Why to Go Active Versus Passive

European equities still offer opportunities

Originally published in the January 2015 issue

I’m going to highlight what we have seen lately, what we can do with it, and how we can implement in our portfolios a strategy that we believe should be rewarding. First of all, let’s focus on Europe, the STOXX 600 sectors, returns last year. Healthcare was up around 20%; utilities, telecoms, consumer staples, discretionary, IT, and financials were in no-man’s-land, hesitating; and materials, industrials and in particular energy were  significantly down and underperforming.

I think there are two conclusions to highlight. The first one is that the oil price collapsed, and it was probably a surprise to a few. If not, it would not have come down like it did. This has an influence on energy of course, but also on materials, because it’s influenced by energy in a way, by ricochet, and also on industrials. In industrials you have a lot of capital goods, and for capital goods, you have a lot of oil services, and so on. All these companies have been influenced by the collapse in energy prices. I think very few investors anticipated that at the beginning of last year.

The second point to highlight, if we know that most stock pickers last year – at least in Europe – have underperformed the benchmark, is that it’s one of the worst years for alpha generators. I think it has been driven largely by the collapse in long bond yields.

The collapse in long bond yields has driven up the re-rating of many companies which have relatively stable cash flows, whether it’s telecoms, utilities, or healthcare. There are other reasons, of course, but I think, underlying all kinds of things that have been happening in each sector, the collapse in bond yields is something that almost no stock picker was able to anticipate. That was a very strong driving force. That is why most stock pickers have underperformed last year; they didn’t anticipate the collapse of the oil price, and they didn’t anticipate the collapse in long bond yields.

How do we position ourselves? I don’t really know what this means, but let’s say, we’re slightly underweight in defensive stocks; we’ll be overweight in cyclicals, and we’ll be underweight in financials. Why? What we know for a certainty is that the oil price has halved, and that will create a big shift in value from the oil producers to the oil consumers. It will also generate economic growth, especially in Europe, because Europe is importing oil. So that’s why we are overweight cyclicals and slightly underweight defensives.

A number of defensive stocks have done well last year, because of the evolution of the bonds component, but I have no clue where the bonds are going, personally. Where I think we can monitor relatively well: oil prices, at least in the short term, and also it takes time for the equity markets to price in all the consequences of such a collapse in oil prices. Six months ago nobody anticipated that. Many people had flawed views, especially on shale oil; they were totally underestimating the increase in shale oil production. The oil price collapsed recently, just two, three months ago, and most people, they actually look at not spot prices but futures. Futures have been lagging on the downside. Futures, to start with, were lower than spot prices; they were sometimes around 90, where the spot was at 110.

Spot prices collapsed fast, to 90, 80, 70, and so on, but futures prices, three years, five years forward, and so on, fell – but much more slowly. Recently, of course, the three-year, the five-year is falling, but it highlights that it takes time for people to adjust their mid to long-term expectation on oil prices.

The other factor is that it takes time for such a move in oil prices to affect many goods and services. We all know that the price at the pump is folding fast, and that’s what you hear in the news. You pay less when you go to the petrol station; that’s adjusted relatively quickly, but the price of oil has an impact on almost everything we buy. It has an impact on plastics, on clothes, on food, and just about everything else.

But, it doesn’t necessarily – or it almost never – affects the price immediately. It takes several months, several quarters, and this gives us a bit of time to take advantage of this. We believe that is a certainty, so this is big, and this is highly likely. That’s what we have to take advantage of. Who are the losers which had not taken into account a low price, and who are the winners? We’ll come back to that.

We try to avoid taking too big bets on things we don’t really control, which are more murky. Interest rates are difficult, for us at least. European politics, or European monetary policy, is difficult. That is why we are relatively light on financials, because in theory banks, in particular, should be doing extremely well in such an environment, because a lower oil price should increase European GDP at least (everything else being equal) 0.8%. It has moved up a bit, the markets have moved up a bit, but the expectations on European growth were very low.

With such an impact on oil prices, I know European politics is often very disappointing, but it doesn’t take much to be optimistic. That’s why we’re a bit more exposed to cyclical stocks. On financials, in theory, loan growth should increase; there should be a pick-up in loan demand – to buy cars, to buy consumer stuff, to invest for companies and so on.

In practice, however, it is a little bit murky, because we have been constantly asking all these banks for more and more capital. We’re asking them for more and more liquidity ratios, for more and more compliance; if you talk to many of the large banks, they are very afraid to lend. They are telling you that the problem is that people don’t want loans. We would like to lend to them, but they don’t want loans. We don’t think that’s the case; we think it’s the banks who don’t want to lend.

They’re afraid of lending; they don’t have that much to lose if they don’t lend, and they don’t really know what’s going to come, what’s going to be the outcome with Basel III, with Greece, so they’re a bit afraid. If you have some new banks with fine balance sheets, with no legacy assets, they’re usually lending fast, but they are tiny. There are very few huge new banks in Europe.

So, at least for now, we are light on the financials, because there could be some unexpected bad news which we don’t really control. In other sectors – the cyclical sectors – things are more simple and obvious. And many parts of the world are going to benefit from what just happened. There’s going to be a shift of value from the oil-producing countries to the oil-consuming countries, wherever they are. It could be in Europe, but it could be Japan, it could be China, India, and others, and I think this will benefit a number of European companies.

We’ve seen a lower cost of capital in Europe recently. God knows where yields will go; it seems so far that the ECB has lost the ability to control inflation expectations – they have collapsed recently. They were close to 2%, which is the ECB target; they’ve collapsed to close to 1% recently, and all the meanwhile, the ECB has been talking but not doing much.

Having said that, you can see that peripheral bonds, Italy and Spain, have been converging fast with Germany and France. What is clear to me is that Spain, in particular, has implemented a number of reforms. The cost of labour in Spain has collapsed. It used to be too high, and now it’s rather cheap. It’s not the cheapest in the world, but it’s much cheaper than it was. There has been a mega-adjustment. We talked to a number of industrial companies who have plants in, sometimes, 60, 70 countries around the world: in the last two years, where has the cost of labour improved the most in the world? Spain.

Spain also had putmore flexibility in its labour markets and has reduced the cost of government. They fired hundreds of thousands of civil servants relatively quietly. They have restructured very strongly the banking sector, with a lot of mergers. The banking sector in Spain is relatively well provisioned (although not always capitalised, as we saw with Santander). And then something that is often misunderstood by many investors: they also have restructured the energy sector, or the electricity sector. This is a huge cost to the community, and is often misunderstood.

For 10 years or more before, with previous governments, they implemented a very foolish policy driven by ideology – going into renewables – and this has led to a massive increase in electricity cost for the community, and it was highly detrimental to the Spanish economy. Rajoy very quietly has destroyed all this, and it’s the change that matters, not the absolute level, and the change is dramatic.

The very worrying country on that front is Germany. Merkel has generated hundreds and hundreds of billions, if not trillions, of hidden liabilities for the German people with her energy policy. It’s an absolute disaster. You can’t see economic growth in Germany with this energy policy. So I think Spain will continue to converge and surprise on the upside.

Beware of political instability, but frankly, it’s an open question. We don’t invest in Greece; we have no clue what can happen. I don’t know if anybody has. It’s a guessing game, and it’s very difficult to anticipate. We shall see.

We have seen the purchasing managers indices (PMIs) in Europe wobbly last year. Should we worry? Maybe, maybe not. I think part of this wobble was due to Russia invading Ukraine, which was a very negative surprise, very poor for sentiment, which has been hurting the German and the Italian economy, and also, definitely the lack of action from the ECB, who have wasted a year.

But again, the collapse of bond yields, the collapse of the oil price, the fall of the euro (which is not major, actually, if you look against the basket) all this, added to the fact that expectations had been very low recently, should be enough to drive positive surprises. And there are a number of other encouraging signs.

If you look at the ECB lending surveys, it’s not great, but it’s slowly improving. Why? Because in the last few years, with the 2011 great crisis, and so on, Europe was totally out of sync with the rest of the world; where many other countries were booming, had huge credit expansion, Europe was contracting fast. There were a lot of austerity measures, typically in countries like Spain and others. This is over. Even the Greek economy is actually doing well. If you exclude politics, Greece is doing great, and many other countries are actually doing well, quietly. Many of the eastern European countries, I think, are on the right footing as well.

These lending surveys and so on, they don’t really take into account, I believe, what we’ve seen in the oil price, so it should continue. People should probably borrow more to buy cars, to buy whatever consumer goods they want to buy. Companies aren’t sharing a lot of cash; people are very bearish on the euro, it’s the flavour of the month, but Europe is exporting a lot at the moment. Actually, the world is short of euros; Europe’s trade balance is very, very positive, and it’s going to get dramatically better with the collapse of the oil price. All this should put money in the pockets of consumers, and probably companies as well.

So, what do we do? Again, we will try to be out of the stocks that have not priced in the fact that the oil price may be as low as $50 for a while. It could be oil-producing companies; it could be oil services companies; it could be some capital goods companies, some chemical companies, and so on. It should be a minority in the stock market. But some of them will be hurt massively.

Usually, when the oil price is collapsing, the pain is fast and is very concentrated in a few hands, while the gains are disseminated for the entire community; everybody benefits from lower oil prices, and the gains take more time to get through. So, the stock market is a little bit afraid these days, each time the oil price is going down, but over time, the winners will emerge.

It is true that, when oil prices go down, there are risks, as we have seen in the past: LTCM, the coup in Russia, and so on. One of the major risks is a liquidity event by a leveraged entity. Could it happen again? Possibly. We don’t really see where that could come from these days. Hedge funds are not as leveraged as in the past (or we don’t know it, at least) and we haven’t seen any weak hand, and real strong forced seller recently, on this collapse.

It is true that Russia is in deep pain, but they still have some reserves. They don’t have as many US dollar loans as 15, 20 years ago. Maybe they’ll be in trouble in a year, but just not immediately. The rouble has collapsed, but is it going to trigger a sell-off in major markets? It doesn’t seem to be the case.

So what do we buy? Well, we try to buy the winners, and the winners will benefit in many ways. They will benefit because their top line will probably be underestimated. They will benefit because their costs often will go down. There is a lot of oil in their cost, and there will be a multiplier effect.

Usually, when commodities are expensive, you have bear markets for equities. When commodities are cheap, you have bull markets for equities. This can last many years. The other thing I want to add is that, for us, the oil price was the last shoe to drop. If you look at most prices, the peak of the commodity market should have been 2008, but there was QE in the US, and there was a huge expansion programme in China, which led to a massive rebound in all these commodities.

Many commodities peaked around 2011 and have been falling ever since. Look at coal and many others – natural gas, nickel, amongst others. There hasn’t been any new investment in all these commodities for a while now. Some of them are trading below the cash cost of almost half of the industry worldwide. Usually, these commodities that have been falling fast were a commodity where you couldn’t speculate much. There was very little in the way of a futures market, and they could not really be stored; it was too expensive. So, it’s just supply/demand.

In others, like oil, like precious metals, there was a lot of speculative money. You can store it, especially precious metals (oil, a little bit less, of course, but you can play a lot with futures). There was major activity around this. I remember talking to some Latin American pension funds, and they had an amazing portion of their assets – and these guys managed, at this time, around $1 trillion – full of Petrobras and things like that, and on top of that, they were full of oil and gold outright, through futures, ETS, etc. It was “the” bubble. And, that was already a few years ago.

But, for a number of years, you could see as well that the oil price should trade in a band of global GDP, and for the last few years, it was at a very, very high level. So, we thought that was just too expensive, but it was not dropping; there was no catalyst. People were expecting a strong demand from China that actually didn’t really materialise, especially in 2014, but there was no real catalyst for new production. Usually, when you have a high price in a commodity, it encourages more investments, but there were not many new large fields.

We are looking at Brazil; we are looking at Argentina; we have looked at many places over the last few years, but it never really took off. Argentina because of Mrs Kirchner – she destroyed the outlook there; in Brazil, because of the massive inefficiencies of the Brazilian politicians, and Petrobras and so on, it’s delayed and delayed and delayed forever. So, we had to wait for 2014 for shale oil in the US. What was striking for us during the middle of this year was how misunderstood this was, in Europe, at least. There are a number of reasons.

People were talking to the big oil companies in Europe, and all these big oil companies, they missed it like they missed shale gas 15 years ago. Shell, BP, Total, all these guys, they missed it again. So they’re telling everybody, “Well, it’s not very important,” and there were a lot of misconceptions. The other thing is if you look at the depletion rate, it’s falling fast. In two years’ time, I think it’s falling 50%, and so people are shocked, and they say, “Well, this is frightening; this is not going to last.” They are used to different economics on the other oilfields.

We believe they just don’t understand the economics. I read stories, 10, 15 years ago, about shale gas: that it was going to stop very quickly after two, three years. Well, I don’t think that’s the case. Natural gas in the US is doing fine. The price is still extremely cheap, and these guys are still pumping like hell. You can see the same misunderstandings on shale oil today. It’s a little bit amazing, but it’s true.

It’s quite simple, at the end of the day. We will focus on consumer discretionary stocks. We’ll focus on retail; we’ll focus on technology; we’ll focus on all the sectors that will benefit from a consumer resurgence, especially the mass consumer, not the very rich people, not the plutocrats, because it benefits more the middle class and the lower middle class, in relative terms. It’s much more important for the lower middle class if he pays less for clothing, for whatever, than for millionaires.

One example is Ryanair. We already had Ryanair for many years, because since the IPO in 1997 the stock has delivered around 20% per annum, total return. If you actually adjust for the fact that they made a couple of mistakes over that period (they lost a lot of money on Aer Lingus; their buy-backs were usually not very well timed). The multiples today are cheaper than the IPO in 1997.

Ryanair has the best-in-class unit cost, which is the key competitive advantage, but when the oil price is high, this advantage is reduced, because their overall cost is growing faster than their competitors. So, the gap in cost is reduced. But, when the oil price is collapsing, their advantage gets bigger, so they’re able to gain more market share, to make more money, and destroy competitors. Also, Ryanair learned their lessons from 2008 – they under-hedged. What matters is not what they are doing in absolute terms; it’s what they are doing compared to their competitors.

Most airlines are hedged around 90% for 2015, so forget it. A lot of airlines are already hedged 80%, 85%, sometimes 90%, for 2016. Ryanair is not very much hedged for 2016. That is a gain of several hundred million euros. It’s a one-off, but it helps. They spotted this one well. And, more structurally, while everybody was piling up to buy the new fancy planes from Boeing and Airbus, because they’re consuming something like 15% less, and paying over the odds and being in the queue, quietly Ryanair went to see Boeing and extracted a very good deal for an old generation – new planes, but an older generation – and they made a calculation that, because they are paying such a low oil price, at $110, it was still a very good deal for them. Imagine what it’s going to be at $50. It is most of the capital employed of these airlines, planes, and they have just locked in, for a number of years, a massive competitive advantage.

And, just recently, Ryanair was trading barely above 10 times earnings; it was such a compounder with such wonderful economics. Why don’tpeople buy it? Why are they all piling up on Nestlé, or whatever? It’s an airline. And, that’s where the opportunity is. Simple. There are other airlines in the world which may benefit. The problem is, you have to find an airline that has strong internal dynamics, and as you probably know, it’s usually not the case for most airlines. For Ryanair, it’s a certainty, I think.

Nicolas Walewski is the Managing Partner of Alken Asset Management LLP, which he founded in July 2005. Previously, he was the fund manager of the Oyster European Opportunities Fund at Banque Syz. He began his investment career in 1993 with Credit Lyonnais in Paris as a currency options portfolio manager and then in Frankfurt as an index options portfolio manager. Subsequently, he was a buy-side analyst specialising in media and information technology across Europe and a fund manager responsible for the European equities portfolios. He graduated from Ecole Polytechnique, Paris, and holds a Master’s degree from ENSAE (National College of Statistics and Economics).

This article was extracted from a presentation at the Notz Stucki Investment Conference held in Geneva on 13 January 2015.