Point of Maximum Pessimism: Time to Buy Europe?

Morningstar analyst Alastair Kellett outlines how to benefit from a possible rebound in European equities

Alastair Kellett 9 May, 2012 | 2:27PM
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Things are awful in Europe right now and everybody knows it. A number of countries have fallen back into recession; others have debt-to-GDP levels in excess of 100%. Ireland and Portugal have had to be bailed out by the European Union and the International Monetary Fund, and Greece has seen a full-blown restructuring of its debt. Amidst all this, many European banks are being dragged down by their exposure to the debts of these countries and some are struggling to stay afloat. There is palpable fear that if Spain or Italy or France wavers, the contagion effects could do irreparable damage.

With all this going on, it certainly sounds as though Europe is a terrible place to invest.

But it’s important to note that everyone already knows that the situation is awful. Market commentators discuss it every single day, as do people in restaurants and on buses. In fact it’s hard to imagine sentiment concerning the region being any more negative.

Point of Maximum Pessimism: Time to Buy Europe?
Could this be, to use a phrase made famous by value investor Sir John Templeton, the “point of maximum pessimism”? Templeton believed it was from just this type of abysmal situation that contrarian-minded investors could use to reap the biggest rewards.

Recent history provides just such an example. After the global financial crisis, equity markets staged a powerful rally off the bottom, with the MSCI World Index rising by more than 70% over the subsequent two years. With the full benefit of hindsight, the best time to have been buying stocks, February 2009, was also the time when things looked most grim, pundits were competing with each other to predict how much worse things would get, and people would have thought you were nuts to be putting money into the markets.

For now, uncertainty, and therefore risk, remains high in Europe. But the European Central Bank has shown a willingness to go to great lengths to provide liquidity to the markets. Its Long Term Refinancing Operations (LTRO) scheme has made vast amounts of money available to be borrowed by European banks at extremely low rates. The so-called “Sarkozy trade,” where banks used a portion of that liquidity to buy high-yielding sovereign debt, has increased the vulnerability of the banks’ balance sheets but also given them a powerful carry trade to bolster earnings.

Another consideration is that as bleak as the macro picture inside the eurozone might be, many large multinational companies within Europe are getting an increasing portion of their revenue and earnings from outside the continent. Much of their growth will depend more on the burgeoning wealth of developing countries than the economic mess closer to home.

On its current valuation the exposure looks tempting. The price-to-earnings ratio of the EURO STOXX 50 Index is 10.7, versus 15.3 for the S&P 500. And it looks to have some diversification benefit as well: over the last 10 years, it has exhibited correlation to the local currency returns of the S&P 500 and the MSCI Emerging Markets Index of 88% and 77%, respectively.

The EURO STOXX 50 is down 19.30% in the 12 months through April. Over the past five years, it is down 34.59% cumulatively, and even over 10 years it is down 6.69%.

Of course, a strategy of catching falling knives doesn’t always work. A classic example of a value trap is Japanese equities, which have been languishing for 25 years. This market continues to burn value investors who are hoping for a turnaround.

Capturing the Returns of the EURO STOXX 50 Using an ETF
Still, investors looking to gain exposure to European equities can do so very effectively with the db x-trackers EURO STOXX 50 ETF (DBXE). Launched in January 2007, the ETF has roughly €1.4 billion in assets under management and has waived its total expense ratio (TER), which is a very rare thing. Go look again at the ETF’s Morningstar Fund Report page, the TER is 0.00%. That’s something you don’t see every day (and will be explained in more detail later in this article).

Suitability of the db x-trackers EURO STOXX 50 ETF
db x-trackers EURO STOXX 50 ETF is best suited as a core building block for a portfolio, providing broad exposure to many of the largest companies in the European Economic and Monetary Union (EMU). The index is well diversified by industry, although on a geographic basis it does tilt heavily towards France and Germany, which is important for investors to keep in mind when monitoring their overall portfolio mix.

Over the trailing 10-year period the EURO STOXX 50 Index has had annual volatility north of 20%, implying it may be more appropriate for those with a lengthy time horizon that can stomach the ups and downs that have historically accompanied this exposure.

The fund pays out dividends from the underlying stocks on an annual basis, currently at a yield level of 3.95%. It is also available in a version that reinvests all dividends (DXET).

Portfolio Construction of the db x-trackers EURO STOXX 50 ETF
The fund employs synthetic replication to provide exposure to the underlying benchmark, entering an unfunded swap with counterparty Deutsche Bank AG. The fund uses investors’ cash to buy a basket of securities, which is then used as collateral in the swap. Deutsche Bank provides full transparency on the substitute basket, which is made up entirely of equities. At the time of writing, the value of the substitute basket was 99.42% of the fund’s net asset value, implying there was minimal counterparty risk to the fund.

Under the terms of the swap, the counterparty agrees to provide the fund with exposure to the total return of the underlying index, net of any costs or fees associated with providing the exposure, in exchange for the return on the substitute basket.

Meanwhile, it’s important to keep in mind that db x-trackers has waived the TER for this fund. The bank is able to extract revenues from this ETF through securities lending, as well as dividend tax optimisation. That means this particular ETF has the distinction of carrying the lowest explicit costs compared to its direct competitors, which will be outlined below.

Alternatives to the db x-trackers EURO STOXX 50 ETF
There are plenty of other products offering very similar exposure to the db x-trackers EURO STOXX 50 ETF. These include:
- Source EURO STOXX 50 ETF (SC0D)
- iShares EURO STOXX 50 (EUEA)
- ComStage ETF EURO STOXX 50 (C050)
- Amundi ETF EURO STOXX 50 (C50

Of these ETFs, the iShares product is the biggest, with assets of €3.2 billion.

Meanwhile, for alternatives to market capitalisation-weighted exposures, there are Ossiam ETF EURO STOXX 50 Equal Weight (OSX5) and PowerShares FTSE RAFI Europe Fund (6PSC).

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.