments?
Thomas Chavez

Jonathan Stubbs: We started 2007 underweight in the European oil sector and with a more aggressive sector strategy tilted to benefit from rising markets. But, following a strong start to the year we raised the sector to overweight in our sector strategy in April for a number of reasons, including a hedge against higher oil prices (then $65/barrel), the potential for higher earnings numbers and also as a market hedge too.

We remain overweight now although we recognise that share prices in the sector have bounced quite hard. The bears will point to unhelpful nationalist governments, sluggish production growth and dollar weakness (for the Europeans). The bulls will clearly point to oil price risk (Brent breaking $80 today), reasonable valuations, stronger earnings trends and trumpet the more defensive characteristics of the sector.

Now, the last factor is its main attraction for us. The oil sector is a defensive hedge which allows us to retain a cyclical tilt elsewhere. Our US strategy colleague, Tobias Levkovich, likes US oils and is overweight too. He supports our valuations and positive earnings momentum.


For a number of years European markets have mirrored US markets, despite a weakening dollar and the rise of markets such as India and China. Will European markets come to their own and permit specific strategies relative to their true intrinsic performance to be exploited by investors?
Vijay Vaswani, London

Jonathan Stubbs: While we expect both markets to rise in the medium term, we think there is reason for European equities to continue to outperform the US, for now. Supporting our view is cheaper absolute valuation, lower discount rates and more certainty on the outlook for European earnings.

European equities remain cheap relative to those in the US, despite considerable outperformance over the last few years. The trailing P/E for European equities is about 16x, while the trailing P/E for the US is 18.4x. The difference between European and US valuations has narrowed over the last few years and we expect this to continue in the medium term.

While absolute valuations for Europe are lower than the US, we find the risk free rate is also lower. The 10 year government bond yield for Germany is about 4.5 per cent. Meanwhile the 10 year government bond yield for the US is just over 5 per cent. Our economists broadly expect bond yields to remain flat over the next 6 to 12 months. Among other things, this means the risk free asset in Europe provides less competition for the equity market than the risk free asset class in the US.

For the time being, the outlook for earnings remains more certain in Europe relative to the US. European companies are benefiting from stronger economic growth in Western Europe. Also European companies have significant exposure to faster growing emerging markets. Meanwhile, economic forecasts for the US, where most US companies source their earnings from, continue to weaken. GDP growth in the eurozone is expected to be faster than the US in 2007. Also, our economists GDP growth forecasts for 2008 are moving up in Europe and coming down in the US


I have a small number of shares in a healthcare company which have been falling in value over the last months. The money is important so should I sell the shares now or hang on in there?
Mrs C E Redman, Gloucestershire

Jonathan Stubbs: I cannot comment on specific stocks for compliance reasons. But, we have just last week raised our strategy recommendation for the healthcare sector from underweight to neutral. Why? Unfortunately, this is not because the industry’s fundamentals appear to be improving - there is still a lot of regulatory/government pressure, earnings growth for the sector is not that attractive relative to the market and patent expiry and generic risks remain.

But, this is more of a valuation story. Pharma in the UK now has a higher dividend yield than the market and is starting to attract some value investors. This could bring more support for the stock.


How do you see the medium and long term prospects for Alstom? Are there any other European companies in the same industrial sectors that you would recommend?
Jan Pendzich, Seattle

Jonathan Stubbs: Unfortunately I cannot comment on the prospect of individual stocks for compliance reasons. But, we remain positive on the outlook for the broader Industrials sector in Europe. Despite more expensive valuations, companies are best placed to benefit from strong global demand, especially in emerging markets.

Additionally, balance sheets are strong and getting stronger. This is likely to lead to an increase in capital distribution from several European industrial stocks. Our economists continue to back a longer economic cycle and ongoing strength from emerging markets. We stick with Industrials for now, with one eye on valuations.


I am a potential first time investor in managed funds. I have contacted an IFA who has put together a portfolio for me to consider. However, given the current market conditions (US on verge of possible recession, rising oil prices, inflation and interest rates, end of bull market etc.) is this not a really bad time to start investing? I feel that maybe I should wait until a market correction sets in. My suspicious nature tells me that the IFA is simply going to encourage me to invest now to get his commissions in before everything goes belly up!
Alan Westbrook, Borehamwood, Herts

Jonathan Stubbs: Obviously much depends on your personal circumstances and also your risk appetite. Here are some other thoughts for you to consider. Equities tend to deliver good returns over the long-term. For example, even with the collapse of share prices in the 2000-03 bear market, UK equities have delivered better returns than both cash and UK gilts over the past one, three, five, 10, 15 and 20 years. But, nobody likes to get in at the top.

You correctly point out some of the key risks facing equity investors today. In particular, UK (and global) rates continue to rise and there remains uncertainty over where the peak in this rate cycle will be. But, there are always risks. It is our job (and your investment decision) to balance those risks against the prospective reward of investing in a ”risky” asset such as equities.

In 2003, at the start of this bull market, many investors and strategists were worried about a ”profitless” recovery. Well, it has been the best ”profitless” recovery since. Equity markets were fretting about a slowdown in the Chinese economy in mid-2004. Running away from equities then would not have been a smart move either. Yes, we think that risks facing equity investors today - specifically on inflation and rates - are more significant than one-two years ago.

With interest rates at higher levels, we think that equity markets are more exposed to rates than previously. Yes, as you also allude to, we think that this equity bull market is no longer in its immature (or early) stage. This bull market is maturing. But, often some of the best gains in the equity cycle are to be had in the last two to three years of the bull market. This could still lie ahead.

Elsewhere, our economists do not think that the US economy will fall into recession although the collapse in house prices is clearly proving a significant drag on overall activity. Our overall view on UK equities remains positive and we are targeting 7,200 for end-2008 for the FTSE 100 index. We back a relatively stable global macro environment, decent profit environment and ongoing M&A and corporate action to drive share prices higher. While you highlight relevant downside risks to equity markets, the key upside risk on this is a re-rating, ie a higher price-earnings ratio. This could deliver returns substantially higher than our current targets.

Finally, with higher interest rates making cash a more attractive asset class, it would perhaps be sensible to start off with a strategy that allows you to invest now in a combination of cash and some lower-risk parts of the equity market - perhaps cheaper big caps or those with decent income characteristics rather than expensive mid-caps. You would then have some firepower left on the side to put in on a pull-back.

Good luck.


What are the most important political risks confronting investors today? In which sectors of emerging markets do you see foreign investment flourishing?
Asli Arbel, Istanbul

Jonathan Stubbs: Politicians and politics are less important for equity markets now compared to 20-30 years ago. This is even true in emerging markets, which have been most susceptible to political risk as elections, military coups and overthrown governments have shown in recent years.

Indeed, lower risk premia attest to lower financial and political risk in many emerging markets today. But, political risk remains both for emerging and developed world equity investors.

Fewer investors in developed world equity markets have been impacted by political risk over the past few years. In the UK, for example, equity markets barely blinked on the arrival of Prime Minister Blair in 1997, and the first Labour government since 1979. Indeed, one of Blair’s government’s first acts was to make the Bank of England independent from politicians, reducing political interference in the financial system at a stroke.

Across Europe, the advent of the euro and a single monetary policy has further has lessened the potential impact of politicians on Europe’s equity markets.

So where are the political risks? While clear geo-political risks remain high profile, the biggest political risk which our economists see today is that of a policy environment which is less supportive of globalisation. There are increasing signs of greater protectionist activity from a number of governments - for example, obstacles on investment from abroad, Doha round of global trade negotiations collapsed etc. If escalated then the performance of the global economy could suffer.

Rebuilt trade barriers, a reverse of economic liberalisation, barriers to technological advances and more aggressive inter-region industrial relations would likely be detrimental to global inflation and activity levels.

We think that there are bigger risks than politics facing investors today. The risk of higher inflation and rising rates tops that list.


Given the recent strong performance in European markets, do you consider value to be hard to find or still plentiful? Are there any industry or geographical sectors you favour in particular? And do you see more value in large, mid, or small cap stocks?
James Roberts, Edinburgh

Jonathan Stubbs: Lots of questions in here. Yes, European equities have done well over the past year and since the end of the 2000-03 bear market. For example, the DJ Stoxx 600 index has delivered a total return of nearly 30 per cent in the past 12-months, +175 per cent since March 2003. But, overall market valuations have not moved much. UK and European equities still trade on a sub-14x year-ahead price-earnings ratio. This is not much higher than at the bottom of the bear market. So, there has not been significant multiple expansion (or re-rating) over the past few years despite a strong regional (and global) economy and one of the most impressive periods of margin expansion and profit growth of the past 40-50 years.

Despite the lack of market re-rating, many stocks in the market have been aggressively re-rated. These have typically been small and mid-caps. These stocks are much more expensive than in 2002-03 when many got down to single-digit P/E ratios and had very high dividend yields. Value is therefore harder to find than a few years ago because there are many more stocks that look more expensive on traditional valuation metrics. The overall market is also not as cheap as 2002-03 or indeed as 12-months ago. The year-ahead P/E for European equities is at the top of its five-year historic range at just under 14x. But this compares favourably to the past 15-20 years.

So, equities do not look expensive in absolute terms, but nor do they look cheap. We need to believe in an extension of the current profit cycle, ie decent earnings growth, to back a positive view on European equities over the coming 12-18 months. We do and expect nine to 10 per cent earnings growth from European companies in 2007-08.

Away from simple absolute valuations, European equities still look good value in relative terms against bonds and credit, despite the rise in bond yields. The arbitrage between cheap debt financing and expensive equity financing (ie low P/Es) has been the foundation of the boom in M&A activity over the past one to two years. While this gap has closed somewhat, it remains and we think there is a lot more (M&A) to come.

It has been hard for investors to make strong returns by playing sectors over the past few years. Stock-picking strategies have had the potential to deliver stronger returns. Nevertheless, we still retain a tilt towards cyclical sectors today. These tend to have higher beta characteristics which should do better in a rising market. They also tend to have more exposure to strong growth in emerging markets.

Our preferred cyclical sectors are industrials, construction, insurance and travel and leisure. It is interesting to note that apart from insurance, these sectors do not offer investors the value case which they did a few years back. With rising rates, however, we have a more balanced, ie less cyclical, sector strategy now compared to one or two years ago.

We do not have a strong regional bias within Europe, although the UK tends to be more defensive and lag strong equity markets and Germany is clearly benefiting from a strong local and international economic story as Spain benefited from aggressive corporate re-leveraging and M&A activity last year. But, work from our global strategist, Robert Buckland, recently showed that Europe was both the cheapest region (including emerging markets) on an ”as now” basis and also relative to its history. This supports our ongoing bull case for the region.

Finally size. There is clearly more value in large-caps than expensive small- and mid-caps across Europe. In particular, the most obvious value lies in what we call the mega-caps. We define these as the top 50 per cent of market cap of the large-cap index. Pan-Europe, this approximately equates to the DJ Stoxx 50 index. This group of stock trades on a year-ahead P/E of around 11-12x and is significantly cheaper than the rest of the market. Many stocks trade at a discount to sum-of-the-parts or break-up valuations. We suspect that this is a good place to look for investment ideas for those who have the luxury of a longer-term investment horizon.

In mid-caps, we see greater exposure to risks, such as credit and rising interest rates. We would prefer to have exposure higher up the cap scale.


Are small and medium UK companies an attractive buy for short term returns?
Sanjaya Kannath, UK

Jonathan Stubbs: Looking for short-term returns from equities generally exposes investors to higher risks. In general, we prefer to look for medium/longer-term investment opportunities in equities. But, what about our view on UK small/mid-caps?

The official FTSE indices split into three main groups: FTSE 100 (large-caps), FTSE 250 (mid-caps) and FTSE Small Cap. The smallest stocks in the FTSE 100 index currently have a market cap of around £3bn with index heavyweights over £100bn. I’ll focus here on ex-FTSE 100 stocks, ie sub-£3bn market caps.

Investors in UK small/mid-caps have enjoyed fantastic returns over the past few years. Since the end of the bear market in March 2003, UK small-caps have delivered a total (including dividends) return of over 170 per cent with mid-caps doing even better, up over 250 per cent. This is much better than the overall market (+150 per cent). Why? Two main reasons - growth and liquidity. In general small/mid-caps have offered and delivered faster rates of profit/earnings growth over the past few years. Small/mid-caps have also enjoyed rare liquidity advantages over large-caps. Generally, many investors have shied away from equities still licking their wounds from the 2000-03 bear market. But, there has been strong demand for small/mid-caps from the following: corporate predators, private equity, mid-cap fund managers, large-cap fund managers, hedge funds and quant managers. This has driven a strong re-rating of UK small/mid-caps. Their valuations have become much more expensive. For example, the FTSE 250 index traded on a sub-10x P/E in 2003. Now, it trades on 16-17x.

Now, given more expensive valuations, higher interest rates and greater exposure to various risks we would prefer to look higher up the market cap scale for investment opportunities today. This is a move that we have been making in our investment strategy since September last year. We think that UK equities still offer investors decent returns over the coming 12-18 months but we would skew our exposure up the cap scale.


Background

Mr Stubbs joined Citi with Robert Buckland in 1998 following four years at HSBC James Capel as UK strategist. The UK and European Strategy team has been ranked number one in the most recent Institutional Investor and Extel investor surveys.

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