Pimco: Seeking Alpha in Equity Returns in Europe

The bond guys PIMCO have decided to move into equities. They are doing so cautiously.  I mentioned some comments they made by Gross regarding safe, high dividend stocks like utilities. At the time, he was suggesting almost all asset classes appeared to be overvalued on a long-term basis, which may explain his move into higher dividend, higher quality stocks first.

In any event, Charles Lahr, an EVP in PIMCO’s global equities group has a piece out outlining PIMCO’s thinking on equities. Here is an excerpt below.

Q. Companies have improved their earnings and balance sheets since the financial crisis. Is there room for further improvement? And what does PIMCO’s view that consumers are more debt averse mean for the bottom lines of these companies?
A. In select cases, as always, companies will have the wherewithal to improve their earnings outlook and balance sheets. Regarding the second question, consumers being more debt averse might imply a few things. For instance, one would expect the top line of companies in cyclical industries to suffer as a result, particularly those companies that are levered to consumer cyclical behavior. Yet, as we know, many corporate managers are rewarded on the basis of their company’s equity value, and, thus, we are likely to see management of economically sensitive companies squeeze their top lines – restructuring costs to get a higher proportion of sales to flow down to net income – and also engage in more mergers and acquisitions (M&A).

M&A is likely to be an interesting area going forward, especially here in the U.S., where a lot of companies already are lean, and the only way really to create further synergies may be via consolidation. Companies in this situation potentially will look for overlapping market exposure, distribution, headcount, etc., and I would expect that – provided we avoid a double dip recession scenario – we may be at the beginning of a substantial rise in the M&A cycle.  

Q. What else can you say about the outlook for companies in different regions and in different sectors?
A. There is one overarching theme that I think is very interesting, given equity markets today: Europe is clearly an area where value investors should be dedicating some time and effort. Many equities in Europe are down for the right reasons, including exposure to sovereign debt in problematic nations like Greece, Portugal or Spain. However, plenty of other companies are not exposed to sovereign risk thanks to their substantial foreign operations and other factors, yet they have been down substantially with the overall market in Europe, trading at meaningful earnings multiple discounts to their U.S. counterparts. Also, as long as stocks remain depressed in Europe, their dividend yield in aggregate could be about double that of the U.S., providing a more attractive level of current yield.  

So, at this time, there is a real potential benefit to focusing on individual companies, looking at their balance sheets, and if you are a long-term investor, buying names cheaply in Europe with the potential to appreciate over time as the market learns that these names actually aren’t that exposed to the negatives of Europe.

Q. What about emerging markets? Does PIMCO’s long-term view of slower economic growth in developed nations and stronger growth in emerging ones suggest the best opportunities for equity investors are in emerging markets?
A. Not necessarily. Looking ahead, we think equity investors are likely to generate the greatest alpha, or excess return, by buying the equities that are most undervalued and that’s not necessarily in emerging markets. Sometimes stocks have very optimistic outlooks built into their prices, including anticipated growth in earnings; and, certainly, the sun is shining on emerging markets on a number of top-down, macroeconomic levels. But it’s our view that one has to find individual opportunities and determine what, if any, discount to the real value of a company is inherent in the stock price. We’re looking for securities trading for 60 cents that we believe are actually worth a dollar. While it’s still possible to find equities like these in the emerging markets, you tend to find fewer of them in markets with such buoyant outlooks.

My takeaways:

• Just because a company is high quality doesn’t mean it’s stock is a buy. It all depends on price.
• PIMCO understands that profit margins are near all time highs. In a mean-reverting world that does not bode well for shares. However, on a bottoms-up basis there are going to be outliers and this is where they are concentrating.
• M&A will be an area to watch regarding value pickup. Whether that means PIMCO believes that some undervalued firms will benefit from takeover offers by cash-rich predators I don’t know. What I do know is that the regulatory zeal of the Obama administration will be put to the test if we do see some large mergers. Google – DoubleClick passed the first real test on that front.
• Given Europe’s sovereign debt problems, PIMCO seems like it is disproportionately concentrating its energies there since it can find value. Regarding Europe, in my post "Gross: Is it possible to get out of a debt crisis by increasing debt?", I mentioned that "some (internationally-oriented) corporates are going to have better ratings than the formerly risk-free sovereign."  Lahr confirms this is PIMCO’s view as well.
• However, it seems their enthusiasm for actual emerging markets is tempered by valuations.

Source: Mergers, Cost Cutting, Regulation: Opportunities and Challenges for Equity Investors, PMCO