Thursday, February 28, 2013

Another Buying Opportunity in European Stocks?

Early last summer, when bearish sentiment on the euro was at its peak, European stocks were trading at incredibly cheap levels.

No one wanted a piece of some of the world-class companies that could be found in Europe, regardless of the fact that P/E multiples were mostly in the single digits and dividend yields in some cases were 3x as much as sovereign government bonds.

All that changed, of course, in late July when European Central Bank (ECB) head Mario Draghi declared the ECB would do "whatever it takes" to save the euro.  European stocks began to rally, and by the time 2012 ended the major European indices had climbed by more than +20% from late July lows.

Earlier this week, Italians voted their displeasure with the austerity measures of current Prime Minister Monti.

In what was widely seen as a protest vote, former Prime Minister Silvio Berlusconi  and populist comedian Beppe Grillo received large dollops of the popular vote, and at this writing the actual composition of the new Italian government is very much in doubt.

The international financial community was largely been stunned by the Italian election results, since incumbent Monti was seen as the voice of fiscal reason.  Austerity is never popular, particularly when it is administered by a leader whom the Italians viewed as merely doing the bidding of the Germans.

Spain, too, has experienced its difficulties since the beginning of the year. Several large bankruptcies occurred in January due to the -40% decline in housing values in Spain since 2007. The trembles in the Spanish system  raised once again questions not only about the state of the Spanish banks, but also the creditworthiness of billions of Spanish debts held by banks throughout Europe.

So, with all of this as a backdrop, do we once again have the opportunity to buy Europe on the cheap?

In my opinion:  not yet, although I still believe that a longer term investment in European equities will reap handsome rewards for investors.

Unlike last summer, when both the bond and stock markets showed the intense investor anxiety over the state of the euro, most of the market reaction seems to be fairly mild.

Here's James Mackintosh writing in Wednesday's Financial Times:

Italy's bonds have only had a worse day once since the euro began, and the country's chaotic politics was responsible then too.  Back in November 2011, the market took fright when prime minister Silvo Berlusconi delayed his resignation.  This time, the market was afeared because Mr. Berlusconi, along with populist comedian Beppe Grillo, did so well in the inconclusive elections.

The 40 bp jump in the 10-year bond yield looks appalling.  Yet, it only rose to 4.9 per cent.  This looks terrible compared with safe Germany, at 1.45 per cent, or even Colombia, paying 3.3 per cent on its dollar bonds.  But Italy was at these levels just three months ago.  All that has happened is the weeding out of the excessive optimists who bought this year.

The relatively sanguine mood of investors was also captured in the remarks by some of the speakers at a private equity conference in Berlin taking place this week.

Here, for example, were the comments of David Rubenstein of the Carlyle Group* as reported in Wednesday's New York Times:

David M. Rubenstein remains bullish on Europe.

Speaking at an industry conference here, Mr. Rubenstein, the co-founder of the Carlyle Group, said European companies were now more open to selling distressed assets, and that sales related to bank bailouts by local governments could provide one of the best opportunities.

“Whenever you can buy assets from a government entity in Europe, you should do it,” Mr. Rubenstein told attendees at the SuperReturn private equity conference on Wednesday. “You will see distressed sellers sell assets at judicious prices.”

His comments echoed remarks he made at last year’s conference, when he described Europe as “one of the world’s greatest investment opportunities” because “there’s no part of the world that will see so much assets sold at a discount as in Europe.”

My impression is that most market participants are much calmer than last year simply because there is so much evidence that the European community is totally committed to preserving the euro block.

*full disclosure:  the Carlyle Group is a major shareholder of Boston Private Financial Holdings, which is the holding company for my employer.

Is Now the Time to Buy AIG?

On Tuesday I went to hear Josh Stirling, who covers Property/Casualty (P&C) insurance stocks for Bernstein Research.

I have only seen Josh a couple of times, but I have been impressed with his knowledge of the industry and of the companies he follows.

P&C insurance stocks have done well in the last couple of years. While earnings growth has been reasonable for most of the stocks, investors who want exposure to the financial sector but have been wary of the bank and brokerage stocks have found a refuge in the P&C insurance group.

Their relative outperformance has driven valuations on many of the P&C insurance stocks to the upper end of their historic ranges.  According to Josh, many of the stocks may continue to perform well, but it is less likely that we will see the strong relative performance that has characterized the group - an assessment that I largely agree with.

That said, there is one stock that Josh has a "table pounding" buy on:

American International Group (AIG).

AIG, of course, was in such tough shape during the financial crisis that the government had to inject billions of dollars to keep the company afloat.  If it hadn't, AIG surely would have failed, and its vast size and huge credit exposures would have been catastrophic.

In 2012, however, the Treasury sold its stock in AIG (at a profit) and the company is once again totally owned by public shareholders.

Current management of AIG is determined to restore its reputation, and has already started the long process to getting the company back to business.

However, its troubled past, and the fact that AIG remains a very difficult company to analyze, has left its stock trading at just 0.5x tangible book value. Most of the other stocks in the PC insurance space, by contrast, are trading at a modest premium to book value.

If AIG can get its operations together, it is not out of the realm of possibility for the stock to trade in-line with its peer group, which would mean big profits for shareholders (in its heyday AIG traded at 4x book, but this would seem unlikely to occur again).

That said, the AIG story still carries significant risks. Although Treasury no longer owns a part of the company, AIG's business operations are still being monitored by the Federal Reserve, making it less likely that it will be able to earn the mid-teen's ROE that many other large PC companies are achieving.

In addition, AIG remains a "show me" story in terms of its operations.  On paper it would seem likely to be able to improve returns, but it is not yet clear that it has the team in place to do this. The current low valuation of its stock reflects the market's skepticism.

Josh, however, feels that for the intrepid investor AIG could be a double or triple in the coming years.  I want to do more work on the stock, but I am definitely interested.

Josh is not the only one who thinks that AIG could continue to work in here.  I came across this piece on the blog Seeking Alpha - here's an excerpt:

The discount from book value for shares in AIG will shrink as the company continues to improve its coverage ratio, which in turn would improve AIG's rating. AIG also has a goal of being investment-grade in 2015. Such a goal will support the view that AIG shares will keep rising. Resuming a share buyback and initiating a dividend would signal management confidence in AIG's interest coverage ratio. This in turn would attract more buyers for AIG shares.