Riding out the market volatility

This has been a summer of discontent for investors, with stock markets enduring substantial volatility. The volatility was most extreme during the two weeks to 17 August. By 24 August, the FTSE 100, for example, stood around 8 per cent below its peak in July after a recovery over the previous few days. This followed positive returns from European equities over the past few years. The MSCI Europe index returned 28.03 per cent over one year to 23 July 2007, 81.93 per cent over three years and 101.33 per cent over five years. There is no agreement, however, on what impact the credit crunch and stock market volatility will have on European economies. The European Central Bank has said it does not expect it to cause a slump in economic activity. Indeed, even though the eurozone’s GDP growth slowed to only 0.3 per cent in the second quarter of 2007, interest rates are still expected to rise in September. This concurs with the ECB’s statement that its key concern remains the medium term upside risks to price stability. Nevertheless, Tom Stubbe Olsen, manager of the Nordea 1 Europ Value fund, which closed to new investors on 12 March 2007, highlights the risks of the end to cheap money. While this is likely to cool private equity deals, Mr Stubbe Olsen says a more dangerous problem is posed by debt already issued. “Nobody really knows the magnitude of the problem created by derivatives and creative structures making debt financing more easily available,” says Mr Stubbe Olsen. He adds that there is also concern over the magnitude of collateral debt obligations (CDOs). Mr Stubbe Olsen says it has been hard to find good businesses that sell at a 50 per cent discount to fair value. But he has been finding companies selling at discounts of 20 to 30 per cent. “These do not need to fall much before we can invest.” He currently favours “established businesses with strong managements that have a proven track record in generating strong earnings power. We believe there is a high degree of certainty associated with the cash flow of these companies as they are less dependant on the evolution of commodity prices, exchange rates and the overall operating environment.” Mr Stubbe Olsen argues that sectors driven by “commodity prices are likely to suffer the most once the operating environment normalises”. Richard Pease, manager of the New Star GIF European Growth fund, says the market volatility showed he had not taken the subprime concerns as seriously as he perhaps should have done as far as European banks were concerned. “The banks do not seem too concerned about the subprime market,” says Mr Pease. “But share prices have been downgraded aggressively. UBS’ share price had fallen a third in a few months. “We took the view that BNP Paribas was not expensive on eight times consensus 2008 earnings. With the fall in share prices, BNP Paribas was around seven times next year’s earnings in mid-August. Management believes it will deliver 12 per cent earnings growth.” Mr Pease believes the fundamentals behind the companies within his portfolio have not changed despite the volatility. “The companies do not seem to be in trouble. “I am taking the view that the bad news is now priced into stocks. I do not see the subprime problems as likely to quash European growth. “We believe the argument that European consumers can take up the slack from US consumers is more right than wrong. Interest rates are unlikely to rise with the volatility in financial markets.” Alexander Scurlock, manager of the Fidelity Funds European Growth fund, says the effect of the credit concerns on European equities depends on what exposure financials have to this area of the market. “More broadly, the overall impact this has on the US consumer, economic growth and interest rates could ultimately affect the European economy.” Nevertheless, Mr Scurlock does not believe European equity valuations look over-stretched. “In addition, European equities look attractive relative to other asset classes, including bonds.” In selecting stocks, Mr Scurlock has focused on companies that will benefit from economic improvement across Europe and in particular Germany. He points to falling levels of unemployment. “The consumer has yet to come through but they are becoming more upbeat and the business climate is improving, which is already feeding through to the industrials sector. “The European economy continues to expand at a pace that is stronger than has generally been expected. It continues to be supported by positive surveys of business and consumer confidence, strong investment and exports. Mr Scurlock believes the biggest risks to European equities are associated with the credit markets, in particular subprime and leveraged debts markets. “Longer term, concerns are any slowing of the US economy and consumption.” Philippe Brugere-Trelat, manager of the Franklin Mutual Europe fund, says he has seen few periods of such volatility, where the FTSE 100 can fall 4.1 per cent on 16 August and then rise 3.5 per cent on 17 August. He took advantage of the cash in the portfolio to add to positions and make new acquisitions during the volatility. He says valuations became “extremely attractive after the falls in markets. His optimism is also based on the relative attractiveness of the valuations of European markets against the US. “What we are seeing is a liquidity crisis and not an economic crisis,” says Mr Brugere-Trelat. “China and India are growing well and so is Europe. There has been a reliance on the US consumer but European exports have been strong despite the slow down in US spending.” Mr Brugere-Trelat says he buys stocks he believes can enjoy 25 per cent share price growth, with a bias to larger cap stocks. He looks for companies priced on low earning multiples with strong cash flow or stocks that are priced on a discount to the main asset value. Freeing energy He also likes the utilities sector, including Eon. A catalyst has been liberalisation of the energy markets by the European Union. “Eon has excellent management, a strong balance sheet, strong cash flow and a good market position. “Eon has a 6 per cent stake in Russia’s Gazprom. This represents 20 per cent of the market value of Gazprom. I asked the chief executive of Eon whether this represented a political risk. He responded that he did not think this was the case because Eon has been a shareholder for more than 10 years, including during a difficult period for Gazprom.” The Franklin Mutual fund has returned 29.19 per cent and 76.76 per cent over the past one and three years to 23 July 2007 compared to 28.03 per cent and 81.93 per cent by the MSCI Europe index. Over five years, the fund returned 101.94 per cent against 101.33 per cent by the index. “We under-perform other funds during a bull market, but we do better than most during flat or falling markets,” says Mr Brugere-Trelat. Mr Pease of New Star evaluates four factors in selecting stocks. These are the business model, management, finances and share price valuation of companies. The weighting of each of the factors will vary according to the industry and over time. For example, Mr Pease says he not only likes management to have a proven track record but also to have the same financial incentives as shareholders. Paul Shutes, client portfolio manager at JP Morgan Asset Management, says the Euroland fund started using a behaviour finance investment approach in the fourth quarter of 1999. The fund tries to identify anomalies in share prices. “The market allows anomalies because of irrational human behaviour. We all suffer behaviour traits such as being over-confident or over-pessimistic.” Mr Shutes adds that analysis shows investors should hold their winning stocks and sell their losing stocks. “But while investors find it easy to lock in gains they find it hard to crystallise losses. Academic studies show falling stocks are unlikely to recover.” He says the fund aims to take advantage of such human behaviour traits. “The first step is to identify cheap and expensive and fast and slow growing stocks. “We have 35 investment professionals who then validate this by analysing, among other things, the price to book valuations. We check whether an earnings revision is based on an underlying change. “We believe in combining value and growth stocks,” says Mr Shutes. “Value stocks out-perform 60 per cent of the time while growth stocks out-perform 60 per cent of the time as well. But when you combine value with growth stocks, you can out-perform between 70 and 90 per cent of the time.” The portfolio has between 160 and 200 stocks. But Mr Shutes says on a percentage basis it is no larger than many other funds in the sector. He says the fund looks to out-perform by between 2 and 3 per cent a year. It aims for a tracking error of around 4 per cent. It has a weighting of + or – 3 per cent for each country and industry. It can go to + or – 2 per cent for each stock. Mr Scurlock took over as manager of the Fidelity Funds European Growth fund on 1 January 2007. He says the fund is managed on a bottom up basis with an unrestricted investment mandate, which is similar to the approach of the previous manager, Graham Clapp. But there are also some differences. Mr Scurlock says he takes a global perspective to identify the competitiveness of European businesses. He builds an understanding of a company’s competitiveness, suppliers, distributors and competing technologies.

Scurlock: credit is the biggest risk