Opt for German equities within the Eurozone

We have designated equities – especially those of the Eurozone– our favourite asset class for 2015. Within that region, our favourite country is Germany, which is in pole position to benefit from the cyclical recovery and from the euro depreciation.

2014 was an eventful year for the equity markets. Investors’ patience was tried by, inter alia, the civil war in Syria, the Ukraine crisis, the collapse of Banco Espirito Santo in Portugal and renewed fears of a “Grexit”. In spite of these threats, equity market performance was still nonetheless respectable. The German equity market, however, was unable to take full advantage of the positive investor sentiment and, in 2014 (without dividends) had to surrender some ground. The Dax – the main German stock market index – will, however, over the next few months, be nicely placed in the current environment to outperform the broader European market.

Eurozone catch-up on the cards

As was also the case last year, liquidity and growth are still vital components of equity market performance. Both will again underpin the equity markets in 2015, especially in the Eurozone. The European Central Bank will introduce its quantitative easing programme, while economic growth gradually picks up. Positive growth has not yet been priced in to the market. Based on a longer-term risk premium in line with the historical average, and actual long-term economic growth of 1%, the potential uptick comes in at over 20%. And, we may add, the Eurozone equity market is not yet expensive, especially when compared to bonds, whose rates are currently flirting with their all-time low. Consequently, equity dividend yields are, in many cases, more attractive than bond yields, all the more reason for even bond investors to increase their equity exposure.

Valuation gap 

Cyclical recovery supports company profits

Now that the cyclical recovery is gradually getting underway in Europe, the boost given to company earnings should also revive the equity market, which, in 2014, lost all faith in company results, substantially revising downwards European companies’ earnings revisions – a trend that will be reversed by the return to positive economic growth. Periods of improved economic growth will undoubtedly positively impact companies’ profit margins and, consequently, profit development. Q3 was, for European firms, in view of the surprising net profits – in excess of 10% – already the best results season since 2011. Thanks to this substantial improvement, Europe’s EPS generated single-figure growth at the end of 2014. In our scenario, Eurozone economic growth of 1% (give or take …) in 2015 should herald in profit growth of circa 10% at year-end.

Germany, with one of the highest operational leverage ratios in Europe, is perfectly positioned to benefit from this. EBITDA (*) and EBIT (**) median-ratio growth versus turnover growth is, in Germany, comparatively higher than in other European countries such as France, the UK, Italy, Spain and even Sweden. In addition, the Dax index consists of an impressive 54% of cyclical companies and 18% of financial sector companies. Also, the impact of the recent reduced-by-half oil price has been kept within certain limits in Germany. Indeed, the Dax has very few energy-related names in the index.

Euro depreciation

Meanwhile, the global context for the Eurozone has also considerably changed. The euro’s value loss (more than 10%) will benefit the region’s exports as well as European company profits as of the Q4 2014 results season. Additional profit growth is estimated at around 3%, courtesy of the exchange rate effect, and here, too, Germany appears the best positioned to benefit. Indeed, Germany’s Dax index companies generate 56% of their turnover outside Europe. That is the highest figure of all the Eurozone countries, and significantly more than the 42% of the Eurostoxx 50.

Conclusion: revaluation of Dax in 2015

Not all the punishment doled out to the Dax in 2014 was deserved. Relative valuation versus the European market is currently at a record low. German companies, with one of the region’s highest operational leverage ratios, should be among the first to benefit from this cyclical recovery and from the euro depreciation.

(*) EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) refers to the profits prior to the deduction of financial costs, taxes and duties, and to depreciations and the allocation of provisions. It measures the gross cash flow (prior to taxation of the result and financial components) and provides information on the profitability of a company’s operating result.

(**) EBIT (Earnings before Interest and Taxes) reflects the operating and investment process over the financial year. It again sees greater wealth as the result of a company’s industrial and commercial activities. Unlike EBITDA, which is based on the operating cycle, EBIT also takes into account the investment process via the calculated costs (depreciations and provisions).

Ken Van Weyenberg
Investment Specialist - Asset Allocation & Private Clients at CANDRIAM Investors Group