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Germany's Anglo-Saxon values

Created:
5 June 2007
Written by:
Algy Hall

After slowing to a near halt, the German economy has now started to pick up speed. Despite a recent substantial VAT increase, the European Commission forecasts healthy gross domestic product (GDP) growth of 2.5 per cent this year. In fact, evidence is now stacking up that this economic resurgence, which began with a rise in exports, is spreading out across the economy. So, what are the likely economic hot spots that UK investors should target? And, more importantly, which UK companies offer the best exposure to them?

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Ruthless German efficiency

Germany has been through a painful transition to get to where it is today. When things started to go badly wrong with the economy, German policy makers and businesses had their backs against the wall. The adoption of the euro meant there was no scope for a currency devaluation, which under different circumstances would probably have been the easiest way to help the export-heavy economy face up to the mounting competitive threats posed by globalisation. What's more, the country's heavily regulated and protected labour markets meant that industry lacked the flexibility to adapt to these new circumstances.

However, with growing support for a reformist economic agenda, iconic industrial giants, such as Mercedes and Siemens, have grasped the nettle by laying off staff and pushing through major restructurings. Mercedes, for example, has cut 8,500 blue-collar jobs in recent years, while its parent company, DaimlerChrysler, cut head-office staff by one-fifth, equivalent to 6,000 jobs. Other manufacturing companies have also reduced costs by shifting operations overseas and utilising the large amounts of cheap and willing labour found just across the eastern boarder. "It's been very difficult to restructure the social structures, because they were working so well for so long," explains Cato Stonex, the respected manager of the St James's Place Greater European Progressive unit trust. "But we've now had the election of Mrs Merkel, and we'd expect an ongoing slow movement towards the Anglo-Saxon model."

It looks like the pain caused by these tough measures has already been worth it. German unit labour costs have actually dropped by around 10 per cent over the past decade, which has kept exporters competitive and helped kick-start the recovery process. Germany's very high level of capital investment per worker should now help it keep this advantage.

Springtime for Germany?

So, having got through the hard times, Germany's sleeker corporate sector has begun to reap the rewards. The success of the country's exporters, which have been boosted by strong demand from booming economies such as China, has helped buoy German business's belief in the vigour of the recovery. The IFO German confidence indicator recently hit its highest level since records began in 1991 and, with rising confidence, has come an increased willingness among German businesses to spend - the lifeblood of sustainable economic growth.

As a result, the unemployment rate has now dropped below the 10 per cent mark - to 9.3 per cent - as businesses boost their staffing plans, and the European Commission predicts a further 2 per cent fall during the two years to the end of 2008. But German businesses are not only spending on new employees. In the current environment, investment is also being made to increase capacity, which means orders for new equipment for other German companies. And i

It is not just business that is benefiting, either. "Despite the increased competition from the rest of the world, the foundations are looking pretty solid on the export side," says Rob Burnett, manager of 2006's best-performing European unit trust, the Neptune European Opportunities Fund, "but it is the consumption side of things that's getting people really excited now."

We have ways of making you shop

As business expenditure rises and jobs begin to look more secure, consumers are becoming more active. Retailers have remained optimistic about trade despite the recent rise in VAT, and there are now signs of modest real wage inflation coming through - which should help encourage Germans to start reaching for their wallets. The European Commission predicts that private consumption will become the main driver of growth in 2008.

Many exciting opportunities could flow from this heightened consumer activity because, after many years of consumer austerity, the German public's bank accounts are bulging. So, should they decide to raid their savings, a torrent of spending power could be unleashed. Although none of this is likely to happen overnight, when it does happen, it will reinforce economic growth and help insulate Germany from any nasty external shocks.

However, nothing is guaranteed and there are still some spanners that could get into the works. The euro is a case in point. Its ascent against the dollar does not seem to have caused many problems to date due to the efficiency improvements in Germany. But a major further appreciation of the euro could seriously hurt exporters, as could a downturn in global economic growth. There are also perennial fears that Germany's still powerful unions will demand too large a slice of the benefits of the economic recovery and bring the whole thing to a shuddering halt. All in all, though, the outlook looks encouraging and there are particular areas of the German economy that could have exciting prospects for UK stocks exposed to them.

The housing market
Unlike the inhabitants of many other European Union member states, Germans have yet to catch the house-buying bug. In fact, in real terms, German residential property values have hardly moved over the past 10 years and they look extraordinarily cheap compared with the frothy markets in countries such as Spain, Ireland or the UK. At present, though, the German system does little to encourage a home-owning culture - few banks are willing to provide mortgages worth more than 80 per cent of a property's value. It can also be difficult to buy a flat in Germany if you are not willing to purchase the whole block. However, it is hoped that increased prosperity and consumer confidence will bring about change. The introduction of the Europe-wide Markets in Financial Instruments Directive (Mifid) in November may even kick-start the mortgage market. So, while any changes are likely to be slow in coming through, prospects look encouraging and the long-term rewards could be substantial.
What to buy for exposure: Speymill Deutsche Immobilien
In April, Speymill Deutsche Immobilien announced that it would soon be fully invested after buying E480m of German residential property and notarising a further E900m-worth of acquisitions. So the fund has gone back to the market and raised a further E250m with a 'C' share issue. The 'C' shares will convert into ordinary shares once the issue is 85 per cent invested, or after two years if this is sooner - all of which should help protect existing shareholders' interests. The fund has also been structured to provide shareholders with a decent income while they wait and hope for a home-buying culture to take hold in Germany. To that end, a 6p dividend is expected on the ordinary shares in the year to the end of June 2008 which, at their current price of 118p, represents a tempting 5 per cent yield. Speymill can employ a high level of gearing, too - it can fund deals with up to nine times as much debt as the equity it puts in. This means it would benefit massively from a significant rise in the market, but would also be badly hurt by any fall. Admittedly, the shares are priced some way above the last disclosed net asset value (NAV) of 94p but, nonetheless, they still look good value.

The recruitment market
The fall in German unemployment is coinciding with the emergence of a German recruitment industry, aided by the recent liberalisation of employment laws. The market is still very young, though - so much so, that some recruiters complain that they have to start some phone calls by explaining what a recruitment company actually does. But things are changing and, due to the industry's early stage of development, opportunities look substantial. So a number of UK players are now targeting this fledgling market, in the expectation that it could produce big returns in time. The experience and professionalism of UK recruitment companies should also give them a head start when it comes to winning and keeping clients. So recruitment firms are helping German companies get around the lack of flexibility that still exists in the German labour market and German companies are slowly beginning to embrace their services.
What to buy for exposure: Empresaria
Earlier this year, acquisitive Aim-listed recruiter Empresaria bought a 60 per cent stake in German temporary staffing business Headway for £10m. And Headway looks particularly well-placed to benefit from the German recovery as it has 47 offices located in Germany, Austria and the Czech Republic. It is already generating E77m of turnover a year from the region, and makes profits before tax and interest of E3m. So it's poised to benefit from the increased use of temporary staff in Germany which, while being the second-largest user of temporary workers in continental Europe, only has a penetration rate of 1 per cent of the total national employed workforce. That compares with over 2 per cent in France and 5 per cent in the UK. Empresaria is also investing in other international growth markets, such as Asia. So, at their current price of 166p, Empresaria shares are valued at a punchy 19 times forecast earnings but, based on the growth potential, they're a buy.
What to buy for exposure: SThree
Last year, IT recruiter SThree opened offices in Frankfurt and Munich, and chief executive Russell Clements believes Germany could ultimately be as big a market as the UK for the group. However, this is not expected to happen overnight. In fact, it looks like it could be a long, hard slog. But SThree's focus on hard-to-find technically skilled staff should help it win over employers to the value of its services. At the moment, though, Germany's contribution to revenues is minimal - so there is ample scope for growth. SThree's shares currently trade at 508p, which is a lofty 18 times forecast earnings, but high margins and favourable conditions in employment markets mean they're good value all the same.

The retail market
For a decade, German consumers have been remarkably thrifty. In fact, there are few international retailers that have bothered targeting Germany because conditions have been so dire for so long. The general feeling is that Germans only do serious shopping at highly-competitive budget retail chains - a segment of the market that most retailers would only enter out of necessity. However, there are signs that the market is changing. A 3 per cent rise in VAT at the start of this year did little to dent retail activity, surprising observers who had predicted a halt to the consumer recovery. And Germany's lofty savings rates show signs of moving in the right direction, too: downwards. Structural changes, such as Sunday opening, should also help to invigorate the sector. There aren't many UK-listed companies that can benefit directly from this, but there are a few that own or manage German retail property.
What to buy for exposure: Dawnay Day Treveria
Aim-traded Treveria has ambitious plans buy over E3.5bn-worth German retail property. And the fund has already gone some way towards this, with E1.6bn-worth of purchases and E830m worth of acquisitions notarised or in solicitors' hands at the end of March 2007. However, Treveria is far from alone in its pursuit of retail assets. International investors have swarmed into the market in anticipation of a retail revival. Consequently, property prices have rocketed, which is reflected in the 15.8 per cent rise in Treveria's adjusted NAV from its float in December 2005 to the end of last year. Current valuations suggest there's room for further upside, though, and the fund is promising to pay out 85 per cent of its distributable profits as dividend. So while the shares, at E1.34, trade at a hefty 20 per cent premium to 2006 adjusted NAV, they're good value.

The construction market
The construction industry is yet to come into its own in Germany, but this could be the year that noteworthy profits start to be made after a tough recent period. Some performance improvements were evident in 2006, with fewer firms reporting big losses - but that may have been because construction work was brought forward to beat the introduction of higher VAT. All the same, with business confidence rising and capital expenditure increasing, the construction sector should benefit. And there are a number of UK-based companies that offer exposure to this market.
What to buy for exposure: Keller
Last year, ground-work specialist Keller saw its German business begin to stage a long-awaited recovery after more than a decade of stagnation. Revenue there grew by about 10 per cent which, combined with increased margins, produced a significant improvement in the division's performance. This progress came not only from commercial work but also from major infrastructure projects. But even if progress slows, this is not the be-all and end-all for Keller. Its German operation forms just part its wider European division, which produces one-third of the group's turnover. Keller's shares, at 1,073p, currently trade on 15 times forecast 2007 earnings, so they now look good value given the group's strong market position.

The SME market
While a lot of attention has been given to the impact of restructuring on Germany's industrial giants, less attention has been paid to the country's small- and medium-sized enterprises (SMEs). But as the large companies have reshaped, many highly-skilled and experienced workers have left to set up businesses of their own - often to do the same work as they were doing at the large firms, with significant amounts of output contracted to their ex-employers. So banks have started to recognise the growing role of SMEs in the German economy and many have set up local lending teams to cater for their needs. If economic conditions continue to improve, these needs will get larger.
What to buy for exposure: Dawnay Day Sirius
This recent Aim float plans to set up high-quality flexible workspace units in Germany. Its management team has a great track record of doing this in the UK - and UK-focused companies, such as Workspace and Bizspace, have already demonstrated that this business model can produce phenomenal returns for shareholders. But will it work in Germany? Judging from Dawnay Day Sirius's success at converting four ex-Siemens buildings prior to its float, the answer is yes. Sirius is focusing on buying tired commercial buildings because, by bidding for such assets, it is less likely to come up against fierce competition from the swathe of international money currently targeting the German property market. The portfolio at float only stood at E200m compared with proceeds of E330m, but the fund now has an acquisition pipeline of over €400m. So, at €1.06, the shares are a buy.

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