Europe's Momentum Plays

Includes: EWG, EWN, EZU
by: Michael Krause

As investors are no doubt aware, the sovereign debt crisis in Europe has become a drag on the economic recovery for many countries in the euro area. This in turn caused a sell-off in equities that pushed some markets into “deep value” territory according to our analysis.

But it’s not gloom-and-doom everywhere. While value investors wait for things to improve in the so-called “PIGS” markets, last week brought reports that German GDP was much faster than for the continent as a whole. And we noticed that firms in the iShares MSCI Germany (NYSEARCA:EWG) and Netherlands (NYSEARCA:EWN) funds are not only surviving but thriving. Specifically, over the past six months earnings estimates for German firms increased more than 12%, while estimates for Dutch firms grew nearly 9%. In contrast, estimates for firms in the larger iShares MSCI Euro Monetary Union fund (EZU, which includes some German and Dutch firms), rose only 2% over the same period (Figure 1).

Figure 1: Trends in Estimate Revisions
Trends in Estimate revisionsClick to enlarge

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These are especially significant since revision activity for broader benchmark ETFs such as the S&P 500 SPDR (NYSEARCA:SPY) and the iShares MSCI EAFE (NYSEARCA:EFA) and Emerging Markets (NYSEARCA:EEM) funds have all but stalled or gone into reverse recently, as it has for many of the Sector SPDRs. This is probably at least in part behind the recent outperformance of German and Dutch stocks within the euro area since that currency began its most recent slide in November 2009.

Of course positive momentum alone does not a good investment make. As always, we examine the fundamentals of each fund’s constituents for more insights. For the most part the three indices are well diversified, with each fund’s allocation to a given sector within a few percentage points of the others. The one exception to this is EWN’s outsized allocation to Staples (mostly Unilever (NYSE:UL)) at 28% of assets (Figure 2),

Figure 2: EWN Sector Breakdown
Sector breakdownClick to enlarge

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Although we suspect that German and Dutch firms are benefiting disproportionately from weakness in the euro based on the number of household names (i.e., exporting powerhouses) on the list of top holdings, the overall data is not clear. Historical sales are not broken out by currency (a “foreign sale” could be to the US or another eurozone country like Italy), and surprisingly forecasts show that sales growth for German companies is about the same as for the euro area as a whole, while it is forecast to be almost flat for Dutch companies this year (Figure 3).

Figure 3. Sales Growth

Sales compClick to enlarge
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What is clear however is that profitability appears to be recovering quicker from the downturn for German and Dutch firms than for the broader euro index. Companies in all three recorded low returns on equity last year, with Dutch stocks slightly lower than the other two. But while ROE is set to rebound quickly for German and Dutch stocks, the recovery for the stocks in EZU is lagging by comparison (Figure 4). As a result, EPS growth in Germany and the Netherlands this year is forecast at 51% and 67% respectively, compared with an increase of 30% for the larger euro area.

Figure 4: Return on Equity Recovery

ROE compClick to enlarge

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Viewed another way, the profitability of German firms is forecast to surpass average levels (shown in Table 1) this year while Dutch firms attain those levels next year. However for firms in EZU profitability is likely to remain below its historical average through at least next year.

In any case, on average German and Dutch firms earn a nearly identical Return on Equity over the course of the business cycle of 11.7% and 11.9%, respectively, although that of German firms has been less cyclical. Perhaps because of that relative certainty, German stocks trade at a higher price-to-book value multiple of 1.4x, compared with 1.2x for Dutch stocks. The result is that EWG has a lower ALTAR Score — our measure of an ETF’s overall investment merit — of 7.8% compared with 9.0% for EWN (Table 1).

In contrast, EZU includes some stocks in “PIGS” markets that as we mentioned appear to be “deep value” but are out-of-favor to say the least. As a result, in aggregate stocks in EZU also trade at a price-to-book value multiple of 1.2x despite earning a slightly better ROE of 12.6% on average, resulting in an ALTAR Score after expenses of 9.8%.

The strict value investor would prefer EZU, the best overall value according to our analysis. We think that holds true for EWG and EZU, where the difference in scores is large enough to matter. But for EWN the case is less clear-cut: the difference in ALTAR Scores is small, and current momentum clearly favors Dutch stocks, where profitability and earnings are recovering faster, estimates are still being revised higher, and stocks are outperforming. For those who don’t want to wait, EWN offers good value and momentum in your favor.
ALTAR calcClick to enlarge

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Disclosure: No positions