German profit machines

So it was with some interest that I read recently that the Goethe Institute - the German equivalent of the British Council - has seen a huge surge in the numbers taking its language courses. I was intrigued enough to take the online German test on the Institute's excellent website to test my suitability as an economic refugee. I could swap a cramped 1930s house in London's suburbs for a reasonably priced apartment in a pleasant town with onion-domed churches and public transport that works properly. I can only blame a score of 21 out of 30 on the length of time since I took my degree.

But you don't need to speak German to see that the country's economic power is making waves in the world. Despite the woe all around it, Germany is booming. It grew by an impressive 3 per cent in 2011, even in the teeth of a massive euro crisis. A fifth of Spaniards might be out of work, but Germany has the lowest unemployment rate in decades – around 6.6 per cent last year, compared with an average of 9.7 per cent between 1991 and 2010.

Its public finances are also in great shape. Its financing needs are minimal next year compared with those of its southern European neighbours; the federal government needs to find €250bn to meet bond redemptions and interest payments, 5 per cent higher than last year, according to an analysis by Credit Suisse. That means the government's own finances will be in remarkably good shape, with spending departments expected to run a primary surplus this year. After the recent raft of downgrades, Germany is now the only major AAA rated country in the eurozone.

That explains why German government bonds, or 'bunds', are in such high demand. Germany was recently able to sell a bundle of short-dated bonds at an effective negative interest rate – investors paid the German treasury for the privilege of lending it money. Such safe-haven demand for bunds has propelled their prices into what many agree is bubble territory, as well as a depressing reflection on the state of Europe's other debt markets.

So while German bonds are definitely not the way to play the German story, what about German shares? Even though many German companies are booming, thanks to a buoyant domestic economy and soaring exports to the emerging markets, the DAX 30 had a poor 2011. Germany's major stock-market index fell 14.7 per cent from the start of the year compared with a 7 per cent decline in the FTSE All-Share and a flat S&P 500, and is still well below the peak reached at the end of the second quarter.

That may reflect an external economic outlook that's less certain than it was. Analysts are more or less evenly split over what this year holds for the German economy; some forecasts suggest that growth could fall back to just 1 per cent in 2012, and some measures of output have started to show negative growth. For example, construction companies reported slowing orders in the last quarter of 2011, but employment in the sector has risen quickly as projects currently under construction soak up labour. Slackening public sector spending on infrastructure projects could also slow down the sector.

Manufacturers seem to be in a cycle of clearing a backlog of orders built up during an exceptionally strong first half. The purchasing managers' index for manufacturing currently stands at 50, suggesting neither expansion nor contraction. Job creation has slackened off in the sector, but some analysts still see grounds for optimism: "There were a couple of bright spots in the German economy, as indicated by the latest rise in exports and surging construction activity, partly caused by the mild winter weather. Hence, according to our calculations, hard economic data points to a slight rise in overall economic activity in 2012 and not to a decline," said Unicredit analyst Andreas Rees. High employment levels are also boosting consumer confidence.

Beyond its own borders, Germany's prospects hinge largely on a resolution of the eurozone crisis and a soft landing in China, another of its major trade partners.

Top German shares

The lack of choice in collective investments means you may want to buy shares directly; easily and cheaply done these days, thanks to the spread of international online dealing. You should be aware that corporate disclosure requirements in Germany are less stringent than those in the UK, and you may come across share classes with different voting rights and companies with large cross-shareholdings. But the good news is that most company statements, presentations and reports are available in English, thanks to the internationalisation of companies' share registers. Many also have sponsored American Depository Receipts trading on the US market.

One company that looks good value right now is Heidelberg Cement. A pick-up in construction activity pushed the shares sharply higher towards the end of 2009, but they have since fallen substantially and the current rating of just over 10 times 2012's forecast earnings looks a good point to get involved - especially as the shares trade at a sizeable discount to its tangible book value per share of €63. Heidelberg Cement, which gobbled up the UK’s Hanson Group in 2007, has also been hit by poor sentiment towards Holcim, its biggest continental rival, which is taking a charge on over-stocked stores of building materials.

Medical shares also represent decent value, such as current IC buy tip, Bayer. The shares have been hit recently after the company was asked to supply more data for its blood clot treatment Xarelto. That creates a more compelling buying opportunity, given that Bayer is shielded by its conglomerate structure and rewards investors with a rising dividend payout.

Overrated and overvalued

German luxury cars are not in themselves bad value - own a BMW and you will probably conk out long before it does – but share prices in the sector have raced ahead since recovering from their post-Lehman lows. Take BMW as an example. Its cars may be flying out of the showrooms in Moscow and Shanghai, but the Bavarian carmaker's share price is currently double its tangible book value of €34 a share.

That might look justified on last year's performance, but the company also noted a build-up of inventory in the third quarter, which could become a problem if demand slows and it is forced to resort to discounting. Investors like BMW for its booming exports to developing markets, but a breakdown of their sales figures shows that traditional markets such as Italy still account for a good chunk of sales and profits – more than 5 per cent in BMW's case – and a continuation of eurozone austerity measures could affect exporters eventually. In short, it may pay to wait for carmakers to de-rate – a price range of between €40 and €45 for BMW seems a more realistic prospect.

There are also dominant shareholders at all the German car-makers. The Quandt family still owns two-fifths of BMW, while the state of Lower Saxony holds a fifth of Volkswagen. Porsche has also been building a stake in VW, using some controversial methods, and this has served to inflate the group's share price.

How the DAX stacks up

The table below shows some key metrics for the 30 shares in the index. Compared to the UK's FTSE 100, you can see it's concentrated in fewer sectors. The resources sector that makes up 30 per cent of the UK market is almost entirely absent from the DAX, whereas the giant Siemens is worth more than all the UK's quoted engineering firms put together. The UK market may lack an auto manufacturer, but German has three in the blue-chip index plus Porsche in the mid-cap M-DAX. The concentration of shares in areas like capital goods means that the Dax is highly cyclical, and highly correlated – shares tend to move with each other, rather than in diverging directions.

And for all the size and power of the country's economy, Germany's stock market is relatively small. At the end of 2011, its total market capitalization was $1.18 trillion compared to $3.27 trillion for the UK. That's because many large corporations remain in private ownership, financed by long-term relationships with banks and other creditors, and because a big chunk of German enterprise is accounted for by the Mittelstand – battalions of small- and medium-sized business, often still controlled by founding families.

Relative to earnings, the German market trades at a small premium to the UK. But compared to book value, many of its companies appear surprisingly expensive despite the Dax's mediocre performance last year (a stark contrast to Japan, whose similarly export-oriented conglomerates look relatively cheap on a price-to-book basis). There are several possible explanations for this. One is that investors have simply cottoned on to the fact that a weaker euro versus the US dollar is great news for big exporters (again, Japan's exporters are battling a strong yen), and have bid up their shares. Another is that German companies are heavily backed by fixed assets, which depreciate over time. The mountains of acquisition-related goodwill and intangible assets common on UK balance sheets are a less prevalent in Germany.

How Dax 30 constituents compare