Finding interesting opportunities in Europe’s cyclicals

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Andrew Koch of Legal & General

For most of the world, the economic recovery from the Global Financial Crisis has been weak compared to previous cycles.

Interest rates are low or negative, and corporate profitability has grown more slowly than in previous recovery periods.

For several years, equity investors have reacted to this by seeking out stable, safe companies. Quality is an attractive attribute, and I am willing to pay an appropriate premium for this.

However, this trend has reached extreme levels compared to history and investors are in danger of throwing the baby out with the bathwater.

Basic materials (chemicals, metals/mining companies and steel producers) are cyclical and so have customer demand that rises and falls with the economy.

What will the ‘Japanification of Europe’ mean for investors?

Their profitability will fluctuate accordingly. There is nothing problematic about this.

When these companies are available at rock-bottom prices, the patient investor sees opportunity more than risk. 

In European markets, there is extreme sentiment in favour of quality and against these cyclicals.

Being classified in a cyclical sector like chemicals leads to a company like Wacker Chemie being ignored, despite its industrial strengths. Yet Wacker’s share price has fallen more than 50% from its levels in early 2018.

However, its largest divisions are in silicones and polymers. It has global leading positions here, and they are relatively stable and profitable areas of chemistry.

Moving to the more cyclical areas, such as steel, we can find further interesting situations.

Companies such as ArcelorMittal faced difficult times in 2015 as Chinese steel makers hurt steel prices around the globe. The company reduced its debt through a rights issue. 

Meanwhile, US and European tariffs led to Chinese mills being scrapped and prices rising. Four years on and the company is profitable, stronger and more efficient.

However, investors have taken fright at an industry that is volatile and hard to forecast. 

Today, ArcelorMittal trades at a valuation similar to the depths of the last downturn, and at a large discount to the value of its assets.

Andrew Koch is manager of the L&G European Equity Income fund

Bull Points

• Basic materials sector includes some strong companies overlooked due to their classification

• Deep cyclicals such as steel are already being valued at levels reached in the last downturn

Bear Points

• Political issues cloud the future path of the global economy

• Out of favour sectors can stay ignored for a long time

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