De-Politicizing Climate Activism

Or how Greta Thunberg can create more converts.

“Nature is not a temple. It is a workshop, and a human being is the worker in it.”                               _                                                                                                         Ivan Turgenev

Item 1: The outbreak of coronavirus that threatens to create a global pandemic and the tragic sudden death of basketball star Kobe Bryant both remind us that the unexpected can happen quickly and that we humans live in an environment that can at times be ruthlessly hostile.

Nature, fate, providence, or whatever one chooses to call it, works in inscrutable ways. The virus will spread and endanger millions, if humans do not stop it. It has no will or conscience and would inexorably destroy those who are dearest to us, in a matter of days. And, before downing Bryant’s helicopter and killing him, his young daughter and seven others, fate or gravity did not pause for a millisecond to ponder the sadness that it would inflict on hundreds of millions all over the world through such a senseless death.

Modern society is generally free of deadly viruses and helicopters are generally safe to fly. But it took centuries of human progress to get there in both instances. And it will take more human progress and ingenuity to seal the cracks in our vigilance that allowed the coronavirus to emerge and spread, and the helicopter to crash .

Screen Shot 2020-01-27 at 2.29.15 PM
CDC photo by Dr. Fred Murphy.

Item 2: Last week in Davos, US Treasury Secretary Steven Mnuchin volunteered that climate activist Greta Thunberg ought to get an economics degree before preaching her message to grown-up policy makers. That is more confidence in university economics departments than most of Miss Thunberg’s critics would be willing to concede. It is true that Miss Thunberg’s message is incomplete, but that is not for lack of economic pedigree. The building blocks that are glaringly missing from her campaign are 1) a better understanding of Turgenev’s aphorism on nature and man, and 2) a trip or two to China, India or other fast developing countries.

Read more

Africa: 800 Million Jobs Needed

African economies are in a race to get ahead of the demographic boom.

“Let us share without fear the journey of migrants and refugees.” Pope Francis (@Pontifex) tweet on 27 September 2017.

While some people in the United States are sweating the presence, against the backdrop of a demographically stagnant white population, of the 11 million undocumented immigrants or of the 30+ million other foreign-born residents, there are far bigger numbers brewing in other parts of the world, numbers that are so large that they could affect, decades from now, the life of an American citizen far more than would the rare determined Mexican or Guatemalan who manages henceforth to scale President Trump’s purportedly impenetrable border wall.

In the next decades as was so often the case in history, the future shape of the world could once again be decided in Europe and by Europe’s and the West’s handling of Africa’s incipient demographic boom.

In fact, if you are a generous-minded European who shares the Pope’s noble sentiment and who views the ongoing wave of migrants coming into your country as a benign and positive development; or, if you believe that borders are outdated constructs and that all refugees and other immigrants should be welcomed into the rich world; indeed, if it is your view that anyone who stands in the way of this openness is misguided by racist and nefarious motives, then it behooves you to test the strength of your belief by examining the larger demographic data coming out of Africa and Asia. Read more

Talking About Brexit with Andrew Stuttaford

“So far as the original founders are concerned, the journey [of European integration] continues. The problem is it is not what most British people thought they were signing up for.” ____Andrew Stuttaford.

Screen Shot 2016-06-19 at 6.15.53 AMAndrew Stuttaford is a British-born contributing editor at National Review and a frequent writer on British and European topics. In recent months, he has been an advocate of ‘Brexit’, the United Kingdom leaving the European Union. A few days before the June 23rd referendum, Stuttaford explains the factors that made him increasingly wary of further European integration. Read more

Demography, the Global Emergency

It is not an exaggeration to say that world demographics are entering uncharted territory. For the first time in a very long time, perhaps the first time ever, the dependency ratios (loosely, the ratio of dependents to workers) of all rich nations and of several emerging markets have started rising and will continue to rise for several decades.

This alone would be enough of a challenge for the world economy. But making things more complicated, it is taking place at the same time as the other big demographic transition of our age, the great population boom in some of the poorest nations of the world. Read more

The BRIC and I

The growth prospects of Brazil, Russia and China are dimming, while those of India are flaring.

If one is a lonely number, then ‘I’ could be a lonely letter, at least when it comes to the ‘I’ of the BRIC countries. Brazil, Russia and China all face mounting challenges in 2015 but the road ahead seems wide open for India. The main concern with this opening statement is that it seems to be the view of a large majority of observers.

Still, a majority is not the same as a consensus and certainly not the same as an extreme consensus. In investing, the consensus view is often right but the extreme consensus is absolutely and always wrong. For example, the consensus to buy tech stocks in 1997 was right but the extreme consensus to sell all non-tech and buy only tech in early 2000 was very wrong. When it comes to India, we are with the majority view, edging into consensus territory, but still far from extreme consensus. There remain enough doubters to ensure that this story still has plenty of time to play out.

Our approach to the topic is resolutely from the point of view of demographics. Demographics are not the be all and end all of an economy, but they are a very important vector, one of three very important vectors, the other two being innovation and institutional strength. Looking at the BRIC countries, the demographics of Russia and China are poor and those of Brazil are neutral. By contrast, the demographics of India, though challenging due to the large population size, could hold much promise if this huge newly created human energy can be harnessed and channelled in the right directions.

In general, the best demographic profile for an economy would be a rising population coupled with a declining dependency ratio (the ratio of dependents to workers). The increase in population means that demand for goods and services continues to grow. And the declining dependency ratio means that there is plenty of discretionary capital for consuming and for investing.

The US, Europe and China were in this sweet spot until six or seven years ago. Indeed, much of the world was in this sweet spot, a fact which largely explains the enormous creation of wealth and improvement in living conditions for billions of people in the past few decades. Things got more challenging in the middle of the last decade when dependency ratios in several countries bottomed out and started to rise.

BRIC Countries Total Dependency Ratios
BRIC Countries Total Dependency Ratios

We can’t blame the 2008 crisis on demographics alone. There were many abuses and excesses in the system which brought about the crisis. But it is worth noting that the crisis struck about the same time that a big reversal in demographics was taking place. A crisis would have come any way but instead of 2008, perhaps it would have come in say 2012 if the dependency ratio had bottomed four years later than it did.

Nor should anyone be surprised that Japan peaked in the late 1980s and has been struggling since then. Its dependency ratio bottomed in the early 1990s.  Or that China saw a huge boom since 1980 after it introduced its one-child policy, thus engineering a very steep decline in its dependency ratio. Or that the US recovery has been slow, given that its population growth has slowed down and its dependency ratio has been rising.

USA, Europe, Japan Total Dependency Ratios
USA, Europe, Japan Total Dependency Ratios

As shown in the first chart above, India is the only BRIC country with a declining dependency ratio between now and 2030. Russia and China’s are already rising and Brazil’s will bottom and rise by the end of this decade. Russia seems to be in the worst shape since it has both a declining population and a rising dependency ratio.

Finally two quick words on the other big vectors of economic growth: innovation and institutional strength. Innovation in Brazil, China (ex-Taiwan) and Russia has been slow and cannot be considered a factor in future growth. There was plenty of excess capital to invest in new businesses when the dependency ratio was declining in all those countries but it went instead into real estate and other unproductive investments. Innovation has been slightly better in India and could take a big leap forward with more capital investments in the decades ahead. India also has an immeasurably greater competitive advantage compared to the other BRIC members: its population speaks English.

Institutional Strength can be the subject of endless debate, especially if we try to draw comparisons across countries. All emerging countries have to make significant progress on this account.

European GDP: What Went Wrong

First the two world wars, then a decline in the birth rate.

Newspapers these days are full of stories on World War I which started 100 years ago. They are also full of stories on today’s anemic European economy, as for example with Italy’s negative growth rate in the second quarter and France’s struggle to reach 1% GDP growth this year. At first blush, these two sets of stories are unrelated. But on closer look, it is apparent that the economy today is a distant echo of the war a century ago. And it all comes down to Europe’s demographics.

4 August 1914
4 August 1914 (via Wikipedia)

In my view, there are essentially three main catalysts of economic growth: innovation, demographics, and a favorable institutional framework. To illustrate this, imagine that a firm develops the best smartphone in the world but that there is only a potential market of 1 million buyers. Clearly, the wealth created by this innovation would be far smaller than if the potential market was 100 million buyers. Thus the importance of demographics.

Now imagine that there is a market of 1 billion people but that there is no innovation of any kind. In this case, wealth creation would be greatly stunted and, with few new assets being created, wealth would become essentially a game of trading existing resources. Thus the importance of innovation. Finally, imagine a country where institutions are weak, where contract law is weak, where access to capital is difficult, where the government is corrupt and political risk is high. Here again there would not be much innovation because there would not be much capital or much incentive to innovate. Thus the importance of a favorable institutional framework.

Too many deaths

So going back to Europe, we could say that it has some innovation and that it has a favorable institutional framework, though in both cases to a lesser extent than the United States. What Europe lacks most is a strong demographic driver. It is enlightening in this regard to look at the sizes of European populations in the year 1900 vs. today:

 Population (millions)  1900 2014 Growth CAGR  TFR 
France 38 66 74% 0.5%  1.98
Germany 56 81 45% 0.3%  1.42
Italy 32 61 91% 0.6%  1.48
Russia 85 146 72% 0.5%  1.53
Spain 20.7 46.6 125% 0.7%  1.50
United Kingdom 38 64 68% 0.5%  1.88
Brazil 17 203 1094% 2.2%  1.80
China 415 1370 230% 1.1%  1.66
Egypt 8 87 988% 2.1%  2.79
India* 271 1653 510% 1.6%  2.50
Indonesia 45.5 252 454% 1.5%  2.35
Japan 42 127 202% 1.0%  1.41
Mexico 12 120 900% 2.0%  2.20
Nigeria 16 179 1019% 2.1%  6.00
Philippines 8 100 1150% 2.2%  3.07
United States 76 318 318% 1.3%  1.97

* includes India, Pakistan, Bangladesh and Burma.

Source: Various, United Nations. Data may include errors. Estimates vary due to shifting borders and uneven reporting.

Two important points stand out:

First, in 1900, European countries were not only the world’s economic and military powers. They were also among the most populous countries in the world. By contrast today, Russia is the only country in the top 10 most populous. Then Germany is 16th and France is 20th. More importantly, some of the new demographic powers, India, Nigeria, Egypt, Mexico, the Philippines and Indonesia, are growing at a healthy clip, as can be seen from their Total Fertility Ratios (TFR, see table) whereas European countries are growing very slowly at TFRs that will ensure stagnation or shrinkage in the sizes of their population. A ranking ten or twenty years from now may show no European countries in the top 20 most populous countries.

Second, comparing European population sizes in 2014 vs. 1900 reveals a very slow annual increase in the 114 year period. And this is where the effects of the two World Wars, of the Spanish Influenza and of communism can be seen. Populations have grown with a CAGR of less than 1% per year for the last 114 years.

The United States had fewer casualties in the two World Wars, more immigration and a strong post-war baby boom, resulting in a healthy 1.3% population CAGR and a near quadrupling of the population over the past 114 years. However, as I wrote previously, the US faces slower, sub 1% population growth in the next few decades.

Here is the tally of deaths for some countries in the two World Wars:

 Millions of deaths  WW1 % of pop WW2 % of pop
 France    1.7 4.3%   0.6 1.4%
 Germany    2.8 4.3%   8.0 10.0%
 Italy    1.2 3.3%   0.5 1.0%
 Soviet Union    3.1 1.8% 22.0 14.0%
 UnitedKingdom    1.0 2.0%   0.5 0.9%
 United States    0.1 0.1%   0.4 0.3%

 Source: Various. Estimates vary widely and may include errors.

Estimates of deaths from the Spanish Influenza of 1918-19 vary widely from 20 to 50 million people worldwide. And Stalin’s purges are estimated to have killed over 20 million. Tens of millions of people and a larger number of descendants would have been added to today’s European population had these events not occurred. I made the case last year that Europe’s economies and markets suffer from weak domestic demand and have for a long time been driven by events outside of Europe itself.

Too few births

In general, a large number of countries are facing a more challenging demographic period in the next fifty years compared to the last fifty. Since the 1970s, there had been a steady decline in the dependency ratios (the sum of people under 14 and over 65 divided by the number of people aged 15 to 64) of the US, Western Europe, China and others. This decline is explained by a lower birth rate and was accelerated by large numbers of women joining the work force in several countries. There were fewer dependents and more bread winners than in previous decades.

In future years, dependency ratios are expected to rise due to the aging of the population in most countries and a decline in the number of workers per dependent. In the United States for example, baby boomers are swelling the number of dependents who rely on younger generations to support them in retirement (whether through taxes or through buoyant economy and stock market). But because boomers had fewer children than their parents, the burden on these children will be that much greater than it was on the boomers themselves.

In effect, our demographics have pulled forward prosperity from future years. Had there been more children in the West in the 1970-2000 period, there would have been less overall prosperity during that time, but we would now look forward to stronger domestic demand and a stronger economy going forward.

Note in the table below that the dependency ratio of Japan bottomed around 1990 which is the year when its stock market reached its all-time high; and that the dependency ratios in Europe and the US bottomed a few years ago around the time when stock markets reached their 2007 highs. The fact that several stock indices are now at higher peaks than in 2007 can be largely credited to America’s faster pace of innovation and to near-zero interest rates. Case in point: Apple’s market value has more than tripled since 2007.


India will soon be the most populous country in the world but because its dependency ratio is still declining, its growth profile may improve in future years. The same is true of Subsaharan Africa where the fertility rate is still high but declining steadily thanks to improved health care for women and declining infant mortality. As such both India and Subsaharan Africa could see faster economic growth than elsewhere, provided the institutional framework can be improved towards less corruption and more efficiency.

Europe is in a bind in the sense that, even if it had the wherewithal to do so, it cannot now raise its birth rate without making its demographic situation worse in the near term (by raising its dependency ratio faster). For the foreseeable future, its economy will become even more dependent on exports towards the United States and emerging markets. The new frontier for European exports may well be in the old colonies of the Indian subcontinent and of Subsaharan Africa.

Euro: Austerity, Breakup or Devaluation?

In a new book, Nomura’s lead currency strategist warns that the Euro is on an unsustainable path.

“I wrote this book because I care about Europe”, writes Jens Nordvig in the preface to The Fall of the Euro.

European by birth and living in New York, Nordvig, who is Global Head of Currency Strategy at Nomura, has a unique understanding of the factors that led to the creation of the Euro, and of the impact that the Euro crisis has had on financial markets.

He also has some unsettling insights about the future.

Breakup or Exit

Many people have speculated on the breakup of the Euro. But is a breakup feasible?

Legally speaking, It would be relatively easy for each Eurozone country to redenominate the Euro assets and liabilities which are within its jurisdiction back to its national currency. But, writes Nordvig,

“What would happen to financial assets and liabilities that were outside the jurisdiction of the Eurozone countries if the euro ceased to exist?… What would happen to a loan made in euros by a US investment bank to a big industrial company in Poland? Would the loan now be in US dollars? Would it now be in Polish zloty?… The lender might have one preference and the borrower another. There would be a potential dispute of this nature for every single financial contract…These disputes would be the catalyst for widespread legal warfare…There would be trillions worth of assets and liabilities denominated in “zombie euros” and outside the reach of Eurozone governments… There was no example of this in history.”

If the obstacles to a full breakup seem insurmountable, the exit from the Eurozone by one or several countries look by contrast to be more manageable. Here as with many Euro-related decisions, the outcome will likely be dictated by politics.

Although the weaker countries are seen as likely candidates for exit, Nordvig notes that any benefit they would derive from reverting to their weaker national currencies would be largely offset by the magnified burden of having to service their Euro-denominated debts.

Nordvig also explores the scenario of a German exit, an option which he views as feasible but improbable.

Austerity or Devaluation

A “hard currency equilibrium” has prevailed since 2012 but this equilibrium is entirely dependent on periphery countries (Italy, Spain, Portugal, Greece, Cyprus) sticking to tough austerity measures. In this scenario, adjustment will take several years before a strong recovery can return.

Should austerity prove unsustainable, the Euro may find a “soft currency equilibrium” in which debt limits are ignored and rescue conditions are relaxed. According to Nordvig, this could turn the Euro into a weak currency not dissimilar to the former Italian Lira.

Bond spreads have tightened and stocks have risen since the dark days of 2012 but Nordvig cautions against complacency:

“Investors should be on the alert and not be fooled by the relative market calm observed since the summer of 2012. There is a difference between bond yields that are consistent with fundamentals and yields that have been artificially pushed lower as a result of insurance from the core.”

Europe: Was (Is) It Worth The Trouble?

No for indexers. Yes for macro trend investors. Maybe (but probably not) for bottom-up stock pickers.

European stocks face a unique situation, which is that, outside of the rolling debt crises from Ireland to Iceland to Greece to Spain, their performance has been, and will continue to be, driven by macro factors emanating from outside the European Union.  This is mainly because Europe itself has the worst demographics of any region of the world with declining or stagnant populations in several countries and rising dependency ratios (dependents per worker) in all countries (see tables or, for more on demographics, see Demographic Megatrends of the 21st Century).  Therefore, except for the cyclical recovery which may or may not show up this year or next, the longer-term prognosis for domestic demand growth is far from encouraging for a large majority of European companies.

UN   Estimate Total Fertility Ratio Population (millions)
  2010 2030 2050 2100 2010 2030 2050 2100
 France 1.99 2.04 2.06 2.09 63 68 72 80
 Germany 1.46 1.74 1.9 2.05 82 79 75 70
 Italy 1.48 1.75 1.91 2.05 61 61 59 56
 UK 1.87 1.97 2.03 2.08 62 69 73 76
 Europe  1.59 1.82 1.93 2.06 738 741 719 675

These estimates are from the United Nations medium variant. Note how the dependency ratio declined for the past four decades and is now expected to rise in the next four.

 Dependency Ratio 
1950 1970 1990 2000 2010 2015 2020 2030 2050
 Europe 52 56 50 48 46 50 54 61 75
 USA 54 62 52 51 50 53 56 64 67

It is fortunate therefore that Europe has some tremendous companies, large and small, which are global leaders in their sectors and which can find growth outside of Europe’s borders.  A large number of these companies have had a very strong performance in recent years thanks to slow growth in the US and fast growth in emerging markets, in particular China. Good examples are iconic automaker BMW, luxury goods powerhouse LVMH, chemical giant BASF, retailer Hennes & Mauritz and many many others.

(Note: stock tickers not shown in the text are shown in the tables, using the Bloomberg convention)

Some of these winners have been smaller companies. Consider for example the Finnish tire company Nokian Tyres (NRE1V FH) spun off from Nokia (NOK1V FH) in 1995. Although Nokia has for years been followed obsessively by investors, it is Nokian Tyres which has outperformed Nokia proper by a stunning margin over the past seventeen years (except for 1998-2002 and 2008-09) logging in a nosebleed gain of nearly 4900% since the spinoff vs. Nokia’s decidedly paltry cumulative 11.3% (excluding dividends). Even if you exclude Nokia’s decline after 2007, the outperformance would still be very large. (Note to Apple AAPL watchers: it may be better to look elsewhere).

In the 1990s, there was much talk of the benefits to investors from geographic diversification. Academic research made a case that greater returns could be achieved with less volatility, a case which was then amplified in the financial media by large mutual fund companies. It is not within my scope to rebut this case from a theoretical perspective. For the next section however, I looked at the numbers empirically and they show that a multi-country European stock index would have underperformed the US or other global markets in the past ten and twenty years. In many periods, this underperformance was not accompanied by a correspondingly lower volatility. In fact, the volatility of European markets in 1996-98 and 2005-08 seems to have been higher. A European indexed fund or ETF (VGK, IEV), to put it plainly, was simply not worth it.

Because the vast majority of mutual funds underperform their benchmark index, you could also say that European mutual funds were not worth it.  In the event of a large deviation between a foreign stock fund and its benchmark, such deviation could usually be explained by currency moves rather than the fund managers’ skill at selecting a portfolio of superior stocks.  This was certainly the case in the 2003-07 bull market when US dollar weakness greatly helped all funds which were not fully currency-hedged. Here the financial media usually gave all the credit to the fund managers’ superior stock selection (often alleged) and not enough attention to the currency moves (always real).


European stock indices usually move in step with the US market.  This is not true in every single year but it is true in most years and on a multi-year basis if not in magnitude, certainly in direction. Going back ten years, the European markets moved roughly in line with the S&P 500 except for 2005 when the European index outperformed by a wide margin, and 2010-2011 when the S&P 500 outperformed for two years in a row.

As things stood last December 31st, Europe had returned 38% in a decade and the US 62%. Much of this underperformance can be attributed to the strengthening of the Euro which nearly doubled against the US dollar in 2001-2008. A strong Euro/weak dollar is detrimental to European indices which are heavily weighted with exporters. A dollar-based investor in Europe who did not hedge out the currency would have benefited from the stronger Euro and would have recorded, in the decade ending on December 31st 2012, a gain of 67% from European indices, marginally better than the S&P 500.  On a twenty year basis, the European index returned 162% for a currency-hedged investor and 196% for an unhedged investor, in both cases less than the S&P 500 which returned 227%. (These returns and the ones shown in the table do not include dividends).

Nonetheless, the overall European index (I use MSCI Europe) masks important differences between countries.  Although the EU has gone a long way to reduce these differences, they continue to be relevant because regulation, taxation, work ethic and basic business practices remain largely country-specific. It is trite to say that Germany is the uncontested leader in Europe, but it has emerged by now in early 2013 as the primary beneficiary of the Euro project.  I made a case here that Germany should in a strange way be thankful for Greece, because it is the presence of Greece (and Italy and Portugal) within the Euro sphere which has kept the Euro at a level that is weak enough to help German exports and to sustain the German economy on a growth path.  Without the Euro, the Deutsche Mark would have been stronger against other leading currencies and Germany’s economy would have probably fared worse than it did.

Twilight or sunrise?
Twilight or sunrise?

When you look at country indices going back two decades, a few things stand out quickly. First, the US, UK and Germany have recovered nearly all their losses of 2008-09, whereas France, Spain and Italy have not.  Second, Germany has outperformed the US by a wide margin in the past ten years and in the past twenty years. Spain has also outperformed the US in the past twenty years but that is mainly due to the first decade 1993-2002 when the Spanish stock market, along with Italy, was a huge beneficiary of the convergence trade preceding the adoption of the Euro.  The UK has lagged the US and Germany but has done better than France in the more recent decade.  All in, of the large markets, Germany stands out as a big winner, Spain a winner only in the first decade, Italy as a big laggard, and France and the UK somewhere in between.

The smaller Nordic markets have done exceedingly well over the past two decades.  Norway was greatly helped by its exposure to oil and oil services in the past decade.  Sweden and Denmark did very well in both decades thanks to stellar performers Hennes & Mauritz, Atlas Copco, Novo Nordisk (NOVOB DC) and TopDanmark (TOP DC). Finland’s index benefited from Nokia’s large market cap weighting in the 1990s and suffered from it in the last five years.  Ex-Nokia, the Finnish index would in fact show an impressive performance in recent years. On the two decades 1993-2002, Finland is still the best European performer by far. Like Germany, it has many world-class exporters.

 1993-02  2003-12 1993-12 2003-07 2008-12
 USA  S&P 500 101.9% 62.1% 227.3% 66.9% -2.9%
 Europe Local  MSCI 89.8% 38.2% 162.3% 85.9% -25.7%
 Europe USD  MSCI USD 77.9% 66.7% 196.4% 144.5% -31.8%
 UK  FTSE 100 38.4% 49.7% 107.2% 63.9% -8.7%
 Germany  DAX 30 87.2% 163.2% 392.7% 178.9% -5.6%
 France  CAC 40 64.9% 18.8% 96.0% 83.2% -35.1%
 Spain  IBEX 157.5% 35.3% 248.4% 151.5% -46.2%
 Italy  FTSE MIB 138.9% -30.8% 65.3% 62.8% -57.8%
 Switzerland  SMI 119.8% 47.3% 223.8% 83.2% -19.6%
 Netherlands  AEX 148.8% 6.2% 164.2% 59.8% -33.6%
 Sweden  OMX 174.6% 124.0% 515.0% 119.3% 2.2%
 Norway  OBX 320.0% 332.0% -2.8%
 Denmark  OMX 166.8% 148.7% 563.5% 132.7% 6.9%
 Finland  OMX 596.7% 0.5% 599.8% 100.8% -50.0%
 Brazil  Bovespa 166089.0% 440.9% 898832.0% 467.0% -4.6%
 Brazil USD 111.3% 836.5% 1879.1% 1030.2% -17.1%
 China  Shanghai 74.0% 67.1% 190.8% 287.6% -56.9%
 Hong Kong  Hang Seng 69.1% 143.1% 311.0% 198.4% -18.5%
 Japan  Nikkei 225 -49.3% 21.2% -38.6% 78.4% -32.1%

Among emerging markets, Brazil was a very strong performer.  The Brazilian Real’s devaluation against the US dollar in the 1990s explains much of this performance.  But Brazil has been one of the best global performers even on a dollar basis.  China has had a respectable performance, but perhaps one more muted than many would have guessed from the steady barrage of headlines about the rise of the Chinese superpower. And Japan as we know has been a dismal place to be an indexed investor, except for brief spurts in the mid-90s and in 2003-07.

Net net Europe has underperformed the US on both a one decade and a two decade basis whereas several emerging markets have performed in line or much better than the S&P 500.  All of this may be discouraging if a person worries about the indices too long. But for those who ignore the indices, Europe offers outstanding opportunities.


After the closet indexers have left the room (or clicked away from this page), we can now talk about two incontestable reasons to invest in Europe: 1) an early warning system and 2) a leveraged play on other markets or trends.

Europe as an early warning system

The first reason is that early signs of an impending crisis often emerge in Europe before they do in the US. This is true not because Europeans are more prescient than Americans, but because their stock market is more fragmented into individual countries.  It would be the same here if each state of the United States had its own stock market.  In that case, we might have , for example in 2007, picked up on signs of distress in the subprime market through the Arizona, Nevada or Florida stock markets several months before they became visible in national indices temporarily held up by other, more buoyant sectors.

If a manager has some holdings in Europe, he is likely to pick up on signs of trouble before his competitors do and long before they appear in the major headlines. This was certainly true in 1997 and 1998 when European banks with large exposures to faltering Asian markets and to Russia telegraphed signals to the bullish markets in the late spring and early summer that all was not well. And it was also true in 2000, when stodgy companies like Alcatel (ALU FP) and the old state-owned telecom operators were trading at very inflated multiples normally reserved for hot new companies coming out of California.

This ‘Europe as an early warning system’ delivered again in the crash of 2008, in particular for people who were paying attention to Ireland. The S&P 500 recorded a small gain in 2007 but Ireland which had wholeheartedly embraced the housing bubble saw its index fall by 27%. Italy too was down in that same year, but by a less alarming 7%.

When the US subprime crisis erupted in 2007 and 2008, there was in Europe widespread belief and barely concealed schadenfreude that the Americans, already out of favor on the continent because of the Iraq war, were getting their comeuppance and that Europe, reinforced by a growing Euro sphere and a billion eager Chinese customers, could now promote its economic success as a new model for other countries. As we know, reality came back unsparingly when all Euro markets crashed in late 2008.

In 2011-12, the US market was to some degree driven by the daily news flow from Greece, Spain, Italy and other parts of Europe. For a while, exploding sovereign yield spreads threatened to throw in reverse the conversion trade of the late 1990s and to tear the Eurozone apart. And now Europe has combined bailouts and austerity and the US has combined bailouts and stimulus, with the net result that Europe is in recession and the US is growing modestly. In the coming years, it will still be a good idea for US investors to keep an eye on Europe, even if its importance has diminished in the global sales mix of American companies because of emerging markets.

I recognize that getting an early distress warning is by itself an insufficient reason to draw investors into Europe.  Insurance is a good idea but no one wants to overpay for it or feel that it has become a distraction. A larger and more positive reason to invest in European stocks is that they offer an excellent way to get exposure to other markets.

Europe as a leveraged play on other markets

Investing in Europe to get exposure to other, non-European, markets and trends can be exceptionally rewarding.  Most of the news that may push many large and midsize stocks higher or lower comes from outside of the European continent, chiefly from the US and China.

Exposure to the US dollar and US economy

Until China became a major source of export demand for European goods, the US economy was the most important driver of earnings growth for a large number of European firms. For this reason, the exchange rate of the dollar vs. European currencies was an important factor in the earnings of these companies. European stocks were a leveraged play on the US dollar. If the dollar moved 5%, some stocks would move 10 or 20%. It is true that you could instead invest directly in the currency markets but stocks gave you more leverage and also gave you the possibility of gaining from periodic efforts to create shareholder value. In the 1990s, for example, you had a wave of restructurings, followed by the tech boom. In the 2000s, you had the commodity boom and the rise of emerging markets.

Exposure to the Chinese economy and other emerging markets

Europe’s relationship to the US dollar and US economy still exists but it has been diluted by the rise of another very large client, the Asia-Pacific region. For a majority of large and midcap European companies, the Asia-Pacific region has replaced the US as the main source of sales growth. China and Japan are obviously the two main poles of demand, with China showing by far the fastest growth rate in the sales mix of European firms. One of the best ways to get exposure to the growing Chinese economy has been through a portfolio of European exporters which are global leaders in their industries.  In fact, such a portfolio would have handily outperformed the stock markets of China and Hong Kong in recent years. This may not be intuitive but investing in European exporters has been one of the best ways to invest in Chinese growth.

Nowhere is this more true than in luxury goods and prestige brand companies which have seen a growing percentage of their revenues coming from the Asia-Pacific Region. Luxury goods companies Hermès, Richemont and Swatch now have about 50% of their sales in that region.

 Luxury & Spirits     Market Cap   AsiaPac % 
     Billions USD   2011 Sales 
 Burberry  BRBY LN           9.49 34%
 Campari  CPR IM           4.44
 Diageo  DGE LN         74.33 10%
 Ferragamo  SFER IM           4.44 34%
 Heineken  HEIA NA         42.50
 Hermes  RMS FP         35.91 46%
 LVMH  MC FP         91.18 27%
 Pernod Ricard  RI FP         33.49 39%
 PPR  PP FP         27.16 24%
 Remy Cointreau  RCO FP           6.46 39%
 Richemont  CFR VX         46.74 51%
 SAB Miller  SAB LN         79.62
 Swatch Group  UHR VX         29.85 54%

European companies are by far the world leaders in luxury goods, and the French among them own some of the strongest brands. LVMH is the largest luxury goods company in the world, with an extensive portfolio of brands, including Louis Vuitton, Bulgari, Dom Perignon and Tag Heuer (see full list of LVMH brands here).  France also has Hermès and spirits companies Pernod Ricard and Remy Cointreau. Switzerland has the Swatch Group, the parent of Blancpain, Breguet, Omega, Glasshutte and, as of this year, Harry Winston (see Swatch Group brands here). Also in Switzerland is Richemont, the parent of Cartier, Montblanc and Vacheron Constantin (see Richemont brands here). Italy has Salvatore Ferragamo, spirits company Davide Campari, eyeglass leader Luxottica (LUX IM) and leather company Tod’s (TOD IM). Germany has automotive luxury with BMW, Porsche, Audi and Mercedes.  Porsche and Audi are part of Volkswagen, and Mercedes is part of Daimler (DAI GY). All of these countries also have many more luxury goods companies which are not publicly listed. I have also written about the luxury goods market in BMW, Louis Vuitton, Swatch: Can the Boom Continue?

The US is active in many of these sectors but has few dominant companies.  Coach (COH) and Tiffany (TIF) offer excellent products but cannot match the pricing power, brand supremacy, geographic footprint and cash flows of Hermès, LVMH or Swatch. US firms have also enjoyed better growth in their home market and have not felt the need to expand into the Asia-Pacific region as aggressively as the Europeans have.

Another sector which has benefited from the growth of emerging markets is industrials.  Here too, Europe has some global leaders in autos, chemicals, machinery, industrial gases, aircraft and heavy trucks. In the first nine months of 2012, for the first time ever, BMW sold more cars in China than it did in the United States.  BMW also owns Rolls Royce cars and the Mini brand. And Volkswagen in 2012 delivered nearly four times as many cars in the Asia-Pacific region as it did in North America. All three of BMW, Volkswagen and Daimler are present in both the luxury sector and the industrials sector: BMW through its own brand, Rolls Royce and Mini; Volkswagen through its own brand, Porsche, Bentley and Audi and its ownership stakes in Scania (SCVB SS, 46% of capital) and in MAN (75%); and Daimler through its Mercedes cars and trucks and Freightliner trucks.

Industrials   Market Cap AsiaPac %
    Billions USD 2011 Sales
Air Liquide AI FP          38.73 22%
Assa Abloy ASSAB SS          14.86 9%
Atlas Copco ATCOB SS          34.79 28%
BASF BAS GY          89.56 20%
Bayer BAYN GY          79.07 21%
BMW BMW GY          62.00 17%
Duerr DUE GY            1.75 39%
EADS EAD FP          39.13 29%
Henkel HEN GY          34.96 15%
KUKA KU2 GY            1.51 24%
MAN MAN GY          17.48
Rolls Royce RR/ LN          28.61
Volkswagen VOW GY        108.79 14%
Zodiac ZC FP            6.46

Because of its Airbus division which competes with Boeing, EADS may be of particular interest to US readers. Last year, I wrote about the epic battle between the two aircraft manufacturers in Boeing vs. Airbus: Orders and Profits. Since then, EADS has undergone some important changes in its shareholding structure. Its free float which is now 54% is expected to rise above 70% after large legacy shareholders reduce their stakes. Management has expressed a new commitment to transform the company from a conglomerate of state-owned or state-sponsored businesses into a more ‘normal’ company which is more responsive to shareholders.

Finally, Europe has some outstanding companies in the mass-market consumer and retail sector which expect to grow in emerging markets as well as in the United States.  Notable among them are Hennes & Mauritz and Inditex, the parents of retailers H&M and Zara, and cosmetics giant L’Oreal.

 Consumer/Retail     Market Cap   AsiaPac % 
     Billions USD   2011 Sales 
 Adidas  ADS GY           19.63 16%
 BAT  BATS LN         100.55 28%
 Beiersdorf  BEI GY           22.32
 Bic  BB FP             5.78
 Hennes & Mauritz  HMB SS           60.76
 Hugo Boss  BOSS GY             8.47
 Inditex  ITX SM           88.35
 L’Oreal  OR FP           91.98
 Nestle  NESN VX         226.60
 Unilever  UNA NA         118.07 41%

What Europe does not have

Outside of indexing and macro driven investing, what about simple bottom-up investing?  Ideally, we would like to invest in names which are insulated from the big macro questions of US and China growth.  However, it is difficult to imagine many large or midsized European stocks doing well in the event of a Chinese slowdown and US recession.  Under this scenario, it would be best to find a handful of smaller names with their own domestic growth dynamic.

Yet, if this seems like a desirable strategy, the US market is more fertile ground to find such small companies for two reasons: 1) the US has more new companies which go public and 2) these companies can grow domestically for longer because the size of the domestic market is many times larger. A good example is Whole Foods (WFM) which was still a small cap name in 2000 (and again briefly in late 2008). It now has over 300 stores in the United States (and 15 in Canada and the UK) and added ten new stores in the last quarter, eight of which were in the US. A similar European company would have hit the wall in its home market at a much earlier stage.  Outside of the large trends described above, there is, in my view, little reason for a US-based investor to put money in a small European company unless it is really a very unique and irresistible story with no US equivalent.

The clear Nordic air
The clear Nordic air

You might think that Nokian Tyres fits that profile. But even here, much of the company’s growth is directly linked to demand from Russia, which is itself tied to the rise in energy prices and ultimately, to the growth of the Chinese economy.  Should that economy slow down, the price of oil would decline which would dampen Russian demand for all sorts of goods, including tires.  Because European companies have a smaller domestic market than their US counterparts, it is more difficult to find good secular growth stories which are not dependent on the global growth picture.

If we redefine a company’s domestic market as the whole of Europe instead of just its home country, we find a handful of steady growth names. A notable pan-European success is the Swedish retailer Hennes & Mauritz which has 406 H&M stores in Germany, 226 in the UK, 182 in France, 177 in Sweden and hundreds of others elsewhere. It also has 269 in the US (from none in 1999) and 111 in China. H&M is among a handful of retailers that have gained market share in several markets (another is Inditex’s Zara). Today, the company’s growth is very much tied to globalization given that its cash flow (and ability to invest) is derived from a very high gross margin, the result of sourcing its products from 700 independent suppliers mostly in Asia. Hennes’ gross margin has expanded from 44.6% in 1998-99 to a blistering 59.5% in 2012 (it was over 60% in 2010-11). As a comparison, Gap’s gross margin in 2011 was 36.2%, down from 45.3% in 1999.

Other interesting growth companies include food caterers Compass (CPG LN) and Sodexho (SW FP), eye lens maker Essilor (EF FP), lock manufacturer Assa Abloy (ASSAB SS), diabetes care leader Novo Nordisk (NOVOB DC), health product suppliers Coloplast (COLOB DC) and Getinge (GETIB SS) and oil services companies Technip (TEC FP), TGS Nopec (TGS NO) and Seadrill (SDRL NO).  Yet they all seem in varying degrees to have grown to their current size because of demand from outside Europe. I maintain that the odds of finding several small or mid cap stocks which will grow year after year from domestic demand alone are significantly lower than in the US.

Europe also does not have a large investable technology sector. Among larger companies, there are SAP (SAP GY) and ASML (ASML NA). Every country has a smattering of smaller companies which operate in services or in manufacturing niches.  What some Europeans call technology tends to be larger scale and sometimes state-sponsored, an R&D effort which may very well be on the cutting edge but which has more to do with machinery and engineering than with computers, data processing or the internet. This includes high speed trains and nuclear plants where the French are leaders. Perhaps there will be another new technology where European companies will take a lead, but if the history of mobile phones is an indication, this leadership will probably be short-lived.

The conclusion is two-fold:  1) the main reason to invest in Europe has in recent years been non-European demand for some superior products and 2) Europe has been the first place to see early signs of an emerging crisis. One has to approach European investing with a macro perspective developed elsewhere, by analyzing demand in the US and China, and then choose the global leaders which are best leveraged to that macro perspective. Obviously, this could work in reverse with a vengeance.  Any evidence of a prolonged Chinese slowdown would tumble some luxury goods and industrial stocks by 20%, 30% or more.

Because Europe is now in recession, a recovery would certainly result in a cyclical upturn in earnings for many companies. Value investors today should be sifting through the long list of beaten down names, among them the long suffering French volume auto producers Peugeot (UG FP) and Renault (RNO FP). But European demographics are poor and cannot contribute a sustained source of demand.  This means that, beyond the cyclical recovery, the longer term growth driver for most European equities will still have to come from outside Europe.