With Europe now heavily integrated, fund managers are finding themselves faced with the tough task of having to apply both industry and country knowledge against a backdrop of globalisation
Over the years, Europe has become an increasingly popular home for British investments. Recent developments creating closer ties with Europe have been used to persuade all sorts of institutional and individual investors that Europe is their new 'home' market.
This has been combined with arguments about the economic attractiveness of the region and all the opportunities for finding undervalued companies with superior long-term growth potential.
In the past, European funds were managed with a heavy emphasis on country allocation, which with about 20 countries within Europe to consider, was always a fairly difficult task. But there was very sound thinking behind this approach. Each country had its own currency, fiscal and monetary policy, and created its own environment for business, as well as many other cultural differences.
Although there are still large cultural, economic and political differences between the regions, there has been a trend over the past 10 years towards industry screening in assessing relative attractiveness of investments as the key asset allocation driver in European portfolios. This trend has been accelerated by the introduction of European Monetary Union (EMU) and the euro.
Even before the obvious integration consequences of EMU, sector allocation was an important part of the investment process for European investment managers. This is because European countries had already agreed to pursue similar macro-economic policies within an agreed monetary framework. This process of integration ended with the successful introduction of the euro.
The strength or weakness of a particular currency had been a key driver in deciding between companies operating in different companies. But with the introduction of the euro, this differentiation was eradicated. In addition, with the single currency came an agreed policy framework that took away many key differentials between companies operating in different countries.
From an investment management perspective, the decision-making process had changed. Before stock picking, industry allocation became more influential than country allocation.
strength in Euroland
There is little doubt that the introduction of the new currency has been a success. The Euroland capital markets have grown significantly and continue to do so, and it seems only a matter of time before the currency becomes the world's second reserve currency ' after the US dollar.
As well as the euro and closer economic co-operation and integration between markets, another key factor in reducing the importance of country allocation for investors is the gradual but very strong globalisation of world markets. This trend is now apparent in almost all markets ' with the same underlying influences and drivers for companies doing the same thing ' wherever they are located.
Good examples of this globalisation are companies in the semi-conductor sector. The price and market for these products is determined not at a country level by local factors, but on a global basis. The fortunes of these companies are determined by global factors.
more global outlook
Increasingly, listed stock market companies are representatives of larger businesses. Most of these are not national in outlook or market. Their sphere of operation is global and therefore, global influences are most relevant.
For example, companies closely associated with Germany, such as Siemens or DaimlerChrysler can no longer be classified as 'German' companies. The scope of their business ' subsidiaries, operation and exports ' mean they are global, and therefore the key business drivers are likely to be global factors. In this way, the importance of country allocation has been further reduced.
Many economists have failed to recognise the significance of these profound changes and continue to take a traditional route of forecasting macro-economic indicators on a country-by-country basis. But country allocation obviously does still have an important part to play.
An example of how this becomes important is where there are separate currencies within the region, for example, in the case of companies in Denmark, Norway, Sweden, Switzerland and the UK. At least some of these countries are expected to join the euro. The situation will change again shortly when the new wave of 10 applicants join the European Union in 2004. These countries generally have functioning capital and stock markets and will join the exchange rate mechanism and then adopt the euro. Investment managers will be looking carefully at their integration, but the increased size of the area using the new currency will further diminish the importance of country allocation versus industry allocation.
Another reason for promoting industry allocation above country allocation is the management of the investment process itself. There are some 20 countries in Europe that require analysis, which is a tall order for even the biggest investment houses. Analysis of Finland, for example, adds no discernible value to assessment of Nokia. However, there are only 10 main industry sectors: consumer discretionary, consumer staples, healthcare, energy, financials, industrials, materials, IT, telecoms and utilities. It is easier to manage an investment process based on 10 sectors than 20 countries.
But investment managers need to be careful. The allocation of companies into sectors is driven by the index manufacturers and some companies can be misplaced in the regional industry indices or cross between the two or even three industries in their business activities.
However, even in the new, post-euro environment, convergence still comes with differentiation. European countries can continue to grow at different rates, despite traditional economic thinking that the different countries must grow within the same currency zone at broadly the same rate. For example, look at the lower growth of Italy or Germany compared with the higher growth of Ireland, where businesses are supported by, among other things, supportive rules and regulations.
So how can investment managers apply industry and country knowledge in a heavily integrated Europe and against a backdrop of globalisation? Here is an example. European growth was about 0.7% in 2002, is expected to be roughly 1.2% in 2003 and should accelerate to 2.7% in 2004. This might indicate that a portfolio should get good exposure to financial services, including banks and insurance sectors. Having decided this, the next question is which banks.
It is at this level that country factors are still significant. For example, listed German banks, faced with a home environment of unfair competition from state-owned banks are operating in a worse business environment than that of banks in countries such as France and Ireland, where the government has provided positive support. Banks in France and Ireland might therefore be preferred.
Staying with financial companies, there are also key differences about the way people live across Europe that have a big impact of financial institutions. For example, in The Netherlands there is a strong bias towards home ownership compared with Germany and therefore their home loans would be a more important contributor to business profits.
Companies exposed to consumer spending are well positioned and investment managers might be considering obtaining good exposure to companies in the consumer spending and consumer discretionary sectors. Again, country factors need to be taken into account.
Regulatory constraints on retailers in France, for instance, on the size and location of stores, protect smaller, less efficient retailers and limit the growth of country and international lenders. On the other hand, the Swedish-based retailer Hennes & Mauritz has grown up in a flexible retail environment and is now successfully operating across Europe and expanding into North America.
Country allocation is likely to have far more influence for investors in smaller European firms. These companies tend to be more domestic market-focused and are therefore more influenced by single country factors.
So country allocation remains a part of the decision-making process, but the trend towards globalisation and regionalisation continues, increasing economic and business convergence between countries. As a consequence, industry allocation should continue to be an increasingly important decision for investment managers.
Most importantly, the euro has been quickly established as a unifying European currency for some two dozen European countries. The UK investor naturally still needs to take a view on the likely changes in the euro/sterling exchange rate before making a commitment to European investments.
The key questions facing European investment managers at the moment illustrate the importance of industry allocation decision-making.
There are strong signs that the economic downturn has reached a low or near-low point. Factors such as the elections in the US in 2004 are expected to drive the US administration to a reflationary stance, with a likely positive impact on the liquidity in world markets.
Easier monetary and fiscal conditions should contribute to a better environment for equities. Companies with greater exposure to global trends should do well. As we hopefully move out of a bear market, more volatile and economic sensitive sectors should outperform. The key questions are which sectors, which companies and when?
There has been a trend towards industry screening over the past 10 years.
Country allocation still has an important part to play, for example, where there are separate currencies within the region.
Companies with greater exposure to global trends should do well.
100 new clients
Achievements, charity work and other happy snippets
Square Mile’s series of informal interviews
Partner Insight: The rise in demand for DFM and multi manager solutions has been largely driven by new mandates from the regulator, says James Bampton, head of UK intermediary distribution at Architas