Although developed economies have lost their lustre in recent years, pension investors can still find some gems in undervalued and evolving sectors
Europe’s battered banking industry, a key culprit in the region’s crisis, may not be the first thing that comes to mind when you think of a place to invest. But many argue that this sector—along with others in developed markets, such as energy and big pharma—offers great long-term opportunities for Canadian pension funds. Although these sectors are changing or experiencing problems at the moment, they’re expected to grow in the long run.
Flush With Cash?
Forget all the scary headlines about Europe. Well, don’t—but understand the big picture. Despite their recent bad reputation, European banks can offer value in the long run. Their share prices remain depressed, making valuations attractive, and they’re acquiring more capital due to regulatory pressure, notes David Hussey, head of pan-European equities with Manulife Asset Management. As Europe slowly emerges from recession, its regulators want to prevent a repeat of the crisis—dark days when the region’s lenders were so cash-strapped that many, especially those in the most troubled countries, saw customers withdrawing their money due to fears that their deposits wouldn’t be guaranteed.
“I’m pretty sure that [the European Central Bank] will continue to flood Europe with liquidity, which is positive for the banks’ ability to fund themselves cheaply,” Hussey says. He adds that, within two to three years, things will further improve in Europe’s recovering banking sector as loan growth increases and excess capital accumulates for future shareholder return.
“The good-quality large European banks are really good long-term investments because they will naturally see their own earnings recover,” he predicts, explaining that they’re well capitalized and will be great dividend payers in the future.
Attractive large cap names include BNP Paribas, Banco Santander, HSBC, Barclays, UniCredit and Lloyd’s, says Hussey, adding that these lenders have seen their market share increase as the weaker banks struggle. Although some of these banks are headquartered in countries that were at the epicentre of the eurozone crisis—such as UniCredit in Italy and Banco Santander in Spain—he still regards them as safe.
“If you look at the profit breakdown of UniCredit and Santander, they’re not plays on Italy and Spain. These are globally focused businesses,” Hussey says, explaining that Banco Santander has sizable operations in Brazil and the U.K., while UniCredit is strong in Germany and eastern Europe.
But while the big banks are safer choices, smaller lenders on the periphery of the eurozone remain risky because they’re likely still undercapitalized and will have to merge with larger ones, Hussey explains.
Investors also need to remember that Europe’s economy isn’t out of the woods yet. If it slips back into recession, banks would be particularly vulnerable because they’re more exposed to macroeconomic risks than other businesses, warns Nicholas Davidson, senior portfolio manager, value equities,withAllianceBernstein.That’s because banks will see more loans go bad if the economy falters, he explains. “Plus, less directly, a recession would worsen the public finances in the countries affected, and banks tend to own a lot of their home country’s bonds.”
Banks and other financial institutions also offer opportunities in the U.S., according to Andrew Smith, chief investment officer of Northern Trust’s investment solutions group. As with Europe’s banks, stock valuations in the U.S. financial sector have room to advance due to the current environment.
“With inflation near zero, bank lending on the rise, household debt service historically low and biological clocks pushing the echo boomers to form households, we continue to believe the stage is set for future spending and investment,” says Smith, adding that strong corporate profits are another positive influence.
Also, as in Europe, Wall Street institutions are better capitalized today due to tighter regulations aimed at preventing a repeat of the 2008 crash. This increased capital, coupled with economic growth and interest rates that are slated to rise, will cause U.S. financial stock prices to move up, Smith explains. And, he adds, while the risk of a full-fledged financial meltdown is always there, fears of such a nightmare scenario are overblown.
Happy Pills
Pharmaceutical companies in Europe and the U.S. may be another good investment choice for the long term, offering reasonable valuations. However, “there’s been quite a bit of bearishness about the big pharma companies because a lot of their blockbuster drugs have come off patent or, in some cases, will shortly come off patent,” says Davidson. This has caused skepticism about the strength of these drug makers’ research and development pipelines.
So when considering that sector— whether in the U.S., Europe or any other region—it’s crucial to research specific companies to understand their product pipeline, says Davidson, adding that it’s also important to follow the development of regulatory approvals for new drugs.
For example, Roche and Novartis in Switzerland, and GlaxoSmithKline in the U.K., offer great value because they have new drugs in the pipeline, Davidson explains. In the case of Swiss companies, these drugs include immunotherapy medications, which target cancer cells by harnessing the powers of the body’s immune system. “The new pipeline of oncology drugs should generate large amounts of cash, and the dividend payouts to shareholders are increasing,” says Hussey.
Pharmaceutical companies around the world typically address gaps in product lineups through mergers and acquisitions. This ongoing restructuring is a positive trend, and it’s expected to continue, Smith explains.
A recent case is the bid of American giant Pfizer for British company AstraZeneca. While the $118-billion bid was unsuccessful because AstraZeneca saw it as too low, some bank analysts say merger talks could be restarted in the coming months if Pfizer offers more money.
Apart from drug manufacturers, in the U.S., healthcare in general is a good area to invest in because the demand for healthcare services and medical supplies is expected to grow over the long term. One major factor is the recent introduction of the Affordable Healthcare Act—which, according to Smith, will be a positive force for the next three to five years. “It’s bringing more people into the healthcare system,” he explains. “A lot of new people will be buying healthcare, in effect.”
Adding to the appeal of the American healthcare sector is the fact that it’s seeing a lot of innovation, says Smith. An example is the development of cost- effective services, such as public and private health exchanges. The majority of exchange members receive financial subsidies or assistance from the government, he notes. “Effectively, the government is giving away money for people to get health insurance.”
Text to Win
As mobile growth slows in developed economies, investors have generally been bearish about western telecom companies. But Europe’s telecom landscape is evolving, which means opportunities.
Almost every EU country saw many new entrants in the industry over the past few years, taking away chunks of the market from incumbents—which, in turn, depressed prices across the board. Regulations intended to reduce consumer charges contributed to the squeezing of profit margins, cash flows and returns on capital, Hussey explains.
However, it’s likely that this trend will soon be reversed, and growth in prices and revenue could resume, he predicts. “The resumption in growth is going to come from consolidation across Europe, so I think the regulators have realized that if they allow these big businesses to just compete away returns below the cost of capital, then they stop investing. And we do need investment in broadband across Europe to boost productivity.” Hussey adds that, once these businesses stabilize and show some growth, the dividend yields for investors and the cash returns will be strong.
According to Hussey, attractive names in the industry include Telefonica in Spain (which also has assets in Brazil) and Telecom Italia, the large Italian incumbent (which also has emerging market exposure to Brazil).
Oil Is Well
While there are lots of opportunities abroad, don’t forget equities at home. The Canadian stock market is dominated by commodities, particularly crude oil—an area seen as promising despite its current infrastructure limitations. “There’s this idea that Canadian petroleum is kind of stuck in Western Canada,” says Melvin Mariampillai, a portfolio manager with Sionna Investment Managers. “There’s a lack of pipeline capacity to get that petroleum to the U.S. to be refined.” This makes the sector undervalued.
But, in the medium and long terms, stock prices should rise because proposed oil pipelines will be approved in one form or another, says Mariampillai. Proposed projects include Keystone XL, which would run from Alberta to Nebraska; Northern Gateway, which would connect Alberta to Kitimat, B.C.; and Energy East, which would snake from Alberta and Saskatchewan to Eastern Canada. Meanwhile, producers are transporting their crude via rail, but Mariampillai notes that this option is more costly and less safe in light of recent derailments.
Another reason the industry is undervalued is that it has lots of oil but few customers. Most Canadian exports go to the U.S., which fails to absorb all of the output from Canada’s vast tar sands. On top of that, the U.S. has new oil discoveries, thanks to its current shale boom.
Many expect that these discoveries will make America self-sufficient, potentially eliminating the demand for Canadian oil. “[But] our view is that, even with these new discoveries, there’s still going to be a role for Canadian petroleum,” says Mariampillai, explaining that they won’t meet all of the demand in the U.S.
Being tied primarily to one customer has made domestic producers all the more interested in exporting crude to other parts of the world, particularly China. This diversification will help companies, because customer concentration is always a risk, Mariampillai explains. But there are many hurdles at home—such as environmental opposition—to building the infrastructure that can connect domestic producers to global markets.
Investors need to keep all of this in mind—along with the overall energy production environment—in order to find the right companies in the sector. In Canada and around the world, “energy exploration and production has taken up an enormous amount of money as oil has become more and more difficult to get out of the ground, and the capital expenditure plans [of companies] have increased,” says Michael Spinks, co-head of multi-asset for Investec Asset Management. Companies with high cash flow, cheap valuations and a story of strong under- lying structural demand are attractive, he explains. Mariampillai suggests Imperial Oil, Cenovus and Suncor as Canadian names that offer value.
Emerging markets may be all the rage, but advanced economies—despite their anemic growth—still offer rewards. Experts say the rule of thumb for pension investors is not to chase short-term gains but to focus on the long run by examining businesses on an individual basis and understanding their long-term prospects, rather than buying into firms just because they belong to underpriced sectors.
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Yaldaz Sadakova is associate editor of Benefits Canada.
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