In their canonical 1934 work, "Security Analysis", Benjamin Graham and David Dodd coined the financial term "margin of safety." The idea behind margin of safety was to buy a security when it was being valued inappropriately low by the market. Graham, who would later teach Warren Buffet at Columbia, is considered the father of value investing, a discipline that picks securities who appear inexpensive based on fundamental analysis of the price relative to earnings, book value, or cash flow.
While value investing sometimes entails rigorous analysis, other times ideas come across that are relatively simple. Currently, The European Equity Fund (EEA) trades at over a ten percent discount to its net asset value. This closed-end fund is managed by Deutsche Funds, and the underlying stakes it holds in a host of large-cap European companies can be purchased through this vehicle for less than ninety percent of their current market value.
The basket of companies held by EEA also trade at a discount relative to the S&P 500 index (SPY). The graph below compares the S&P 500 versus the holdings of EEA on the basis of several multiples.
The underlying companies in EEA trade at about a third less than the S&P 500 based on a comparison of price to trailing earnings, price to book value, price to cash flow, and price to sales. The portfolio companies in EEA also pay over twice the dividend rate of the S&P 500 constituents. Whether coupling this one-third discount and the additional ten percent discount of the investment vehicle is enough of a haircut for the economic uncertainty in Europe becomes the overarching question.
In addition to EEA's portfolio companies being roughly half the size of the S&P 500 constituents, EEA is also more heavily concentrated in its top holdings. Both this size factor and the relative lack of diversification should lead to more variable returns for which a potential investor must be adequately compensated. An examination of these top constituents can help potential investors gauge the riskiness of this fund. The top ten holdings of the fund include some of Europe's largest companies.
As of year-end 2011, Total SA (TOT) was the fund's largest holding at 4.7% of assets. The France-based company is one of the world's five oil and gas super majors. The company's P/E multiple of 7.7x places it at a discount of sixteen percent discount relative to the average multiple of the three largest U.S. energy companies (XOM) 10.37x, CVX 8.27x, and COP 8.67x). Given that Total SA sells its products to a global marketplace priced in dollars, the uncertainty over the macroeconomic picture in the eurozone and its common currency could be overstated in the price of this stock. While the company grew earnings by 11% in 2011, the stock opened up 2012 trading at a marginally lower price than the first trading day of 2011.
The second largest holding (4%) in the fund is Sanofi (SNY), the world's fourth largest pharmaceutical company as ranked by prescription sales. This Paris-based multinational trades at a lower multiple of earnings (13.1x) then U.S. based Pfizer (PFE) at 16.6x, Merck (MRK) at 18.9x, or Abbott (ABT) also at 18.9x.
The third largest holding in EEA (3.8%) is German business software giant SAP AG (SAP). SAP is the largest enterprise application software provider and the third largest software company in the world. In 2011, the company boasted record profits prompting a recent dividend increase. The company's 2011 revenue was roughly split between Europe and a combination of its Americas and Asia Pacific geographic segments.
Telefonica (TEF), the Spanish telecommunications giant with operations in 25 countries recently released 2011 results, which included record free cash flow generation. The fourth largest holding in the fund (3.7%) gets 40% more of its revenues from Latin America than it does its native Spain.
The fund's fifth largest holding (3.4%), Vodafone (VOD), is a British multinational telecommunications company that ranks as the world's largest in that sector by revenues. The company operates in thirty countries, including the United States, where it owns a 45% stake in Verizon (VZ) Wireless. Voadfone trades at a forward price to earnings ratio roughly thirty percent less than Verizon despite having a major stake in the U.S. company's higher growth wireless segment.
Unilever (UN), the consumer goods powerhouse, is the sixth largest holding in the fund with a 3.4% weight. The company trades at a slight discount relative to the multiples of American comparable Proctor and Gamble (PG). Unilever at 17.2x trailing earnings and 1.55x sales compares favorably to P&G at 19.6x trailing earnings and 2.15x price to sales.
Banco Santander (STD) is the seventh largest holding and the biggest financial position of the fund at 3.3% of assets. While the high unemployment and real estate slump in its native Spain will continue to weigh on results, the bank reported 51% of its 2011 profits in Latin America in 2011.
Danone is the eighth largest holding in EEA, and claims world leadership in fresh dairy sales. This food products multinational claims renowned brands Evian, Dannon, and Actimel. The company does not have a U.S. ADR.
The ninth and tenth largest holdings are comparatively smaller than the top eight, and are both recent additions to the fund's top holdings. TGS-NOPEC Geophyiscal (3.2%) is a Norwegian geoscience data, software, and services provider that should benefit from strong oil prices driving increased exploration expenditures. Rounding out the top ten is Aggreko PLC. The Scottish company is the world's largest temporary power generation company.
Comparison of Price to NAV Historically
While the fund does trade at a substantial discount to its net asset value, this discount has persisted for many years.
In an effort to close the discount of the fund relative to net asset value, the fund began a Discount Management Program in early 2011. The program requires the fund to conduct a tender offer for shares if the fund averages a ten percent discount over a twelve week measurement period. The fund also has a standing share repurchase program, buying roughly 0.3% of shares outstanding in January 2012. These efforts could help close the gap between the market price of the fund and its net asset value, which could provide upside for holders.
EEA holds a diversified mix of stakes in European corporations operating internationally. The equities of these companies are trading at lower multiples relative to their American counterparts. Purchasing the fund offers potential investors an opportunity to buy these companies at a further discount. Hopefully, this margin of safety proves a compelling entry point into solid businesses domiciled in the downtrodden European markets.