European equities have experienced a tumultuous several years as the global recession followed by the EU debt crisis have placed strain on both the Euro and domestic consumer markets. German stocks have profited tremendously from currency weakness while the broad markets in other primary EU economies still register ugly double-digit negative returns on a three-year basis. One fund manager that has thrived in this divergent environment is Lucerne Capital Management, Institutional Investor reports.
Lucerne is a somewhat unlikely player, a hedge fund run by two Dutchmen based in suburban Westchester NY who have been quietly racking up enviable returns trading European equities.
Co-portfolio managers Pieter Taselaar and Thjis Hovers worked together at ABN Amro during the 1990s. Taselaar ran the bank’s equity desk in New York while Hovers was a research analyst based in Amsterdam. Backed with a seed investment from their employer, the duo launched Lucerne in 2002, which has subsequently racked up eye-catching results. Last year’s performance exceeded 25% net of fees and the fund’s average return is 16.5% net since inception. At just over $200 million in assets under management firm has done very little marketing and has no staff to speak off, just the way the partners like it. According to them, the freedom provided by operating this way allows them to focus solely on analysis without bothering with the mundane operational responsibilities of running a business.
Taselaar and Hovers focus on mid-cap equities listed in continental Europe, capturing inefficiencies in markets that are less closely followed. The fund’s strategy is long/short with a focus on deep fundamental analysis and a willingness to take concentrated positions when the managers’ convictions are strong. According to Taselaar, the fund only focuses on opportunities that present a potential 20% annualized return and an acceptable risk profile – and for most of the past decade mid-sized European stocks have presented Lucerne with a steady stream of these.
Institutional Investor contributor Andrew Barber Spoke with Taselaar and Hovers about the macro situation for European companies and what opportunities they see in the current markets there.
Institutional Investor: How do you view the political risk facing the EU currently? There is obviously a tremendous amount of uncertainty over the future shape of the union.
Thjis Hovers: I would almost call it, “Germany’s balancing act,” in terms of the cross-currents and the potential costs and benefits of them holding the Euro together or letting it fall apart. To a large extent Germany is in the driver’s seat. Economically it’s very much in their interest to hold the Euro together because of the cost involved if it would fall apart, their currency would be revalued at probably 20 to 30 per cent and they would lose their competitiveness. Right now they are extremely competitive because of the weak currency. Also, the German banks hold massive amounts of Italian and French debt, so if that all would be devalued, basically half of the Germany banking system would be insolvent.
On the other hand, you have the political situation. It’s become harder and harder to sell to the German population and the Dutch population – and for that matter, the Danish population – on the fiscal transfer to Greece and Portugal and Spain due to those nations’ overspending. It is very much in Germany’s interest to hold it all together but harder and harder to sell politically. But we think that even America now realises that it has to be sold politically and that the EU has to be held together.
II: So it’s in Germany’s national interest to support the Union in the long term, but also in the best interest of German corporate sector in the near term?
Pieter Taselaar: From a macro perspective, as the political and economic divisions become wider we are seeing some German companies having the best time of their lives. Every CEO there without exception says that the euro is still going to be there, it’s going to be kept together, and there’s no alternative. It’s all political games going on now but it’s going to be kept together and they are going to benefit from it.
II: So they are set to take advantage of the uncertainties.
PT: Yes, for instance look at labour costs. The labour laws in Germany are very strict and it’s very hard to fire people and the unions still have a fair amount of power but, with such a publicized crisis in 2007 and 2008, this has been the first time in decades that managements were in a position to really clean house and to address their cost basis. For the first time, the unions were really willing to negotiate and basically say “OK, you guys can fire 10-20 per cent of people, you can lower the salaries,” and in return they started going to more profit-sharing arrangements.
Rheinmetall is a specific example where they laid off about 10-15 per cent of the workforce and fixed the rate hikes for the rest of the workforce in exchange for a profit-related incentive program. The crisis was an opportunity for German companies to cut their cost base and implement major efficiency improvements. Now you see this macro political crisis which basically shows the divisions between north and south. On the corporate level the southern economies haven’t, with certain exceptions, made efficiency improvements because they received free money, low interest rates, etc. They basically invested in real estate but they didn’t invest in technology or in efficiency improvements. So suddenly now you’ve got this division, you’ve got a relatively weak Euro, and the Germans are benefiting wildly. A lot of mid-size German companies have nearly 70 per cent of their revenues coming from outside Germany. They are massive exporters, so this currency issue is a very important one for them. Corporate Germany likes this situation of maybe slight uncertainty, a little pressure on the Euro…
II: So you are fairly negative on the corporate environment in southern Europe?
TH: If you discuss the future trajectory of revenues longer-term with major companies in the healthy European economies you get a clear picture. What features on their maps of where growth going to come from is China, Brazil, Russia, United States and core Europe. Peripheral Europe is not even being discussed as an end-market. It’s remarkable – if you sat down with 25 big German companies you would probably never discuss peripheral Europe once except from a policy perspective. It’s not looked at as an end market of any relevance.
PT: With some small exceptions. One is Northern Italy, which is almost like Germany if you look at the industrial activity there, and has some very high-quality companies. Historically, they became less competitive compared to Germany because of the Euro. Also in Spain you have some petro-chemical exposure which on a project basis sometimes is interesting for companies, but that’s basically everything.
II: Is it likely that German manufactures will seek out lower cost capacity expansion in these weaker states?
PT: The only way that could happen, and it hasn’t happened to a large extent yet, is through wage adjustment, right? And that’s a slow process but it looks like we’re going into this process now where the weaker countries have to become more competitive. Since they don’t have the currency to move that way, they have to go through wage deflation.
TH: We saw that about five or six years ago when the Germans moved very swiftly into countries like Poland and the Czech Republic and created a lot of production facilities there. But those costs rose pretty quickly there. What Germany does better than anybody else is to invest for the future rather than focus on what the quarterly numbers are going to be. A lot of companies don’t even give you detailed quarterly numbers, they just give you a revenue line and that’s about it. What they’ve done, which is really paying off, and they continue to do, is they really invest in technology. So we think that particularly in the industrial sector, technology content is extremely high. The technology content in terms of what quality product they provide, but also in the way they manufacture. The level of automation is very high so they’ve been able to lower their production costs that way also through automation and more efficient production, thereby being less reliant on labour costs. They now say actually that they can produce even in slightly more commoditized areas like in auto parts, that they can produce almost as cheaply and efficiently in Germany as they could in low labour cost countries.
II: If the vast majority of sales for many of these companies are abroad now, how competitive can they be ultimately against large US or Japanese firms in the developing markets?
PT: In large part this goes to quality of management. One company we hold has a CEO is in his early fifties who has been operating in China and Brazil for over 20 years. That’s a key difference between German and Dutch companies and US companies – because their home markets are quite small they have been used to operating internationally for much longer than some of their US counterparts so they are much more aware of the pulse of a local market. They have made a lot of the mistakes already and they won’t repeat them.
TH: One commonality for our portfolio is that these companies are based in core Europe but have a significant part of their revenues coming from growth markets outside of Europe. The way we look at it is that we invest in growth markets both geographically and product-wise, but we do it through western European companies. Where the company is based is relevant because culturally we understand it, the accounting, and the companies themselves operate in an environment where educational level is high so they can recruit high-level staff and they’re used to a competitive landscape. When we say we invest in Germany – yes, the companies are operated from Germany, but we invest in the world through them.
II: So as US based investors focused on the German market, do you find the corporate culture there is more difficult to navigate?
PT: There is cultural gap with respect to communicating with shareholders. It’s almost like in Japan – it takes a while to build the trust of management, to build the relationship. We build relationships with companies there like we build relationships with a client here. If you can do that then they talk to you in a normal manner and are transparent. It helps to speak the language, to understand the culture, etc.
We were in a meeting the other day with a German company that is in three different business activities. Ideally, based on Corporate Finance 101 – because there are no synergies between the three businesses – the company should be split up to capture a big discount of breakup value. The fact that management is not breaking it up wipes out 60 to 70 per cent of the investor base – mostly Anglo-Saxon investors, because they don’t think the management is shareholder-friendly. But it’s really a different mentality – they say, “Ok, we will first make sure that each one of these three businesses are being run optimally and we maximise profits and then maybe we would think about splitting the company up and that may be a longer process and it may be three years from now.” In other words they fundamentally don’t believe that value would be created in splitting these three parts up now and the market attaching higher individual multiples to it. They say well, we don’t need to go to the equity market anyway because we’re cash-flow positive, so we don’t really care about the next six months or twelve months. So you have to break through that and understand that sort of thinking to navigate the German market. It’s not that they don’t care about shareholders, they just have a longer-term view.
II: What is your base investment process, what do you look for in companies that you analyse?
PT: I’d say the commonality – the main commonality – is excellence of management. If you look across our holdings that are doing well, these companies are run by excellent people. They adjust to market changes, they adjust to technology changes, they adjust their business model to the changing economic environment, changing end-markets. Second, the managements are focused on [the idea that] the shareholder is an important constituent and that they want to create shareholder value. And our bias is typically on companies that have very good products and leading positions in their markets, and are growing from those strong positions and by doing that we tend to be more value-biased so we look at companies that generate a lot of free cash, and ideally we’re not so much activist or breakup-artists or anything like that … ideally, we like companies that generate high free cash flow and can re-invest those free cash flows in their business at ever-higher returns. If you have that combination of excellent management, good products, technology content, and high cash generation that they can invest at high returns, then it comes down to valuation. If we can pick those up at attractive valuations, then nine out of 10 times we’re on the money.
II: Ok so let’s flip that, what do you look for in a short?
TH: When it comes to company specific shorts we really focus on blowout situations, companies that we see have severe balance sheet issues, severe competitive issues, where they ultimately have to print a lot more shares to survive.
PT: If a company is cash flow negative but manages to show increasing earnings per share by doing “bolt-on” acquisitions that generate negative returns on internal capital deployed. We find cases where you may see solid EPS growth but the return on capital deployed is deteriorating, in the end the company has to raise new capital, typically by issuing new shares.