I. Introduction: Back from the Brink
Two years ago, we called Europe “the investment opportunity of a generation.” Today, the opportunity is far from played out. In fact, it is more compelling than ever.
As of late 2012, the sovereign debt crisis had prompted many investors to cash out of European securities – with no regard for the fundamental value left unrealized. As a result, we saw numerous attractive investment opportunities in select, deep-value special situations. We believed that M&A activity in Europe was likely to explode. We also anticipated that Europe’s leaders would take more forceful steps to address the region’s problems.
It was a decidedly contrarian view. Europe was still in the throes of pancontinental financial and economic crisis. Some observers were speculating about such dire outcomes as the collapse of the euro currency and, ultimately, the fragmentation of the European Union (EU) itself.
Yet, our view has been borne out in the months since then.
The title of this report – “Europe – Lonely and Lumpy, Yet Extremely Compelling” – encapsulates our current views of the opportunities in Europe. “Lonely” means that investors have less competition in the region than before (a good thing). The “lumpy” nature of the markets (i.e., volatility in stocks and expectations) has scared off many investors – but is also creating opportunities. Deep value, catalyst-driven investors are not concerned with “lumpiness” – rather, they often welcome stock price volatility while they remain focused on the values of assets and businesses, and what they pay for them.
A Slow Return to Economic Health
Today, we are seeing the clearest signs since the onset of the global credit crisis in September 2008 that Europe is returning, albeit slowly, to economic health. What’s more, we continue to see the investment opportunity that we predicted two years ago – one that we believe offers extraordinary prospective value for discerning investors.
In many areas across Europe, company-specific developments along with a long-term strengthening of macro-economic fundamentals are, in combination, yielding more tangible investment opportunities than we have seen in years. Both in quality and quantity, the opportunity set is far better than merely a year ago – and it continues to grow.
Where’s the Value?
Though the European opportunity is coming into sharper focus every day, we are still in its “early innings.” Undeniably, investors who didn’t have a stake on the Continent over the past two years have missed some considerable gains. But we believe there is much more to come.
The opportunity is real and readily accessible, but investors must understand that it is a highly selective one – it is not a characteristic of the entire Continent at this time. Leveraging it requires in-depth experience and knowledge of the Continent’s realities and the most careful discernment of its best prospects from among all the available situations.
A long term perspective is also imperative. Indeed, in 2014, during the latter part of the third quarter and the beginning of the fourth quarter, fears of Europe re-entering recession took hold. Having barely dipped their toes in the water, many investors fled Europe. Yet, the macro environment only reinforced the unique opportunity among specific companies that have taken advantage of crisis to launch transformational change – solidifying their prospects for a future where Europe has evolved out of crisis and austerity and achieved stability and growth.
Today, we do not believe that Europe’s bad news is completely behind us. Europe’s ongoing recovery will likely be marked by occasional setbacks, with extreme volatility at times in the markets. But, underlying this complex landscape are tremendous opportunities at extremely compelling valuations.
With the right approach, the potential reward of Europe can be substantial – in ways without precedent for this generation of investors.
This paper provides our perspective on:
- The nature of today’s European opportunity
- The forces shaping the European investment marketplace today, and for the future
- How best to take advantage of the opportunity as it continues to unfold
II. Turning the Ship in 2013: Key Forces at Work
The opportunity that we see in Europe does not depend on sweeping improvement in the region’s macro-economics. Yet, Europe is clearly on the mend – a positive trend that helps underpin efforts of opportunistic corporate managers to realize value.
For the past two years, Europe’s economic and financial policymakers have been working feverishly to re-direct the Continent’s leading economies and, consequently, the viability of the European Union (EU) itself. Today, their efforts are starting to bear fruit.
The 28-member European Union remains an economic powerhouse. It was the world’s largest economy, with GDP of over $17.4 trillion in 2013, according to the World Bank.
Though the United States remained the world’s largest single national economy, with nominal GDP estimated at $16.8 trillion as of December 2013i , the 18-member Eurozone ranks just behind the US, with $12.7 trillionii in GDP in 2013.
With just 7% of the world’s population, the EU’s trade with the rest of the world accounts for around 20% of global exports and imports.iii Around two-thirds of EU countries’ total trade was done with other EU countries.
Just as we forecasted, EU leaders in 2013 launched more aggressive steps to address the Continental crisis, focusing less attention on austerity measures and more on growth initiatives. In addition, M&A and spinoff activity greatly increased across the region.iv Perhaps most significant, 2013 marked the end of Europe’s long-running recession.
Europe turned a corner as concerns about the Euro and Eurozone debt problems eased, and the global markets found stability that was lacking over the prior three years. The Eurozone officially exited recession in 2013’s second quarter with a small upturn,v among other early (though admittedly still modest) signs of broader economic recovery.
The European Central Bank (ECB) has been foremost among the key players offering support to the Continent’s recovering economies and financial markets, a role most notably marked by its ongoing massive purchases of government and private debt securities.
In late 2013, the central bank launched plans to search for and expose bad loans and damaged investments in Eurozone banks, a first step in forcing banks to fix their problems so that they could resume lending.vi On another key front, the European Banking Authority outlined a stress test for the EU’s biggest banks as part of the ECB’s preparations for the beginning of supervision of these banks later in 2014.vii
The EU’s top economic policy chiefs signaled their ongoing activist intentions as well, issuing a warning in November 2013 to the Eurozone nations to address fundamental problems with their economies, as part of a new exercise to screen all 28 member states for economic risks.viii
Investors began to take notice of the Continent’s improving prospects, with an impact on market benchmarks. The MSCI Europe Indexix was up 25.23% for 2013, and investors realized substantial gains on a country-by-country basis as well, with London’s FTSE 100 gaining 14 percent, France’s CAC-40 18 percent, Germany’s DAX 26 percent, and the pan-European Stoxx Europe 600 17 percent – its biggest annual gain since 2009.x
III. 2014: A Challenging Year, An Aggressive Response
Though progress has been inconsistent country by country in 2014, the Continent has inched closer and closer to full recovery.
As 2014 began, the European Commission (EC), the EU’s executive body, looked toward brightening prospects. According to the Commission’s Winter 2014 European Economic Forecast:
GDP growth in the EU, which has turned positive in the second quarter of last year, is increasingly driven by domestic demand. This year, domestic consumption and investment are set to expand further, reducing the dependency of the recovery on the external sector.xi
In its spring 2014 forecast, released in May, the European Commission reiterated this essentially positive view:
The EU economic outlook is strengthening. While leading indicators point to GDP growth gaining momentum in the near term, the conditions for a sustained recovery in the medium term are also improving.xii
One of the more remarkable results of such improvements Continent-wide was that the Euro, so soundly battered during the financial crisis, seemed to be re-emerging as a “safe haven” currency. In February 2014, analysis by HBSC showed that broader swings in appetite for risk were exerting no consistent impact on the euro. In the more than five years up to that point, the situation was exactly the opposite, with the euro positively correlated with risk.xiii
The Realities of Recovery
Recovery hit a speed bump mid-year, with Eurozone GDP stagnating in the second quarter. Although there were some bright spots among them, GDP growth accelerating quarter to quarter in the Netherlands, Portugal and Spain – the euro area was held back overall by weaker conditions in its three biggest economies, France, Germany and Italy.xiv From mid-2013 to mid-2014, the euro zone’s economy expanded just 0.7%.xv
Forcefully responding to a still troubled environment, ECB President Mario Draghi announced that the ECB would offer €400 billion ($484 billion) to Eurozone banks to borrow at 0.25% or less over four years on the condition that the funds be used to make loans to small- and medium-sized businesses. This program – labeled the “Targeted Longer Term Refinancing Operations” – and a separate ECB plan to buy asset-backed securities had the goal of expanding the ECB’s balance sheet by about €1 trillion ($1.21 trillion), unleashing a flood of liquidity into the Eurozone capital markets.
With the aim of boosting recovery even further, the ECB also cut its deposit rate in September 2014 from -0.10% to a new historic low of -0.20%, sustaining a multiyear program to keep rates low.xvi
Then, in October, the European Central Bank released the results of its year-long stress test of the Continent’s biggest banks, announcing that the bulk of these banks – 117 of the 130 major eurozone banks under review – would be able to survive a financial crisis or severe economic downturn, in the words of the New York Times, “potentially a turning point for the region’s battered economy.” xvii
In its autumn 2014 forecast, released in November, the ECB adopted a measured tone, projecting weak economic growth for the rest of the year in both the EU and the euro area, with some improvement in 2015. Real GDP growth was expected to reach 1.3% in the EU and 0.8% in the euro area for 2014 as a whole, with growth expected to rise slowly over the course of 2015, to 1.5% and 1.1% respectively, on the back of improving foreign and domestic demand.
The ECB looked to an acceleration of economic activity to 2.0% in the EU and 1.7% in the euro area in 2016, driven by the strengthening of the financial sector as well as recent structural reforms starting to bear fruit.
At the same time, the ECB reiterated its commitment to moving the Continent forward, using “all available tools and resources to deliver more jobs and growth in Europe. We will put forward a €300 billion ($363 billion) investment plan to kick-start and sustain economic recovery. Accelerating investment is the linchpin of economic recovery.”
Sounding a forceful call to action for all of Europe’s key players, the EC emphasized that “we need to act across three fronts: for credible fiscal policies, ambitious structural reforms and much needed investment, both public and private. We must all assume our responsibilities, in Brussels, in national capitals and in our regions, to generate higher growth and deliver a real boost to employment for our citizens.”xviii
In January 2015, the ECB took its most compelling step to date: the launch of an aggressive bond-buying program that will pour more than 1 trillion euros ($1.21 trillion) into the eurozone with the goal of dramatically accelerating continent-wide efforts to restore prosperity.
A central tenet of our view of the European investment opportunity is that the macro outlook – albeit a strong driver of investor perception of the region – is not at all the most critical factor in realizing investment value across the Continent today. Far more critical is identifying situations where corporate managers and other players are taking aggressive steps, company by company, to retool company operations and structures to meet the challenges of a radically altered business environment.
With that kind of approach, the benefits of macro-economic recovery become a bonus for company valuations, complementing the value-enriching steps that managers, investors and companies have already set in motion.
The reality is that, today, we are seeing this kind of value-enriching action all across Europe. What’s more, we believe that it will build in dimension and force in the months and years to come.
IV. The Drivers of Investment Opportunity Across the Continent
Against the backdrop of a slowly improving Continental economy, a myriad of other forces are creating opportunity on a company-by-company basis – making the most selective, bottom-up approach absolutely vital.
Shareholder Activism on the Upswing
Since the start of the financial crisis, shareholder activism has risen significantly around the globe, with global shareholder campaigns increasing by 62 percent since 2010. Europe has not been immune from the trend. Once considered pariahs, activist shareholders are at work across the Continent, seeking to impel strategic change for enhanced value.
The root causes of activism are diverse: Activists are targeting companies that have underperformed significantly compared to peers. These activists are pushing aggressive transactions or strategic plans among companies that possess a diverse set of assets under which a split-up could improve strategic focus and bring stronger returns.
Other typical features of target companies include perceived poor governance, hidden assets, low leverage and significant debt capacity, or steady cash flows but low distributions to shareholders.xix Often, these companies can be trapped in complex holding company structures and undercapitalized by the parent company. Alternatively, they can be operating companies with non-core assets that have been ignored by management, but could create significant shareholder value if spun-off or sold.
Though the underlying circumstances are varied, the common motivation is unmistakable: Compelling recalcitrant management teams to do what is needed to unlock value.xx
Merger & Acquisition Activity Accelerating
Merger and acquisition activity is another significant force serving to re-make the European corporate landscape. M&A activity for European targets totaled $869.8 billion during 2014, an increase of 55% compared to the level of activity seen in 2013.xxi
“The risk aversion triggered by the financial crisis, which steered companies toward organic expansion, is beginning to fade as belief resurfaces that growth is returning. Low financing costs, the availability of debt, and the rise in acquirers’ market caps are enabling this surge in M&A activity as well.xxii ”
Several mega deals boosted volumes in 2014, including Novartis and GlaxoSmithKline’s asset swap, Lafarge and Holcim’s merger, Numericable and Altice’s acquisition of SFR, and Medtronic’s acquisition of Covidien.
Spinoffs on the Rise
Today, companies that have successfully cut costs and increased margins are out of options to grow the bottom line because top-line growth isn’t yet materializing. A logical step for these companies to create shareholder value is to spin off lower margin or non-core businesses into separate companies, leaving the parent company with an even better margin profile and, ideally, a higher valuation and stock price.
Spinoffs are becoming more common across Europe. With recent examples including Abengoa, Royal Dutch Shell and Metso, these transactions make for a rich source of ideas to evaluate. Companies resulting from spinoffs can be extremely attractive situations, as they are generally not well understood parts of larger companies that can come to the market extremely mispriced.
Globally, there were 60 spin-offs with an initial market value of $150 billion in 2014, compared with 37 with an initial market value of $86 billion in 2013, according to Spinoff Research. This represents the highest annual total since 2000.xxiii
We believe that an increase in activist campaigns in Europe in 2015 will spur increased spinoff activity in the region from the 32 spinoffs the region saw in 2014. xxiv
V. Our View: Charting the Right Path Across Europe
At the macro level, the news has been encouraging. Across the Continent, and country by country, economic conditions have been slowly strengthening. Activist investors have been pushing for value creation. Transactions have been revitalizing companies across industry sectors. The financial sector has been restructuring its way back to viability.
Just as we saw in mid-2014, the path forward undoubtedly will likely be marked by fits and starts; for example, JP Morgan estimates that the Eurozone won’t get back to pre-2008 levels of output, adjusted for inflation, until the end of 2015.xxvi
In our view, in Europe, opportunity must be realized on a situation by situation basis. Where does an investor start?
The Silver Lining of Crisis
Because economic growth, although positive, does remain slow, companies for the foreseeable future will likely need to rely heavily on internal – and profoundly transformative – approaches to create shareholder value. Yet, this is actually the “silver lining” of the long and painful crisis from which Europe is now emerging.
Europe’s multi-year travail has impelled select, appropriately-managed companies trading at depressed valuations to fine-tune, re-tool and, in some cases, move to aggressively right-size their operations in ways that previously were difficult to rationalize or accomplish.
The Critical Ingredient: Catalysts
The term that we use to describe such initiatives at work within companies is “catalysts.”
Some of these initiatives have admittedly been at the behest of aggressive, outside shareholders. But, in many other cases, action has been taken under the firm guidance of strong, perhaps new, management teams that have realized that the crisis offered a generational opportunity to take their companies to a new level.
In our experience, when such catalysts develop, they signal the very real prospect that appropriate value, over time, will be restored.
Catalysts take many forms, but value creation is always the end game. They include streamlining and restructurings; disposing of non-core businesses via asset sales or spinoffs; break-ups and liquidations; plant closings, or the introduction of innovative operational enhancements.
Catalysts are critical – but they are not, by themselves, enough. We seek to deploy capital not just where transformative events are underway, but where in our opinion companies are significantly undervalued and we have strong confidence, based on our due diligence, that management will actually deliver on their promises and plans. In addition, a long-term horizon is essential, for in some cases such situations will take many months, if not years, to play out.
In Europe, investors first and foremost should seek to identify and take advantage of these transformative situations. It requires a highly focused, bottom-up approach, deeply informed by company level realities and to a lesser extent by macro issues, and ideally executed with experienced and knowledgeable partners.
Identifying Opportunity “On the Ground”
Acquiring the knowledge and perspective critical to evaluating such situations cannot be easily done from a distance. In fact, today, taking the time and effort to observe conditions literally “on the ground” in Europe is essential to understanding – and taking advantage of – its emerging opportunity.
This kind of on the ground assessment has long been an integral element of our value investing approach. In just the latest example, over the past year we traveled to Europe on numerous occasions to meet with senior management from more than 50 companies (both portfolio companies and others) as well as other stakeholders and strategic investors in Germany, Italy, Norway, Portugal, Romania, Spain and Sweden. These trips confirmed the emergence of catalyst-driven value creation in many places. In addition, we met with an additional 50+ European management teams in the U.S., as they made their way here to review their U.S. operations or to meet with existing and potential investors.
A common refrain we heard from nearly every CEO we met was that, in their companies, growth was clearly emerging on a division by division basis. Most of these company’s CEOs understandably were hesitant to sound an emphatic “all clear” call for every segment of their business. Yet, taking a step back and considering all these inputs as a whole, we see many more positive developments in aggregate than these managers are seeing in their own narrow operational sphere. Recovery is obviously not yet evident across the board, but it is definitely breaking out, business line by business line.
Just as important, every company we visited offered a tangible example of the transformational phenomena that are pushing Europe forward, including restructuring and the sale of non-core assets, two key catalysts we often seek in considering an investment.
Extremely aggressive cost cutting programs are underway with more focused, talented and deliberate management teams running some of the most compelling transformation situations that we can remember at any time during the past 25 years. Additionally, a number of companies not yet restructured now find themselves the targets of activist investors pushing management teams to take action.
The capital received from the sale of assets and cost savings is generally being funneled directly to shareholders. In leveraged situations, cash is being applied to pay down debt and, in over capitalized situations, it is often being used for bonus dividends and large share repurchases.
More importantly, we believe that this refocus on core assets and cost cutting can ultimately translate into an explosion in earnings at select, well managed companies in the not too distant future.
Europe is not unique in offering such deep value opportunities today. But today, in our opinion, the Continent holds the globe’s best and broadest range – and some of the most compelling situations we have seen in a generation.
VI: Seize the Moment
In Europe, the extreme economic and financial crisis that helped give rise to so many special investment situations has abated. But full economic recovery remains elusive.
For discerning investors, the upshot is that the entry opportunity for many European special situations remains enormously appealing.
In Europe, a venerable mantra of value investment has never been more true: Crisis is creating opportunity. Crisis has forced the hand of many inherently undervalued companies. Management teams or outside investors are taking steps to improve such companies’ competitive prospects and growth potential – in the process, unlocking value.
Discernment and Patience
Across Europe, discernment of catalysts as well as patience remain essential. Investors need to carefully pinpoint those situations where management is rising to the opportunity that economic, financial and market crisis – even with all its challenges – has brought to the fore. They also need to take the long view with those situations that show the most promise.
The Time is Now
Historically, taking advantage of periods of stress in the markets has served investors well. Good businesses, good assets, and good management can not only survive, but prosper even when the cycle turns down. For investors, the key is to stay the course – to be vigilant in engaging with management, and to take advantage of market disruptions by adding selectively to existing positions and building new ones.
We believe today there is a confluence of events that collectively make this an exceptional time to be investing in European special situations – the price of oil has collapsed, the Euro has fallen precipitously against most currencies (especially, the Dollar), interest rates are at generational lows and company valuations are very attractive. Any one of these events could have a positive impact on certain companies, but the collective impact, coupled with the QE program just put in place is so substantial that investors must focus now to take advantage of this compelling investment opportunity.