Investing in German Companies
The article below is from our BRIEFINGS newsletter of 15 October 2019
Faced with geopolitical uncertainty, a slowing economy and negative yields, more than 180 German companies shared their strategies and challenges with investors at Goldman Sachs’ eighth annual German Corporate Conference, held in Munich last month. We sat down with Goldman Sachs’ Michael Schmitz, co-head of the Securities Division in Germany and Austria, to discuss key takeaways from the event.
Michael, based on your conversations with clients, what is the sentiment among investors and German corporates?
Michael Schmitz: There was a divergence in sentiment between investors, who were rather negative, and corporate clients, who were cautiously comfortable. Investors, for their part, focused on current economic data which indicated that a slowdown in global trade was weighing on the German manufacturing sector and the DAX stock market index. Meanwhile, German corporations, which have gotten used to operating in a volatile environment, have been guiding earnings expectations lower since the second quarter.
The German economy has slowed significantly since 2018, and we expect a technical recession (two negative quarters of growth) in the second half of 2019. However, we do not expect a deep downturn and we believe there’s scope for improvement if and when there’s a pause in the global trade conflict and a Brexit resolution is found. Moreover, support for measured fiscal expansion (including green investment) seems to be gaining political traction in Germany, while the European Central Bank’s latest stimulus package ensures that financial conditions remain accommodative.
Indeed, with regard to German equities performance, the picture is not that dire. The DAX is up 18% year-to-date through September. How do you explain that?
MS: We think this relative resilience is a function of changes in the German index. While the DAX still has exposure to the slowdown in global trade – with 15% in China and 35% in industrials, chemicals and autos – the technology sector now makes up 13% of the index, which is a higher proportion than any other blue-chip index in Europe. Other growth or growth-defensive sectors, such as healthcare and real estate, have also increased as a proportion of the DAX. These sectors tend to do well in a low-inflation and falling yield environment. Altogether, we think the DAX is fairly valued compared with the rest of Europe.
Could you share a few thoughts on the negative yield environment in Germany and how companies are thinking about their capital allocation strategies?
MS: Over the course of the three-day conference, the topic of corporations’ capital allocation priorities dominated the discussion. Negative yields have incentivized corporates to borrow more and increase buyback activity, resulting in a shrinkage of equity supply as a percentage of market cap. In addition, investors were also focused on whether companies were planning to use their cash to engage in M&A.
What are potential challenges that could test the ability of the German economy to deliver long-term growth?
MS: The country still has a strong industrial base which is currently undergoing a profound transformation. Investors are observing closely how companies are addressing four major challenges. First, the automobile industry is facing a major transformation as it transitions from manufacturing combustion engines to electric vehicles. Second, there’s a potential for some degree of deglobalization given current economic and political developments. This will have implications on many levels for Germany as its manufacturing sector is tightly integrated into global value chains. Third, companies will need to continue to invest in the digitization of production processes, which is likely to raise productivity and businesses’ ability to customize production on a larger scale. Finally, as climate change becomes an ever-more important topic, German companies have to reduce their carbon footprint. This transition will not be easy and, in some cases, entire business models will need to be redefined.
What do you think the prospects are from here?
MS: The ability of the German economy to cope with these structural challenges will be decided by its overall innovative capacity and policy responses. Germany has always been known for its innovative strength. Given this, we are optimistic that the country will be able to cope with the structural challenges mentioned earlier. Also, Germany has some distinctive advantages: low debt, high savings, low financing costs and a highly-qualified workforce. These factors will not insulate it from the shorter-term headwinds, but should provide the basis for longer-term growth and prosperity. From an investment perspective, many of the German equities we like fall into one of four categories: fast-growth or disruptive retailers, technology, real estate and companies focused on renewables.