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Be it for lack of the premise of adventurism that fast-growing Asian markets exhibit or for lack of the hegemonic magnetism the U.S. can traditionally count on, European markets might appear to just idle on the sidelines of investors’ restored faith in stocks at the moment. According to Ian Ormiston (pictured, page 48), who manages two funds on behalf of Ignis Asset Management in London, this preconception is undeserved. As he explains, while the prospect of a smooth economic recovery in Europe is less than certain, there are both large- and small-caps that are undoubtedly worth a closer look.          

Q: In October’s note to investors you wrote that there is little to get excited about in the outlook for European economies. To what extent did the 3Q GDP figures change this?  

A: The economy is still pretty soggy. And I think that growth for 2010 and probably 2011 will also be quite weak. And that’s universal; it applies across the whole of Europe. Recently, I was looking at Germany’s inflation statistics and we still have deflation in Germany which, obviously, is the core that drives the ECB (European Central Bank). And the big issue is whether this can drive any kind of growth. Beyond that, we have issues at all the edges of Europe—the UK, Ireland, Spain, and you can continue around the clock with the Baltics and so on, where we’ve got bigger, structural issues. And that is why I think that we still have got quite a bit of pain ahead. Latvia is a great example: we still have not decided whether we’re going to have devaluation or not. So, does that sound incredibly gloomy? I say yes, it does.

Q: Let’s take this into account and let’s contrast it with the thirteen-month high that markets reached last week: is it a good time to start investing in European stock?

A: I think that what we need to do is to contrast different elements. I think that way too often people confuse economies and markets. And there is clearly a difference between the two. That said, people are probably right to be pretty negative about the economy. The transfer of responsibility in terms of debt from the private to the public sector is not a good thing for the economy because the private credit creation has been the driver in the past and it will be in the future. But it is probably not going to happen next year, maybe the year after. And under these conditions, the obvious question is why would you invest in anything at all and if you would, where should you invest. Government bonds, given that it is in government’s interest to create inflation and given that yields are incredibly low anyway, are not particularly attractive in my view. And corporate bonds, to me, having had amazingly high spreads at the peak of the credit crisis are, yet again, really not attractive right now.

Q: In other words, is it fair to say that you consider equities sort of the best choice out of the available spectrum of not-so-interesting investment opportunities at the moment?

A: What is attractive on equities is that other asset classes are probably less attractive. Moreover, it is in governments’ interest to stimulate economies. And the way to do so is through fiscal stimuli programs where you get a direct help to the construction companies, the car companies and so on. And, obviously, through the central banks’ monetary schemes that effectively mean that liquidity is pouring into equity markets and risk markets. This stimulates the market and, actually, as always with capitalism, is a self-fulfilling process: the equity market goes up, confidence goes up, and economy recovers. Which doesn’t mean that this is the best environment I can imagine. Still, the slow recovery phase of the economy can support equity markets to continue performing quite well. And the other issue important in terms of equity markets is that the companies’ profitability is actually much better than in previous cycles. The trough for European profitability was much higher than the previous trough—actually, the trough is close to its peak. And so, in that sense, the companies are better run, more profitable, and any kind of recovery makes them look pretty attractive.

Q: Despite this one might still ask: why choose the European market over the rapidly growing Asian markets or, alternatively, the more robust and thus less risky U.S. market?

A: I think that’s a fair argument. And, again, there are several aspects to it. First, Europe is traditionally quite a good recovery market. Part of it is the openness of its economy—even though Europe tends to trade a lot with itself it is also very open. Germany is a great example: it makes all those high-end machines that basically drive manufacturing so when we see Asian growth a lot of the mining machines and manufacturing machines that fuel this growth, those machines that make machines, come from Germany. Moreover, when I say Germany I mean corporate Germany, which is now spread through eastern Germany down to Central and Eastern Europe. And this means that Europe as a whole is very geared to economic recovery elsewhere. Second, people tend to forget the difference between the country and the market. How much does, for example,  [food company] Nestlé sell in Switzerland? Well, probably less than five percent of its total sales. What matters is that it is a dominant manufacturer of ice cream and confectionery in many rapidly growing markets. Which means that Nestlé and other European high quality companies can capture this growth.

Q: Is it just the big European companies or are there any small caps you would bet on in connection with the robust growth beyond the EU’s borders?

A: Small companies may be in a very narrow niche but they can dominate it globally. Lots of European companies have done quite well for themselves by just staying at what they do and expanding country by country. Again, Europe, big and small, is quite often misunderstood because people don’t realize that European management teams tend to be very long-term oriented and that they have actually built up their positions over 50 or 100 years rather than five, 10 years along the lines of a what might be called an Anglo-Saxon view of the world. Many traditional companies have very imbedded positions and so they will perform very well in the strong global economy.

Q: Mostly, it is Western firms that benefit from these historical ties. Does this mean that you prefer the big, traditional markets over the emerging markets of Europe at the moment?

A: One of the big opportunities now has to be investing in companies with large exposure to Eastern Europe—be it a big Western European bank with large exposure to this region or a company selling there directly. Sure, given what I’ve mentioned earlier about the structural issues that have to be solved you might ask why. And my answer to that would be that it is a question of expectations, a question of valuation versus reality. For instance, the Swedish banks are massively exposed to the Baltics; terrible lending, currency mismatches, all these things are known now. And the opportunity is there because the expectations in terms of losses got too negative. At some point, we will see return to a higher growth simply because these countries have competitive advantage. Take Latvia for instance—its structural devaluation of economy without devaluing the currency means that it became massively competitive again. So, in the longer-term, Central and Eastern Europe is attractive.

Q: In other words, Western banks with high exposure to the CEE region are among the titles you would recommend or are these burdened with too much of a risk?

A: I’ll give one of the examples I’ve met recently, which was SEB bank (Skandinaviska Enskilda Banken), which is very exposed to Estonia and Latvia. Why I feel comfortable with it is that they’ve already raised a lot of capital and they are running the bank pretty much as the bank should be run—maybe they’ve even got far too much of a buffer; right now; it is a very, very ‘safety first’ approach. They have a pretty clear idea what their exposures are going to be and so in terms of risk there is little chance for a surprise. And even if Latvia devalues today it would only basically bring forward two years of loan losses into an instance effectively. But the bank is strong enough and thus it would not cause any kind of a crisis. And I think that with the banks you want to look for those who similarly did or want to recapitalize themselves. Like Erste Group Bank that is raising capital at the moment. When banks are undercapitalized you are taking too much risk. Once that’s done, yes, you might have missed some investment opportunities from taking an extra risk but that risk in itself is pretty high. And so I think that the ‘safety first’ approach is still merited.

Q: Thus, are the financials the most interesting sector in Europe or are there areas you would prefer if for nothing else than the simple fact that they still involve a lesser degree of risk?

A: In the large companies sector financials remain pretty attractive. And we’re focusing on those where they have recapitalized themselves, where they have raised more equity, and where they have anticipated the change of regulations because the regulation will have to be a lot tighter, a lot stricter. Which is also why [financial] companies such as BNP Paribas or the Credit Suisse Group are already running themselves with a much safer buffer than they have in the past—be it capital or liquidity. And liquidity, I think, will be a big debate for later in the year.

Q: And what you are saying is that banks should, basically, be running ahead of this…

A: Exactly. The ones I would be more concerned about at the moment are those comfortable with existing regulations; those that aren’t really preparing for the next stage. If we have a look at how I run my two funds then we’ll see that I’ve got a slightly ‘safety first’ bias within the financials but am still overweight on banks. The reason is that banks are the ultimate cyclical. They were largely a cause of this downturn and they are the one area where the focus is—the aim is to save them, to make things easy for them. Taking this into account, the real risk are those that don’t realize that at some point the governments will want something back or will tighten regulations to lessen a chance that something like this will happen again.

Q: These are banks, or financials in more general terms. How about other cyclicals—do you expect them to start profiting from what appears to be a revival of the European economy?

A: We’re a bit nervous about pure industrial cyclicals. The reason is that their valuations have become pretty high. The market seems to be kind of pricing in earnings returning to the peak by 2012 which is in some cases a bit too optimistic. And that’s why we are looking for our cyclicals exposure through the banks and through the insurers at the moment.

Q: These are the large caps. How about the small companies’ sector—do you also largely bet on the rise of financials or does your strategy differ?

A: In the smaller companies it is slightly different. Here, it’s a quality issue. And by their very nature, a good bank will be a big institution; it’s just the way the markets work. For smaller financial companies it’s a much tougher environment—you, obviously, don’t have the economies of scale, you still have to carry a high level of capital and so on. Which means that to be profitable is more difficult. This is why the small caps are about small industrials and about those companies where the general nervousness drove the evaluations to such a low level back at the turn of the year that there’s just a huge opportunity. The market was quite rightly concerned that the small companies will not get access to capital markets and that they might go bankrupt. Well, because of the liquidity injections none of that happened. What we have seen since the late spring was that a lot of these companies were able to recapitalize themselves—we’ve had rights issues, we’ve had equity placing. Which means that the balance sheet issues the market might have had evaporated effectively.

Q: Does it mean that it is time to dive into small caps despite their largely sluggish performance in the third quarter and the macroeconomic outlook discussed at the beginning?

A: Amazingly, companies that are, let’s say, 20 percent year-on-year down on sales—which is unprecedented—are still a massive recovery story at the moment. Just take into account what we saw in Q1 and Q2 when for instance a company such as Wavin, which makes plastic pipes and fittings, was down 40 percent year-on-year and had to close half of its factories. For them, moving down to 20 percent year-on-year is a huge sequential increase. This means that as an investor you don’t have to get too excited about the economy being too good. It’s just close to normalization from what was a terrible situation we saw in Q1 and Q2.

Q: Obviously, when it comes to small caps it is all about stock picking. What is it that is most interesting to you—in other words, what should the investor focus on at the moment?

A: All the companies that understand that things have changed deserve attention. A smaller company might have a CEO and a CFO but everybody else is just doing their day-to-day job and so there are not really a lot of people that can stand aside and think about the business. As a result, it is much more difficult for them to recognize that things are not the same. But they are. The companies can now raise debt, but it’s more expensive. They can raise equities, but it’s more expensive. This means that they have to think about new things more carefully. New projects, the internal rate of return of those, have got to be higher. So that aspect has changed. And some companies just don’t seem to understand that. They might have debt maturing two or three years out and so they’re not worried. They think that the times will return to exactly as they were. That might be true but it’s still quite a cavalier attitude. Which is why I am saying: the best management have recognized the change.

Q: That’s sort of a forward-looking evaluation. How about the way in which companies approach the ongoing global economic crisis—what is it you are interested in on this front?

A: We’re looking for companies that are taking advantage of the weakness—the ones that are trying to cut costs, to structurally change themselves. The company I’ve mentioned earlier, Wavin, might serve as an example. As with many other small caps it was a product of many mergers and acquisitions over time. But none of the businesses were ever integrated so they would sit as individual units in individual countries. And what the best companies are doing right now is that they are actually cutting costs but not necessarily just by closing facilities: if they have two plants shut and these both have kind of half and half doing the same thing they just switch the production lines and end up with a specialist plant in, say, Austria that supplies Holland, Germany, and France, and then with another specialist plant, say in France, that does the reverse. In other words, what we are looking for now is the proper industrial engineering that, when things are great, when growth is going on, firms are not focusing on; all they care about is growing the top line. Now, the good teams are actually looking to rationalize their business. And there is still plenty of that to be done.