When Europe’s debt disease spread to Cyprus, accompanied by bank runs and public unrest, some doubted the European Central Bank’s (ECB) ability to contain the contagion. And, even more recently, Slovenia turned up sick, warning of escalating debt problems and faltering banks. But with the setbacks have come some surprising steps forward, too, including progress in Italy, which recently formed a new coalition government.
Par Rostom, portfolio manager of Franklin International Growth Fund, shrugs off the latest bits of bad news and sees the setbacks as part of Europe’s long-term healing process as countries and companies shed their debt, as austerity programs take effect, and as the ECB continues to take measures like interest rate reductions and pumping money – more than €1 trillion so far – into banks via cheap three-year loans.
“Earlier on, the ECB was a bit slow in dealing with the issues in Europe. Subsequent to that, particularly with the appointment of [ECB President] Mario Draghi, the ECB has initiated emergency measures, which we believe should have adequate firepower to contain the risk in the periphery of Europe. And, in fairness, we’ve also seen the [credit] spread on southern countries in Europe come in. Following the speech of Mario Draghi that the ECB will do whatever it takes to contain the contagion in the periphery, we have seen the spreads on sovereign debts of Spain and Italy fall substantially, easing market access and helping reduce chance of default. [perfect_quotes id=”1957″] “We’ve seen more recent flare-ups in places like Cyprus, and in the last few weeks, Slovenia. They are much smaller countries, so their problems have not really dented the gradual improvement of sentiment that we’ve seen in Europe. So we’re reasonably comfortable that, despite this backdrop, with gradual deleveraging and gradual endorsement of austerity, we’re going to see Europe heal over time.”
Recently in Italy, rivals came together to form a new coalition government, to the surprise of many market watchers. New Italian Prime Minister Enrico Letta pledged to work on improving economic growth and employment, and won an initial vote of support of the Italian parliament. Will this lead to an Italian revival? Rostom weighs in.
“Investors will continue to question political volatility and reform momentum in Italy, and will express their views in sovereign debt spreads. We believe that the three-way coalition government with a more efficient and accountable political system could mean more longevity (than a few quarters). At the top of Prime Ministers Letta’s agenda is political reform, which should help the credibility of the government and minimize future feuding among political parties. Also, the appointment of a highly-regarded economist as economy minister [Fabrizio Saccomanni] may help with measures to stabilize economic activity, curbs to government spending and enhance privatizations of public companies, which in time could drive growth and hence fiscal health.”
Back to Business
The healing extends to European companies, which, Rostom says, have followed their governments’ lead and are reducing their debt loads. Lower interest rates have allowed companies to refinance their debt and cut the cost of borrowing “pretty substantially,” Rostom says. The lower rates also are helping companies acquire other businesses.
“What we’ve seen is that companies get it. Companies are global enough. Their investors are global enough – both equity and, importantly, credit investors – to emphasize that companies need to de-lever, to use free cash flow to pay down debt. When debt has matured, companies have been refinancing given that the cost of borrowing has come down pretty substantially. We think companies also are being prudent in doing debt-financed acquisitions. All in all, we’re actually seeing leverage being reduced. For companies that we monitor that are very free-cash flow rich, the free cash flow margins are very high. We see those companies using that free cash flow to gradually de-lever. And that’s also being rewarded in the stock price or in the credits.”
Even in the midst of an epidemic, not all will succumb, and some will even remain healthy. How can you judge who looks strong enough to endure? Through careful examination, of course. Rostom and his team believe so strongly in thorough research they’ve even named their process “360° Research Process.” Rostom elaborates:
“There’s an inordinate amount of depth that goes into researching an idea, and our 360° Research Process captures the generally holistic touch points that analysts look at such as economic exposure, revenue exposure, the competitive landscape, the opportunities with regard to mergers and acquisitions and, importantly, external factors in terms of regulation. For companies in the financial sector, we also look at capital structure.
“We continuously question assumptions. And we don’t only look at the stock. If, for instance, we’re covering a stock like Elekta1, which is a (Sweden-based) manufacturer of radiation therapy equipment, we also will be looking at its competition. And we’ll also be talking to the regulators in the different localities where Elekta operates.” [php function = 1]
Yet again, there’s just no getting around doing your homework.
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What Are the Risks?
All investments involve risks, including possible loss of principal. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. These and other risk considerations are discussed in the fund’s prospectus.
1. As of 3/31/13, Elekta AB common stock represented 0.287% of total net assets of the Franklin International Growth Fund. Holdings subject to change without notice.