China is the key to growth in the European car-making sector, not the UK, despite what leading Brexiteer politicians may think, according to Niall Gallagher at GAM.
Brexit concerns have helped depress investors’ appetite for UK stocks, but many on the Leave side of the debate have insisted Brexit will be just as bad, if not worse, for the EU.
Some have suggested that the UK is such a key market for automotive firms, particularly those in Germany, that these companies will lobby their respective governments to convince the EU to soften their negotiating stance.
But Gallagher, who manages the GAM Star European Equity fund, disagrees. In fact, while the UK is not irrelevant for German car makers, it’s certainly not important. Indeed, the biggest risk to the German car industry would be a serious downturn in China, not a no-deal Brexit.
“By far the most important market for German car makers is China, and when I say by far I mean by a multiple, not by a percentage,” Gallagher claims. His fund holds Volkswagen (VOW), which derives somewhere in the region of 40-50% of its profits from emerging markets, the bulk of which come from China.
China, China, China...
The most popular car brands in China are the likes of Volkswagen, Audi – which is owned by Volkswagen – and Peugeot (UG). Not only do these firms exports cars to China, they also manufacture them there through joint ventures with local firms, which net them royalties. The UK, by contrast, is solely an export market for European car makers.
“The UK is not profitable for car makers,” says Gallagher. “The margins in China are between 2-3 times the margins in the UK. This is a complete misnomer that people in the Tory party have got obsessed with; the UK is not important for most of our companies, and it’s certainly not important to the car makers.
“It’s all about China, China, China for the German car makers. The US and Germany are important, too … in terms of numbers, China is 30-something million cars a year, the US is about 18 million cars, the UK is around 2 million.”
But it’s not only the car makers that rely on China and the rest of the emerging market universe for a large chunk of their earnings growth. About 40% of the revenues derived by European companies comes emerging markets.
Despite Gallagher’s fund being more domestically oriented than the market as a whole, he also likes Inditex (ITX), which owns retail store chain Zara, and LVMH (LVMH), the luxury goods retailer. The latter is well exposed to the rising middle-class consumer in emerging markets like China and India and Gallagher says it is attractively valued, at bang on its 30-year price/earnings average.
Despite Friday morning’s figures showing growth in China slowing to 6.5%, the slowest rate since 2009 and shy of economists’ 6.6% forecasts, Gallagher says he’s optimistic on the outlook: “China is slowing somewhat, but it’s a controlled slowdown and our emerging market fixed income team expect a bounce towards the end of the year.”
Brexit Won't Impact European Valuations
On Brexit more specifically, Gallagher says companies he meets don’t tend to talk about it much, though they are starting to look at its impact more. One thing that strikes the manager is the lack of investment in the UK there has been in the past couple of years. Therefore, there could be a bounce if we get a good deal.
But, of course, the likelihood of a hard Brexit is rising. While there will be differences in terms of the impact of no deal depending on where you are – if you’re in Northern France it’s probably worse than if you’re in Greece – chances are it will be more damaging for the UK than Europe.
Certainly, he doesn't foresee any reasons why a no-deal Brexit would throw up buying opportunities, as he can't see how it would impact company valuations on the continent at all.
And Gallagher remains bullish on the outlook for the companies and economies that make up his universe. While economic growth has certainly slowed, 2-2.5% is still healthy. Meanwhile, unemployment, particularly among young people, is rapidly coming down, while wages are starting to grow.
Earnings growth of 8-10% looks attractive, meanwhile, especially when combined with a market that trades on just over 13 times earnings. “Our fund has quite a lot of stocks that are trading on single-digit P/Es,” he says.
“These are often companies that have no debt and are run with balance sheets with fair amounts of net cash. They have high return on capital employed and have decent free cash flow yields. But, for whatever reason, they trade particularly cheap.
“We think they will continue to be good businesses that generate good returns and this cheapness will attract people to invest in them some more.”
