The Eurozone has recovered from the depths of the summer of 2011 and the odds of a euro breakup have dropped dramatically, now trading at a probability of 12.7%. This probability is based on the website Intrade, which allows individuals to place bets on a number of different events. I've found the website to be a useful store of information, as you have a number of market participants making predictions heavily incentivized with their own capital.
Below is the chart of the odds from October 2010 to January 2013:
I wrote back in August of 2012 that FEZ would be an excellent way to play the improving Eurozone, which is an ETF that tracks the Dow Jones EURO STOXX 50 Index (FEZ), a free float, market capitalization weighted index of many of the largest companies across Europe. The investment thesis revolved around 3 points:
- Although these companies were based in Europe, they were international businesses that earned a significant amount of their revenues abroad.
- These companies would survive and thrive whether there was a Euro or not.
- In the meantime, you were paid a healthy dividend of 4% to own world class companies.
Since this recommendation, FEZ has gained over 14% in addition to the 4% dividend. The chart below shows the performance of FEZ since the article was published (the blue shaded region), and the performance of the Euro (green line):
The return on FEZ has been highly correlated with the appreciation of the EURUSD (FXE), which is odd as the higher EURUSD exchange rate is thought to reduce companies based in Europe's exports and thus earnings. This relationship holds over the longer term as well, as since 2008 the EURUSD and FEZ have traded in tandem with a correlation of 0.71 (bottom chart with green shading):
As stated earlier, the dividend was a key reason why I bought FEZ, as opposed to buying the EURUSD, as it's preferable to be paid to wait.
The Dividend Yield Of FEZ
The average dividend payout ratios of each sector of the companies underlying FEZ are all below a reading of 100%. This indicates that they are generating enough earnings to cover their current dividend. Of course, the lower the dividend payout ratio, the more excess cash relative to earnings.
Below is a table breaking down each sector within FEZ's weight, dividend yield, dividend payout ratio, price to equity, price to cashflow and price to book:
As you would expect, the telecommunication services and utilities contribute the greatest to the dividend yield, as well as boast dividend payout ratios on the higher end. The telecommunication services dividend payout ratio is skewed due to incomplete information on the other companies within that sector, which is a cause for concern, but the price to book suggests that they may still be offering good value.
Below is a chart of the nominal dividend payment (orange line) and the dividend yield (white line):
Since the dividend cuts in 2008, the dividend has stabilized at $1.26 per quarter, and given that the worst is likely behind us, I'm not concerned about the dividend being cut again. In addition, I find the fact that FEZ is still trading at a price which puts the dividend yield above where it was prior to 2008 encouraging, as it is a sign there is further capital appreciation to be had.
In addition, if the Eurozone continues to improve, it is likely the dividend payments will rise, as they were in a solid upward trend prior to 2008.
Financials Are Driving The Return In FEZ
Since my recommendation in August, the financials have been the driving force of the return:
This was consistent with my initial investment thesis, in which I stated:
Although the heavier weighting in financial services may cause concern, I see it as a benefit. Financial service companies are trading at historically low valuations worldwide, and a diversified holding of them will allow an investor to profit once the financial sector recovers.
I continue to like that the allocation of FEZ is skewed towards financials, as I see financials around the world still having more upside than downside. I believe much of the policy uncertainty around new regulation will be resolved, in addition to politicians bark being much louder than their bite. It's also worth noting the attention span of the populous, as the calls for bankers heads has largely subsided, and rightly so, as they should have been calling for the heads of politicians who are the ones truly responsible for the mess of 2008 (such as the loose monetary policy which enabled the malinvestment and the government approved monopoly of rating agencies).
The Bottom Line
FEZ continues to be a great way to invest in the Eurozone recovery. The dividend yield is still a healthy 3.68% and the valuations of the underlying companies combined with the above average historical dividend yield suggest there is still room for more capital appreciation. I see upside in the recovery of the financials in Europe, therefore I like the heavy weighting of financials within the ETF.
With the high correlation to EURUSD, it is worth noting that the EURUSD exchange rate is at multi-year highs, and if it were to retract from these, there would likely be a similar fall in the FEZ. But over the long term, I'm optimistic that the euro will survive and eventually return to trading at levels it was trading at before, in the 1.50 range. This may take many years, but as long as I'm paid to wait, I'm comfortable in having FEZ as part of my portfolio.