A Look Back at 2011’s Global Market and a Bullish Outlook for 2012

David Nadel

Looking back at Europe in 2011, what is your overall view? What has worked and what hasn't?

That's a big question. First, you have to separate the macro picture, which is dire, from the select group of what we believe to be well-positioned companies, in many of which Royce is invested.

From a macro perspective, the region is home to a disproportionately large number of countries that have unsustainable debt burdens, a situation exacerbated by the euro currency crises. Whereas prior to the creation of the euro, less-productive European countries could conveniently devalue their currencies to manage a credit crisis and/or to stimulate growth via exports, the euro takes that tool away, leaving those countries hard-strapped. Plus, many of those same countries have historically had weak mechanisms for tax collection. While "core Europe" has been more fiscally-prudent than so-called peripheral Europe, it too is conflicted: Germany and other members of core Europe want a weak currency, but they don't want to continually subsidize and bail-out more profligate nations. Unfortunately, it's tough to have it both ways.

Add to these structural problems an aging population, generally high taxation, a lack of natural resources, and declining social mobility, and you have, to say the least, a very challenging environment for businesses selling to Europeans.

Despite all that, Europe still offers some compelling investment opportunities; you just have to be careful what you pick. More than any part of the world, Western Europe is well-schooled in designing and marketing products the world demands. Many European markets are small so European companies, including the smaller ones in which Royce invests, have been forced for many, many years to think pan-regionally and even globally. They never had the luxury of selling to a single, 300-million person market like U.S. smaller-companies have. In today's global economy — where the West is licking its wounds while emerging markets drive growth and demand — that makes Western European exporters very well positioned, while many U.S. smaller companies are still catching up. We particularly like the classic exporters based in German-speaking Europe, the UK and the Nordics. Many of these companies manufacture around the world, so they are not that vulnerable to the high labor-cost and currency issues of their home market. We have generally eschewed PIIGS (Portugal, Italy, Ireland, Greece and Spain) Europe because of its high levels of leverage, and comparatively weaker corporate governance and managements.

Is the European recession priced into shares? Are the companies you own feeling the recessionary pressures yet?

Given trough P/E multiples and elevated dividend yields for European markets, it's safe to say a less-than-rosy picture has been priced into European stocks. Recession is the consensus view for Europe, which indicates that it is at least somewhat priced in. And, the companies we own that sell to Europe – these are American companies, Asian companies and European companies alike – are feeling recessionary pressures in the European end markets. However, we have deliberately structured our portfolios to have less exposure to the European consumer, and for that matter to the American consumer, who in my opinion is just as troubled as their European counterpart, whether or not our government reports U.S. GDP as recessionary.

Have our investments been more affected by headline news than fundamentals?

Yes, in the short term. When the Swiss national bank drew a line in the sand and committed to the 1.20 exchange rate versus the euro in September, Swiss stocks abruptly stopped their rapid descent that had been fueled by the strengthening Swiss franc in the weeks leading up to that decision. When Italy's sovereign bond yields suddenly spiked in November, Italian companies got hit hard, even if their sales were not dependent on their home market.

Headlines are a funny thing. What passes for investing in today's markets looks to me more like headline-driven speculation: a choice between a "risk-on" or "risk-off" day, breathlessly reported by the TV business channels. We see this as mostly noise, and ignore it for the most part.

Interestingly, international investing still seems to be treated as some sort of ghetto by a lot of investors. It has taken these massive European sovereign debt crises that have been dominating headlines for two years for many mainstream investors to accept a notion that should have been more apparent – namely that Europe is not a monolith, and that Germans and Greeks are about as different as any two peoples can be culturally, despite being geographically close. Amazingly, this hasn't stopped investors from treating all of Europe – be it the troubled PIIGS countries and severely compromised French banks on the one hand or the well-positioned exporters with global operations on the other – as uniformly European and therefore undesirable. We think this is a major mistake. Fundamentals continue to be strong for many European exporters, as they have been for the past 100 or 200 years. Certain companies have been succeeding through all the previous crises.

The fact that all of Europe is painted by many investors with the same brush means we can try to take advantage of the reduced valuations of these companies. As they say, never waste a crisis. If 2010 and 2011 were the years that certain investors finally woke up to the historical differences between, say, a Switzerland and a Spain, then we think 2012 could be the year they more carefully separate the wheat from the chaff in terms of companies.

Describe the type of companies that you look for.

We try to invest in companies with sustainably high returns on capital, strong balance sheets, and defensible market positioning. They tend to be largely self-funding businesses managed to take market share in tough periods. For the most part, I think our companies have defended quite well and are executing in a more than satisfactory manner. Important operational achievements like accumulating market share don't always reveal themselves immediately. But we think they will over time.

What is the biggest risk factor for your portfolios? Is it the collapse of the Euro? An Italian default? China slowing?

We don't see default as a major risk factor, but more as a potential cleansing event. After Brazil defaulted on its sovereign debt in 1983, its stock market roared back in the next two years. The Bovespa surged about 125% per year.¹ Think also about Mexico in the two years after its 1982 sovereign default: The Bolsa rose 115% a year.¹ Russia had a similar bull run after its 1998 sovereign default, up 116% per year for two years.¹ Similarly, today, the Greek market has lost 90% of its value in four years, with the Greek stock market's aggregate market cap at just 14% of the country's GDP. However, history shows that sovereign defaults are far from the end; they are often a new beginning for stock investors. In fact, we've got our "shopping list" of Greek and other PIIGS equities at the ready should defaults materialize. We'll be buying while many others hide. Our portfolios currently have very little invested in 'PIIGS' companies, but we're watching that situation carefully for opportunities.

I think the single biggest risk factor would be something that would derail the entire investment world as we know it, such as a sharp, synchronized reversal in demand from creditors like China and other emerging economic champions such as Brazil, India, Turkey, Indonesia, South Africa, Singapore, Malaysia and South Korea, to name a few. These countries have some combination of relatively young and socially mobile populations, natural resources, fiscal prudence, and even in some cases relatively sound banking systems.

A second risk would be a sharp rise in real interest rates within the developed debtor world, particularly U.S. Treasuries, which would stall or perhaps weaken commodity prices, particularly gold and silver. Our international and global funds have significant weightings in precious-metals mining companies, which we believe are on the cusp of being embraced by mainstream investors, much as many oil exploration & production companies were from 2004 onwards after oil prices ran higher in the wake of the Iraq War. Historically, when the U.S. Treasuries' real (i.e. inflation-adjusted) interest rate is greater than 2.5%, the price of gold stops climbing, which is the risk I'm describing. However, given U.S. inflation is at least 1.5%, the Fed would have to jack up rates by a whopping 400 bps to hit that 2.5% rate. I see that scenario as highly unlikely, given our economy.

We are invested in several German and Austrian exporters, and many people assume that a return to the Deutsche Mark would be catastrophic for them. I don't agree. First of all, Germany has a long history of being a successful exporter even with a powerful Deutsche Mark. Second, the German, Austrian (and for that matter, Swiss and British) exporters in which we're invested have continually diversified the geographic exposure of their manufacturing and production. When it comes to currency, what matters is not where a company is domiciled, but where it manufactures and sells. Interestingly, many investors gloss over these points in their rush to throw the baby out with the bathwater. And third, don't forget that our investments are valued in U.S. dollars, so if a German investment suddenly switches from the Euro to the Deutsche Mark then the value of our investment could be marked up proportionately.

What was different in 2011 versus 2008?

The fall of 2008 was very different – a unilateral global meltdown in demand, combined with paralysis in the global credit markets. Two thousand eleven did not match this severity or uniformity. Even as we exit the year, demand and credit remain strong in many so-called emerging markets, which today actually comprise the economic champions I like to refer to as the "creditor world." That was not the case in 4Q/08 when almost everything came to a grinding halt, at least temporarily.

What is your outlook for 2012? Which countries are you optimistic about?

Broadly speaking, I'm entering 2012 more bullish on international equities, at least those of the high-quality companies in which Royce looks to invest. I'm particularly bullish about emerging markets: they have generated three-quarters of real GDP growth over the last decade and are positioned to lead.

In 2011, we've seen massive underperformance by the international markets versus the U.S. No one will say global equities were correlated in 2011! So on the back of this cataclysmic underperformance, I think 2012 will be the year international equities storm back, while U.S. equities could take a breather from their perch as the "safe haven."

One source of optimism is American ingenuity. No country on the planet is as stubbornly optimistic, and has such a strong ability to reinvent itself to survive a crisis. I think the better U.S. smaller companies will continue to be the models for the world.

Another area of optimism is India. A year ago, Chuck Royce, George Wyper and I visited India and identified some good companies out of those we saw there and researched. India should grow 6%+ this year, without the autocratic/command issues of China. We think our Indian exporters will benefit from the recent weakness in the rupee, and at the same time we also like the emerging-consumption story of what is the world's biggest democracy.

Another area is South Africa, which has among the best corporate governance in the emerging markets, with an Anglo-Saxon legal tradition and companies that are managed for returns on invested capital and generous dividends. The political landscape has improved considerably as of late, with the political career of provocateur Julius Malema essentially derailed by his 5-year ban from the ruling ANC party, and tough prison sentences being meted out to high-profile government officials convicted of corruption. South Africa is the linchpin of the pan-African strategy of any multi-national corporation, and Africa is doing a lot better than most of the world; in fact 6 of the 10 fastest-growing economies anywhere in the last decade were African. I'm also bullish on South Korea, which is home to some good quality companies that look exceedingly cheap. I also like Brazil whose stock market massively underperformed the U.S. over the last 9-12 months and offers some of the most transparent corporate governance in the emerging markets.

What are your main worries heading into 2012?

Chief among my worries would be the bond bubble, which I believe is not going to end well for investors. I think people are taking serious career risk hiding their clients in fixed income today. In fact, the same investors who fled equities at the bottom in late 2008, and then fled to the perceived safety of fixed income, I think are going to be hurt when the bond bubble bursts.

We are in a global credit and currency crisis, of which I think Europe is only the tip of the iceberg. For all of Europe's debt woes, its consumers are by and large not that levered. Unfortunately, the American consumer remains highly levered. In fact, aggregate debt in the U.S. – and I mean federal, state, local, consumer and financial debt – is 6 times the size of our GDP. That is twice as high as the world average. Historically, when countries have had debt at just 2 times their GDP, they have gone to war once the usual tack of inflation and currency debasement runs out of steam. As Ernest Hemingway said, "The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin."

Everyone wants a weaker currency to stimulate exports, but of course it's mathematically impossible for all currencies to depreciate at the same time. The competition is particularly intense between the U.S. dollar and the euro. When Barack Obama said last year that he wants America to double exports in 5 years, I suspect what he really meant is that his Administration will do what's necessary to weaken the U.S. dollar, because how does a mature nation like the U.S. double exports otherwise? Now, the EU is revving up the printing-presses too. It's a real race to the bottom.

On a more positive note, I am cautiously bullish about Europe's long-term prospects. This crisis will get resolved, one way or another. Europe has historically survived a lot worse than what's going on today, and frankly its crisis today isn't all that different from the Asian crisis of 1997-1998. In both cases, the challenge stemmed from currency pegs (17 nations pegged to the Euro), unsustainable exchange rates, and over-indebtedness.

The Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank – recently provided cheap dollar financing for the ECB. Do you think the market rally from that news is sustainable?

I don't see why these actions should have a sustained positive effect. Why is it good to lend more to those drowning in debt? Isn't it a bit like giving heroin to an addict? To me, all this lending, the European Financial Stability Mechanism, the bank bailouts, and the quantitative easing come down to one thing: money-printing. And money-printing is just digging a deeper hole, throwing gasoline on the fire. The problem here isn't just liquidity; rather, it's veering in some cases towards solvency. Don't forget, in the wake of the global economic crisis, when U.S. banks re-capped, European banks for the most part didn't. Some of them are still levered 40 or 50 to 1.

The answer, to us, lies in gold, silver, and other hard assets. We recently penned a white paper on silver, and a year ago did one on gold. Another difference between 2008 and 2011 is that the U.S. and the EU have printed $3 trillion of money in those three years. There were more dollars printed in the 15 months after Lehman Brothers collapsed than in America's entire 230 year history previous. That fundamentally changes the playing field. Needless to say, in a world of infinite money, we continue to see the wisdom of investing part of the portfolios in companies which mine for gold and silver: commodities that have finite-to-declining supply.

David Nadel manages Royce Global Value Fund (with Whitney George), Royce European Smaller-Companies Fund (with Chuck Royce), Royce International Smaller-Companies Fund (with Chuck Royce), Royce International Premier Fund, Royce International Micro-Cap Fund and Royce Global Select Fund. In addition, he serves as Assistant Portfolio Manager for Royce Micro-Cap Fund, Royce Global Dividend Value Fund, Royce Capital Fund–Micro-Cap Portfolio and Royce Value Trust, a closed-end portfolio.

¹Milken Institute: Thoughts on Capital Markets December 5, 2011