Euro companies will "sink or swim" in battle for credit

The Interview

The battle for the survival of the fittest is getting fiercer among companies in today's hostile economy. That's why backing the right ones has never been so important if you want investment returns, according to Barry Norris, fund manager at Argonaut (http://www.argonautcapital.co.uk/).

At the crux of this new wave of competition is cheap credit. Companies on the stock market are going the same way as countries in the eurozone went when they fell prey to the unforgiving sovereign bond market during the eurozone crisis. While Greece struggles to borrow, Germany is able to borrow huge amounts very cheaply, and so continues to prosper while Greece suffers.

So with banks refusing to lend, access to cheap credit for companies has become an exclusive members-only club. Only a select number of the largest companies, which Mr Norris terms "uncommon" stocks, boast the strongest balance sheets and are therefore able to join.

Feathering their thriving nests in the corporate bond market by scooping up all-time low interest rates of 2 per cent or less, using their size and vitality as a bargaining tool to secure bargain deals, they are looking like increasingly attractive stock picks for investors.

But weaker competitors (he calls these "common" stocks, don't get a look in and are shoved out in the cold, where sky-high rates are the only credit option going. With no choice but to lump it, they struggle to grow their businesses, crippled by the costs, and end up losing out to the competition.

This contrast between companies with access to cheap capital and those without is stark, and is for Mr Norris the single most important theme of this new economic and stock market cycle.

Characterised by sluggish growth which he believes will persist for the next five years to a decade, his investing focus is firmly on companies with a competitive advantage, because having access to capital is likely to be rewarded by superior earnings momentum, he says.

And this is a self-renewing process, according to Mr Norris. "Precisely as a consequence of a lower-risk business model and therefore preferential access to capital, this is a self-perpetuating process which will continually reinforce the advantages of the 'uncommon' stock." In other words, the strong will bolster themselves continually while the weak fester.

Among his pet stocks is Volkswagen - which has boosted its share of the European market to 25 per cent this year. Its balance sheet boasts €15bn net cash which enables it to access capital very cheaply at a rate of less than 2 per cent - an important ability for a car company because of the prevalence of car loans.

And compared to its major competitor, Peugeot, Volkswagen looks even more tempting. "Peugeot has just 12 per cent of the market share, and this is shrinking, along with its balance sheet. Unable to secure cheap credit, it is forced to take what it can get - refinancing for around 8 per cent - a full 6 per cent more than its rival, Volkswagen."

Mr Norris continues: "Volkswagen will hurtle ahead of Peugeot because it has a competitive edge. Peugeot has a weak brand and runs inefficiently. Its factories only run at 50 per cent efficiency so it's closing down one of its main factories in France. It's in trouble now and will require intervention by the French government by the end of 2013 at this rate."

The recipe for success appears simple and Mr. Norris says there are some easy indicators investors can look for if they want to single out those who can swim from the vast sea of probable sinkers. He says looking at companies' credit default swap costs (the cost of insuring against defaulting on debts) gives a good indication of the strength of their balance sheets. While this costs some industries less than others, note pharmaceutical and food companies generally have lower costs, 150 basis points is an acceptable cost level. Unsurprisingly Peugeot's currently costs 701 bps, while Volkswagen's is a comparable snip at 91 bps.

If you believe European equities will fall further or regain value at a rapid rate, Mr Norris's view is perhaps one for the scrapheap. But if you take the view that slow growth is on the cards for the foreseeable, it's certainly one to consider.

Mr Norris's IM Argonaut European Alpha fund (ISIN: GB00B7MW8T72) has been a respectable second quartile performer over a three year period, but slumped to the fourth quartile over a year, according to Trustnet. Mr Norris says this is because lower quality companies have dramatically outperformed over the last six months.

Only time will tell if favouring companies with a "competitive edge" will pay off in the way of investment returns.

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