What if the Eurozone remains intact, or better yet, resumes pre-crisis levels of production? How do investors go about structuring a play to “kapitallize” on a European comeback?
Before making an investment you have to have a thesis. In this case, our thesis would be: Given a European turnaround backed by the ECB, large cap stocks underperforming the DAX year-over-year should outperform the index as institutional capital flows back into European equities. DAX is a stock market index consisting of the 30 largest German companies trading on the Frankfurt Stock Exchange.
Our sub-criteria are: heavily weighted on the DAX, sub 10% institutional ownership, and dividend paying. We chose the DAX because institutional capital should flow to the country with the strongest GDP and most flexible balance sheet.
So we have our thesis, what now? There are many different ways to accommodate this thesis; one could invest solely in a single stock, purchase a basket of equities, or long an ETF. The strategy we are to employ depends on our confidence in our thesis—that is to say, how bullish we are about the play. The most bullish person would invest heavily in a single security, and the least bullish in an ETF. Given the current circumstances surrounding Europe, it may be unwise to long an individual stock considering the possibility that the ECB’s revival of the Eurozone may kick the inherent problems down the road without resolve—this is very likely from our standpoint. Consequently, we remain bullish, but not that bullish; so we will buy a basket of equities instead.
Developing a basket of Equities is both challenging and educational because it requires one to evaluate the opportunity costs of their capital; is my dollar better spent on good X or on good Y, what are the upsides and downsides, and how much risk does my dollar take on in good X versus good Y.
How do we create our shopping list? Let’s start from the “top-down” (investor jargon) because our thesis pertains to capital flows and a Eurozone turnaround which are constituents of the “top-down” approach. What industries are best positioned to capitalize on a European comeback?
History tells us that in recovering economies tech, manufacturing, utilities, and automotive sectors have had successful rebounds though the pace of their recovery will be highly dependent on the velocity of capital inflows and the size the ECB’s involvement. Because it is nearly impossible at this time to determine the size of the ECB’s strategy it is therefore unfathomable that we could accurately predict the rate/size of capital that will return to Europe. Considering the uncertainty mentioned above, we have selected 9 securities that should protect us in the case the rebound is slower than expected—we will call this basket of equities “Draghi,” named after the head of the ECB since his decisions should determine our success. (We would like to point out that financials usually react quickest to monetary and fiscal policy; however, we believe banks in Europe are subject to many other variables that may impede their long-term ability to generate earnings for shareholders.)
Our basket, Draghi, will consist of: Siemens AG (SI), industrial; SAP AG (SAP), tech; Thyssen Krupp AG (TYEKF), industrial; HeidelbergCement AG (HDELY), construction; and Linde AG (LNAGF), industrial gasses & engineering; E.ON AG (EONGY), utilities; Allianz SE (AZSEY), insurance; Daimler AG, (DDAIF), automobiles; and Volkswagen AG (VLKAY), automobiles.
A few questions should be raised upon review of our shopping cart, ‘Why multiple industrials and automobiles? And, if construction does well won’t utilities and industrials preform accordingly?’ The first question is difficult to answer; we have two industrials because while they both function in the same industry Siemens is a much larger company with a bigger global presence (2/3 of SI’s business is outside of Europe) and is therefore more diversified whereas Thyssen Krupp has a lot more upside comparatively to the DAX. As for the second question, it is true that if construction does well so should utilities and industrials; however, though we have correlated industries our upside/downside will be determined by how we weight each security individually against one and other. (Weighting is a measurement of composition, how much of security X makes up of the entire portfolio)
Weighting & Risk
Without becoming bogged down in portfolio construction, we propose that in order to protect our downside we balance our strongest long term performers against the securities that have struggled most in the recession and therefore have the largest potential upside (in theory). Additionally, we believe it economical to play the recovery of the industrials and autos against that of tech since tech is a secular and internationally demanded industry. This is not to say the securities will perform inversely to one and other; quite the opposite, but in the case that their businesses are slow to recover; capital should flow to securities not involved in cyclical industries.
We will pair SAP (20%) with TYEKF (12%), SI (13%) DDAIF (7%), and VLKAY (7%); additionally we will pair AZSEY (9%) equal to EONGY (9%). Meanwhile, we will leave HDELY (9%) and LNAGF (14%) unpaired but grounded by the rest of the portfolio. This now provides us with three separate structural sub-theses regarding the speed of recovery: secular industry < cyclical, jobs rebound < utilities, and speculation. (These weightings are not merely derived from a top-down analysis but for the sake of time and complexity we shall assume a top-down analysis is sufficient)
Now that we have Draghi’s skeleton in place, we must make sure we are managing the risk in a way that allow for strong upside while minimizing downside. How do we as an investor manage the risk accordingly? We derived out risk management strategy by quantifying each security’s, YTD performance, 3 year performance, annual volatility, industry risk, and our prescribed weighting all compared to the portfolio itself and the benchmark (DAX). Having done all of that, we will demonstrate what we believe would be a prudent allocation of risk.
In our basket we created three tiers risk: low (34%), medium (38%), and high (28%) =100%.
- High Risk: Daimler (DDAIF) 7%, Thyssen Krupp (TYEKF) 12%, and HeidelbergCement (HDELY) 9%
- Medium Risk: Siemens (SI) 13%, VW (VLKAY) 7%, Allianz (AZSEY) 9%, and E.ON (EONGY) 9%.
- Low Risk: SAP (SAP) 20%, and Linde (LNAGF) 14%.
Now we have a portfolio. Let’s review what Draghi is made out of! Our low risk segment is comprised of tech and industrial gasses/engineering that have performed similarly over the past three years. Our medium risk segment is made up of industrials, autos, insurance, and utilities—all industries that should be second to return to pre-recession levels of output. Lastly, our high risk is comprised of autos, industrials, and construction—the businesses most likely to expand once Europe begins growing at a foreseeably consistent pace.
There are bottom up factors here as well, that is why we have Daimler in the high risk category while VW is not. Equally, though Linde’s industry more closely aligns with those in the medium risk category, we believe the company demonstrates strong financial flexibility and performance making the argument for a low risk demarcation. We want to stay away from discussing the bottom-up factors because they further complicate an already labyrinth process; however, investors should know that bottom-up analysis (looking at the fundamentals of a security without emphasis on current events and macro-economic drivers) is crucial to long-term success in investing. That being said, there was a lot of bottom up analysis that took place in the creation and weighting of Draghi.
The last thing Draghi provides us with are dividends! Part of our original strategy was to orient the portfolio so that it returned a sizable dividend to the investor. We chose this because in today’s volatile markets, investors are seeking returns that correspond with stability. This is another top-down element of our overall thesis. So how much does Draghi pay his investors every year? With a hypothetical $100,000 invested in Draghi, one would receive $3,161.49 or 3.16% a year–consistent with the yield derived if every security held an equal weighting (11.11%). Not only is that a pretty nice yield, but coupled with the prospect of some serious equity growth, Draghi becomes very appealing.
The last thing every investment needs is an exit strategy. Since this is not an ETF play each individual security comprising Draghi should have its own independent exit strategy. However, we are going to outline an overall exit strategy and the reasoning behind it.
Since our thesis is top-down, our exit must too be top-down. Therefore, when Europe becomes stabilized or better yet, capital inflows realized, it would be prudent to exit Draghi or to rebalance the portfolio accordingly. Our exit strategy is dependent on each individual security’s performance versus the DAX. That is to say, once a security begins to outperform the DAX on a 728 day trailing basis, one should strongly consider closing that individual position. In an overview, the first industries to rebound should be the first positions exited as our thesis is not geared toward any long term belief but rather an anticipated rush of capital into Europe. Another indication it is time to exit would be when the DAX reaches 8000. This is a poor metric to justify an exit, but should always be considered. Lastly, investors should always keep an eye on the DAX compared to the S&P 500. This is a necessary measurement because the S&P is viewed as a no risk investment. Consequently, how expensive the DAX is relative to the S&P (by valuation metrics, not merely the price) it would be prudent for an investor to reassess the individual positions and their comparative expensiveness.
Fast Facts about Draghi:
Average YTD performance Vs DAX: -14.1%
Average 3 year performance Vs DAX: -31.4%
Dividend Yield: 3.16%
Average Percentage Weighting on DAX: 5.2%
Average Annual Volatility: 37%
Overall Risk: Medium
Exposure: German: industrials, tech, automobiles, insurance, industrial gasses, utilities, and construction
(Click on the image for more data and tools on these names)
Written by Mark Blumenfeld