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FPM Funds – Stock-picking in Germany

The German stock market is the number three in Europe by capitalisation, but represents the largest European economy. Its market capitalisation is about € 1.3 trillion. There are some 800 listed companies, more than half of them investable in terms of market value.

The performance pattern of the market over the past twenty years is comparable to that of other western equity markets: After a prolonged bull run lasting until into 2000, an economic slowdown and the overvaluation existing at the time led to steep price slumps from which the market (as measured by the major indices) has not yet fully recovered to this day. This, at least, is how it looks at first glance.

Closer scrutiny, however, reveals a different picture: Many shares have charted strong gains since 2000. Quite a few have risen several-fold in price. For a flexible investor not tied to indices, this meant the opportunity to achieve substantial price appreciation even in the last few years.

Equity market presents a heterogeneous profile

Divergence between a stock market’s sub-segments is nothing new. Time and again in the past, the individual segments of the market have performed very differently from each other. Thus, at the beginning of the 1990s, small- and mid-caps did considerably better than large-capitalized equities. In the second half of the past decade, the opposite was the case: Large-caps were in demand while less capitalised shares were treading water for years. Similar comparisons can be drawn for the different sectors, not to mention individual shares, where the divergences were necessarily even greater. In this respect as well, the German market differs little from other western markets, which is no surprise given the integration and global focus of the financial markets.

Much more diversification is achievable across the full breadth of a single national market than by spreading investments internationally within just the large-cap segment. Germany (like other sizeable markets) offers all themes and industries, growth and value plays, as well as emerging companies and industries. The sole prerequisite is that the size of a portfolio is not under restrictions that significantly limit its scope of investments.

While the big European equity indices are driven by companies in the energy, financial services, pharmaceutical and telecommunications sectors, the German stock market when taken as a whole presents investors with a much wider universe of choice. Aside from the usual suspects – notably auto makers and their suppliers – the quotations lists include a host of other companies from any number of industries that should be of comparable relevance to an economy. This not only permits diversification by fundamental criteria, but also holds opportunities in the form of the temporary undervaluations that arise in all market segments over time.

German market strongly driven by foreign investors

Unlike the Anglo-Saxon stock markets, investors from abroad play a very important role in the German financial markets. This among other causes has contributed to above-average volatility. For foreign investors, the German equity market is less important than their home markets, and this gives rise to opportunism: Foreigners can be invested here but do not have to be, and typically prefer to get out of the market when there is growing uncertainty. As well, non-German investors draw analogies to other markets and companies that frequently do not correspond to reality. This is the case both during phases of excessive over- and undervaluation of shares.

Faced with the abundance of available information, many investors fall prey to the temptation to oversimplify. One of the chief examples is the attempt to evaluate markets, and thus companies, in a top-down manner, i.e. from the macroeconomic angle. Where the German equity market is concerned, in recent years foreign investors have applied this approach to assessing the reform efforts of the governments – efforts which, moreover, were not always even correctly understood.

The long-term performance of a company is basically generated by itself. Naturally, there are business conditions that help or hinder corporate success. But these say little about a given company and are not the chief drivers of its long-term performance. Rather, the key determinants in the long run are the business model, market position and management quality. And only once an investor has understood a company’s particular business model he can choose an appropriate valuation model: The value that an enterprise creates for its investors is often not reflected in the results of a single business year. An individual investment thus requires extensive detailed work to realise sustained satisfactory returns.

German companies structurally more profitable

In the past several years, despite relatively weak economic activity, Germany has seen a new trend that is broader than almost anyone at first realised. German companies by and large now are not only profitable in accounting terms, but also create value; in other words, they earn their cost of capital. Whereas in the early nineties, for many businesses the cost of debt and equity capital consisted of interest and dividends, the present approach is completely different: Companies today usually base their calculations on the economic cost of capital.

One of the first sectors to realize that an investment is not necessarily profitable just because it produces a positive cash surplus was the chemical industry, which as a global business was quick to follow the example of international practice. Subsequently, one sector after another absorbed, embraced and implemented this insight. By now, profitability is clearly put before growth when growth entails poor margins and little benefit for a company’s market position. Structurally weak activities are shut down, sold or merged; healthy ones are invested in within the bounds of good economic sense; and surplus capital is distributed to shareholders in the form of dividends or, increasingly, share buybacks – the way it should be. The benefits of these improvements were coupled with the stimulating effect of the strong global economy, which allowed many German companies to prosper. As a result of all this, and despite the significant rise in share prices from their nadir in 2003, the stock market’s valuation based on earnings is low by historical standards.

The question for investors is therefore how lasting will be the increased corporate profitability. What proportion of earnings is due to windfall profits from higher prices and how sustainable are these?

In this respect as well, it is of paramount importance to examine companies with a magnifying glass. How are the business models structured and how long-lived are the revenue flows? How do companies behave in response to the higher earnings? How does the management do business and what are the firm’s governance structures? And, as a crucial question especially for sectors such as telecoms and energy, how is the regulatory environment changing?

Stock exchanges again functioning as primary market

With its rally over the past few years, the German equity market has reclaimed its capital-raising function among primary markets. The number of initial public offerings has almost reached the high seen in the year 2000. It is a good sign that this is happening in a setting where the valuation of the IPO candidates plays an important role and where the equity story alone is no guarantee of success. Major themes in the flotations, aside from the exits of private equity investors, are capital procurement by firms in the renewable energy segment and – for the first time prominently – the IPOs of real estate companies, which in the past were underrepresented as an asset class on the German equity market. Companies in the alternative energy sector naturally have a very different risk profile from property firms because they operate in a different regulatory – and therefore politically influenceable – environment. All this gives the stock market as a whole considerably more diversity and macroeconomic significance. Even if there is still some way to go, the trend in Germany is in the right direction.

FPM Frankfurt Performance Management AG
Markus Dahlheimer (Vorstand)

Tel:  +49 (69) 79 5886 13
E-Mail: Markus.Dahlheimer@fpm-ag.de
Internet: www.fpm-ag.de

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