What If Greece Thrives Outside the Euro Zone?

At virtually every analyst meeting I have attended recently - including the one I just left - it is assumed that Greece will be forced to leave the euro block.

The consensus thinking is that Greece's profligate spending habits, and its reluctance to adopt the austerity measures that the rest of euro countries have tried to force on its citizens, have made it inevitable that Greece will be forced to exit.

But what if Greece actually does better outside the euro?


Tuesday's Financial Times carried an editorial authored by Arvind Subramanian titled "Why Greece's exit could be the eurozone's envy".  Here's an excerpt:

There is an overlooked scenario in which default is not a disaster for Greece.  If this is the case, the real, more existential threat to the eurozone might be a very different one, in which the Greeks have the last laugh. Consider that scenario.

The immediate consequences of Greece leaving or being forced out of the eurozone would certainly be devastating.  Capital flight would intensify, fueling depreciation and inflation.  All existing contracts would need to be redenominated and renegotiated, creating financial chaos....

But this process would also produce a substantially depreciated exchange rate...And that would sent in motion a process of adjustment that would soon reorientate the economy and put it on a path of sustainable growth.  In fact, Greek growth would probably surge, possibly for a prolonged period, if it adopted sensible policies to restore rapidly and sustain macroeconomic stability.

http://www.ft.com/home/us

Mr. Subramanian notes that other countries have gone through similar wrenching economic events, and have come out stronger than before:  South Korea; Russia; and Argentina all were forced by external events to change their economic ways, and their economies recovered nicely..

And this is Germany's problem.

Germany has been a huge beneficiary of the euro idea.  Unemployment is at lows not seen for at least two decades, and corporate profits have soared. 

While the consensus thinks that Germany has the strongest negotiating hand, it could in fact be one of the weaker players, since it needs the euro to survive in order to continue to enjoy strong economic growth.

Think of it this way:  if Greece does better outside the euro block than it had as part of the euro, why would other countries not wish to follow its lead, and leave the euro.

Mr. Subramanian continues:

Suppose that by mid-2013 Greece's economy is recovering, while the rest of the eurozone remains in recession.  The effect on austerity-addled Spain, Portugal and even Italy would be powerful.  Voters there would not fail to notice the improving condition of their hitherto scorned Greek neighbor.  They would start to ask why their own governments should not follow the Greek path and voice a preference for leaving the eurozone.  In other words, the Greek experience could fundamentally alter the incentives for these countries to remain in the eurozone, especially if economic conditions remained grim.

In other words, could a Greek exit from the euro be Germany's nightmare?

European Economies Refuse To Cooperate With Bearish Forecasts

If you were only to read the financial press, and watch the plunging prices on European stock markets, you could easily reach the conclusion that Europe is in the depths of a major economic recession.

But data released yesterday tell a different story.

Helped by a robust German economy - which grew at +0.5% in the first quarter, or 5 times greater than expected - euro zone economic growth in the first quarter was flat overall.

There were some countries that showed significant slowdowns - especially Italy, whose economy contracted by -0.8% during the first quarter - but the yesterday's data surprised pundits and analysts with a resiliency that belied the euro bears.By comparison, the U.S. economy rose by 0.5% in the first quarter.



Now, to be sure, flat economic growth is hardly cause for champagne.  On the other hand, the data suggests that corporate Europe is doing better than expected.

Here's how the New York Times described the results this morning:

Still, along with growth in Germany that was much better than expected, the data provided mild respite from the gloom that has pervaded Europe in recent days. Despite the figures, major stock indexes retreated Tuesday in Europe, and Spanish and Italian bond yields, or interest rates, edged up on news that those two countries’ economies continued to contract. Indexes in the United States, however, were modestly higher in afternoon trading. 

The euro zone, by not slipping into recession in the first quarter of 2012, ran counter to expectations. Growth in the region was zero compared to the previous quarter, according to the figures, from Eurostat, the E.U. statistics agency. 

http://www.nytimes.com/2012/05/16/business/global/euro-zone-economy-skirts-recession.html?_r=1&ref=business 

So here's the continued conundrum that frankly puzzles me.

Yes, the euro has serious structural issues.  And, yes, it is possible that Greece will be forced to leave the euro block (even though the Greek economy grew in the first quarter as well).

But the simple truth for now at least is that European stock markets are trading at valuation levels that are at 10-year lows despite the fact that business in general continues to grow above expectations.

Willem Buiter Talks About Europe

As part of my continuing search for more information about investing opportunities in Europe, I went to hear a lunch speech yesterday given by Willem Buiter.

Mr. Buiter has long been involved in European economics.  In the past he has served as an external member of the Bank of England's Monetary Policy Committee as well as chief economist for the European Bank for Reconstruction and Development.

He is now a professor at the London School of Economics, and is the chief global economist for Citigroup.

There was a pretty big audience yesterday. European politics are driving much of the activity in the financial markets, and every day it seems there is a new development that needs to be studied and understood.

Mr. Buiter spoke for almost 90 minutes, so I will not attempt to capture all of his comments here.  However, although he also talked briefly about China (it will be OK, according to Buiter), here are some of the highlights from his talk specially focused on Europe:

• Europe faces three issues: insolvent sovereigns; insolvent banks; and near-insolvent sovereigns.  However, all three issues can be addressed by aggressive intervention by the European Central Bank (ECB).  The euro will survive;
• The fiscal shape of the combined countries of the euro zone is actually better than the United States.  However, with 17 different member countries - rather than 50 states - fiscal solutions are much more difficult;
• The near-term problems in the euro zone are largely related to its banking system.  The total size of the European banking system is 330% of euro GDP, while in the U.S. it is less than 100%, making the problems of the European banks that much more important;
• Greece will probably leave the euro zone, but the departure is not as easy as some would think.  In particular, leaving the euro block would be devastating to the Greek economy  - who would want a separate new Greek currency knowing that it was kicked out of the euro block?  Buiter thinks hyperinflation in Greece will inevitably follow any departure, accompanied by a severe economic recession.  Greece's leader obviously understand this;
• The ECB is the only institution capable of keeping the euro going.  Buiter estimates that it could pump 2.9 trillion euro (!) into the system without creating any inflationary pressures.  In addition, the ECB has 500 billion euro in gold reserves that could be used to help the banks;
• Buiter thinks that ultimately bank shareholders will be wiped out in many countries as part of the recapitalization efforts;
• Germany does not have as much influence as many believe.  Its financial institutions hold huge amount of euro debt, and a collapse of the euro would be devastating.  Leaving the euro zone would hurt Germany tremendously.  Moreover, the euro has been a boom for German companies;
• France has "so much fat" - public sector spending accounts for 58% of GDP.  President Hollande will probably try to enact some of changes he discussed during the recent campaign, but Buiter doubts these will amount to very much. In particular, Buiter joked that if Hollande raises the maximum tax rate to 75% (as he proposed during the election), 50,000 Frenchmen will simply move to London, and help the British real estate market;
• Much of the euro zone is actually doing better than commonly believed.  Spain, for example, is showing export of growth of +13% yoy, and is actually taking market share from other European economies.  If the financial system can be stabilized, growth can resume, and some of the severe unemployment issues can be addressed.

I would only quibble with Mr. Buiter on his thoughts on the banks.

I don't think that the European authorities will nationalize the banks. While this move might have some emotional appeal, the simple truth is that running a large multinational bank is very difficult (just ask Jamie Dimon of JP Morgan!), and no government wants to get involved.

When France nationalized its banks in the early 1980's, it was a disaster.  Lending collapsed, and the economy suffered.  Hollande well remembers this - he was serving President Mitterand at the time - and would rather simply use the banks as convenient scapegoats rather than take them over.

Bottom line:  The euro survives, and baring any major financial policy blunders, business should continue to muddle along.

Bargain Hunting In Europe

I wrote a piece last Friday noting the incredible values now to be found in the European stock markets.

Quoting global strategist Michael Hartnett of Merrill Lynch in a piece from last Friday:

European equities as cheap versus German bonds in almost 90 years. The spread between European equity dividend (4.29%) and German 10-year government bond yield (1.52%) was 277 basis points.  This yield spread has been surpassed only once (303 bps in Feb '09) since 1925.

This morning, with European markets once again in turmoil, 10 year German bunds now offer 1.45%, making the relative attraction of European equities even more startling.

Saturday's Financial Times had a long story about Carlos Slim, the Mexican multi-billionaire.

Mr. Slim has made most of his reported $69 billion net worth through investing in markets that others have fled, yet still offer compelling fundamental value.

In an article entitled "Mexico's meticulous mogul with an eye for a bargain", here's what Mr. Slim is up to these days (emphasis mine):

In 1982, as Mexico lurched towards a financial crisis so brutal it triggered the Latin American debt crisis, Mexican and international investors stampeded for the exit. Except for one:  Carlos Slim.

That was the year Mr. Slim, now the richest man in the world...set out on a shopping spree to Mexican companies at fire-sale prices across industries as diverse as aluminum, tobacco, insurance and rubber...

That {value-investing} approach drew him into the now-booming Brazilian telecoms market in 2002, when fears of a socialist government under then newly elected Luiz Inacio Lula da Silva were crushing prices.  It also led him into Argentina when it was still in disarray after financial collapse in 2001.  Now a similarly distressed situation has led him to the eurozone:  shares in KPN {a Dutch telecoms company}, which has operations in Germany, Belgium and Spain, had fallen 30 percent this year before Mr. Slim made his move.

http://www.ft.com/home/us

Now, to be sure, the problems facing the euro zone are very real, and very serious.  Investing in Europe these days will require patience, and a recognition that while the eventual returns could be substantial the ride will be a bumpy one, to say the least.

However, it seems to me that if you are looking for markets that are trading on emotion rather than fundamentals, Europe is your first and only stop.

In Search of a One-Handed Market

Former U.S. President Harry Truman famously used to say that he wished he could find a one-handed economist.

Truman was frustrated by the fact that he never seemed to be able to get a definite answer on the issues of the day from his economics team.

Whenever he would ask for an opinion, Truman related, he would inevitably get a response that started with "Well, on one hand" but then shortly followed with a completely different opinion that started with "Of course, on the other hand".

Hence Truman's desire for a one-handed economist.

If Harry Truman was investing into today's economic climate, he too might be frustrated by the lack of a cohesive economic pattern.

For example, government bond yields in "safe haven" countries like the U.S., Germany and the U.K. are approaching record lows. 

So investors are worried, right?

Well, maybe, but why are corporate bond yields also approaching record lows.  Investors are not only gobbling up bonds from high grade issuers like IBM but also riskier credits as well.  Ford, for example, was able to borrow 3-year money at 3% earlier this week, despite the fact that its credit rating remains below investment grade.

Then there's more:  earnings estimates for companies are gradually being moved higher after first quarter results for not only U.S. companies but European corporations as well.

Yet global analyst Michael Hartnett at Merrill Lynch wrote this morning that (I have added the emphasis):

European equities as cheap versus German bonds in almost 90 years.  The spread between European equity dividend yield (4.29%) and German 10-year government bond yield (1.52%) was 277 basis points.  This yield spread has been surpassed only once (303 bps in February 2009) since 1925.

German bond yields are at lower levels today than during the depression of the 1930's. Indicates Europe very oversold. As does the price relative between European and U.S. equities, which is trading 3 standard deviations below norm.

Finally, consider the price of gold.

Gold prices have plunged by -15% since reaching a peak last September, and now stand at roughly the same level as a year ago.  Someone who had heeded the advice of the gloom-and-doom crowd last fall and bought gold rather than stocks would have suffered a relative return shortfall of nearly -30%.

So if we are approaching financial Armageddon - as many pundits are suggesting - why is gold (the ultimate safe haven) losing value?

Hal Prince on Broadway

My wife and I headed over to the Museum of Fine Arts (MFA) last night to hear Broadway producer Hal Prince give a talk.

Hal Prince has produced some of the most memorable musicals on Broadway over the past half century.  Shows like West Side Story; Fiddler on the Roof; Cabaret; Evita; and The Phantom of the Opera were all produced in whole or in part by Mr. Prince.  Not surprisingly, he has won the most Tony awards (21) of anyone ever involved in theater.

Last night's talk was hosted by Stephen Terrell from Emerson College. There were also two separate musical interludes featuring students from Emerson performing some of memorable music from Mr. Prince's shows.

I always come away from these talks learning so much about what goes on "behind the scenes" in music and the arts, and last night was no exception.

Many of the musicals that Hal Prince produced have, of course, become American icons, yet at the time they were first introduced critical reaction was often less than favorable.

West Side Story, for example, features a story and music that is some of the most memorable in our culture. However, when the show was first performed in 1957 the reviews were largely negative, according to Mr. Prince. Audiences found it difficult to relate to a love story set in the Puerto Rican community in New York City, and the music written by Leonard Bernstein was too different than what audiences were used to hearing.

Mr. Prince related how he became involved in West Side Story.  The show's rehearsals had not gone well, and it lost its original backers.  Desperate for money, Bernstein and lyricist Stephen Sondheim called Prince and his partner Hal Wallis in Boston to come to New York.

It was the last chance for West Side Story.  Its unconventional story - for the late 1950's - was falling on deaf ears in the Broadway community, and had Prince and Wallis decided to not take a chance the show probably would have never seen the inside of a theater.

But as Mr. Prince related last night, he immediately loved both the music and story, and the rest is history.

This was a pattern repeated in many of Prince's shows, and moderator Terrell asked him why he seemed comfortable to challenge the conventional wisdom.

Prince said that it had always been his opinion that Broadway producers should produce what they considered quality work, and not base their decisions on what they think the public might like.

Ironically, he said that he personally did not like musicals when he was growing up.  While the music was often memorable, the stories were banal and formulaic, and as a young boy he was often bored at the theater.

So when he decided to get involved in producing Broadway shows, he was determined to make the kind of shows that he found interesting, and hope that the audiences would follow.

This, in his opinion, is no longer the case on Broadway, which is part of the problem in theater today.  Audiences are surveyed as to what they might like to see, and shows are produced accordingly.  However, using public opinion polls to make artistic decisions inevitably leads to watered-down productions.

That said, Prince said several times that finances play a critical role on Broadway.

He noted, for example, that a typical Broadway show now costs 40x what a show would cost when he first started in the business.  With so much money at stake - shows often have to run for at least a year before they become profitable for their backers - it is hard to take a chance on unconventional performances.

Naturally, because of what I do for a living, I was reminded of a paragraph written by legendary investor Benjamin Graham in his book The Intelligent Investor.

Although Graham was speaking about buying stocks - and not producing Broadway shows - it is clear to me that both Prince and Graham looked at their work in the same fashion.

Here's what Graham wrote:

If you have formed a conclusion from the facts and if you know your judgement to be sound, act on it - even though other may hesitate or differ. (You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right).

My Two Cents on Facebook

It has been a long time since an IPO has been as eagerly anticipated as the Facebook offering that is scheduled to be priced next week.

Facebook management was in town yesterday to pitch the deal. Here's how the Boston Globe reported it this morning:

The excitement surrounding Facebook Inc.’s forthcoming Wall Street debut arrived in Boston Tuesday as the company’s top executives pitched the massive social media company to hundreds of potential investors, and Mark Zuckerberg, its 27-year-old celebrity chief executive officer, met privately with some of the city’s premier money managers.

It was the second stop in a nationwide “roadshow’’ ahead of the social network’s initial public offering, when it will sell shares on public markets for the first time. The company could begin trading as early as May 18, and is expected to raise up to $11 billion in the biggest-ever stock launch for a technology company. Last week, it set a $28-to-$35 price range for its shares.

http://www.boston.com/business/markets/articles/2012/05/09/facebook_pitches_boston_investors_on_coming_ipo/

Facebook has also prepared a 30 minute video for potential investors:

http://facebook.retailroadshow.com/show/retail.html?m&u=6642#

In my experience, it is difficult for investors to make money in an IPO.  By definition, companies sell shares to the public at the highest possible price, and at a time that is most advantageous to itself, and not to the investor.

I remember when Apple came public in 1980.  The hype was similar to Facebook, and for a while Apple's stock soared.

But then reality set in. Steve Jobs was fired, and Apple nearly went out of business.  Apple of course has since rebounded in a spectacular fashion, but it took many years.

I suspect that Facebook shares will enjoy a strong start when they are priced next week, but then the real work begins:  justifying its lofty valuation.  This will take time, and I also expect that Facebook investors will experience some pretty volatile times.

We have seen numerous IPO's of internet properties over the past year - Groupon, Zynga, Pandora Media and LinkedIn - and all wound up trading below the IPO price within months of the offering (although LinkedIn has since rebounded).

I am not as skeptical as some about the valuation of Facebook.  True, the projected offering price is 99x last year's earnings, and 50x revenues, but Facebook's potential growth could be phenomenal.

I am probably not buy Facebook shares for clients at the initial offering, but I am also going to keep a very close eye on the company.  If they can figure out a way to direct advertising to their 900 million users, it may very well be that we'll look back 5 years from now and wonder why we weren't buyers.


Although I did not attend yesterday's event, my colleague Rich Sipley did, and here's a small excerpt from an email that he wrote to all of us when he returned (thanks Rich!):

 

-        Mark Zuckerberg and his black hooded sweatshirt did not make it.  COO Sheryl Sandberg and CFO David Ebersman led the discussion.  Both were well dressed.

-        Investors were asked to be at the hotel at 7:15.  

    A few got there as early as 6:30 (not me!).  Rather than casually filing into the meeting room, we were kept in the lobby as a security detail kept people from going up the stairs.  Around 7:30, they started letting people go through 25 at a time.  I’m guessing there were 250 people or so.  The meeting didn’t really get started until 8:05.

-        Ebersman made a few initial comments, mostly revolving around the concept of the company – the words “social”, “connected” and “experience” were seemingly in each sentence in one form or another.  They then threw it open to Q&A.

-        The questions were fairly powder-puff and revolved mostly around ads on Facebook and how they provide a different experience to marketers in the way they can target their message.  

    The sense is that they will introduce more ads and charge more for each ad going forward.  Sandberg stressed points that from a marketing client perspective, ad dollars spent on Facebook have the highest ROIC and that marketers need to rethink how they market on Facebook (they will get more bang if they target their ads rather than take their print message, which isn’t all that targeted, and just port it to Facebook).  She told stories of Ford’s introduction of the new Mustang and Pepsi’s involvement in the Indian Cricket championship as success stories.