Selective Contrarian Investing in Europe

By Maxwell Kirchhoff - February 10, 2012 | Tickers: ING, RDS-A, SNY, TOT | 0 Comments

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Whether or not you believe the U.S. economy is back in full-force, you have to admit that compared to several Eurozone countries, our economy has performed quite well since the financial crisis.  

Warren Buffett, arguably the greatest investor of all time, made several acquisitions near the bottom of our market's crash stating, "Be fearful when others are greedy, and be greedy when others are fearful."  In academic lingo, this means that Mr. Buffett is a contrarian investor.  This time-honored advice and investing behavior inspires us Fools, but also presents a few challenges:

• How can I determine that others are fearful?
• How can I be sure that when I buy stocks during these periods that they will re-emerge to their previous (or higher) valuations?
• Which sectors should I invest my money in?

The remainder of this commentary will attempt to steer investors toward the fearful areas, demonstrate which sectors investors should focus their attention, and highlight a few key metrics at the company level.

The answer to how one can determine that others are fearful is not as simple as it should be due to the irrational behavior of markets, but I believe that Google Trends is a tool that can aid investors wondering if: 

• The current "fear" is real and substantial.
• The fear is growing or dissipating.

A search for the term "global recession" presents the following:

This result demonstrates that the volume of searches for "global recession" very closely mimicked the actual global recession.  If investors made Dow index purchases at point "E (July 29, 2009)," or when the traffic lowered substantially and plateaued, they would be sitting on a handsome capital bounty today.  The DOW is up just over 40% from that point: 

The next question investors must answer following Buffett's advice is how they can be sure that when they buy stocks during periods of fear that they will re-emerge to their previous (or higher) valuations.  

Let's turn to Warren Buffett again and remember that he once uttered, "Some men read Playboy, I read financial statements." This statement should not just make you laugh, you should also take Mr. Buffett's level of discipline seriously.  He scours thousands of financial statements looking for what Mary Buffett calls a durable competitive advantage.  That is, the company should hold a leadership position in its sector and enjoy a name-brand mark-up that will last for generations.  Without going into full detail (you can buy Ms. Buffett's book revealing all the secrets here), some key indicators Buffett looks for are:

• Gross profit margin should be 30% or greater.
• R&D should be under 55% of gross income.
• The past seven years should show increases in sales.
• Net profit margin should be above 20%.
• ROA should be greater than 12%.
• There should be little (relatively) or no long-term debt facing the company.
• ROE should be greater than 20%.

If the company under consideration meets these thresholds, there is an excellent chance that said company enjoys a durable competitive advantage.

Finally, the last question investors must answer following Buffett's advice is which sector they should invest in.  This question is very easy to answer.  Let's turn to Buffett again and remember when he said, "If we can't find things witin our circle of competence, we don't expand the circle.  We'll wait."  

More simply, Buffett is saying stick to sectors you know about and are familiar with -- do not look into securities that operate in sectors beyond your knowledge with attractive valuations -- wait until the attractive valuations come to the sectors you are personally familiar with.  

On this point, Buffett has truly practiced what he preached.  As a young man Buffett drank plenty of Coca-Cola, delivered Washington Post newspapers, and chewed plenty of gum.  As such, Coca-Cola, the Washington Post Company, and Wrigley have all been mainstays in Buffett's portfolio.

Now that we know when to buy (during times of fear), where to buy (a sector one is comfortable with), and what to buy (a company with a durable competitive advantage) -- is there anywhere a selective contrarian investor should direct his or her attention to currently?  Yes.  Europe.

Let's run through each part of the selective contrarian methodology to uncover undervalued companies that enjoy durable competitive advantages in markets that are rampant with fear.  

As stated at the outset, U.S. indexes have outperformed some European indexes since the 2008-09 financial crisis.  A majority reason behind Europe's underperformance stems from the debt of certain Eurozone nations.  If you use the Google Trends tool and search for "Eurozone crisis," you'll get this:

This result displays that compared to 2010 there is presently a tremendous amount of interest in a "Eurozone crisis."  The word crisis in economicspeak is synonymous with fear.  

Currently there is a downswing in search volume, but I believe the trend should head upward yet again.  I hold this view because Greece's bailout hold-up was cited in numerous forums as the reason global markets were down Friday and the Dow suffered its worst decline this year.

Greece's tiny economy has been a major thorn in the global economy's side as of late, and it has dragged on fellow Eurozone countries the hardest.  France and the Netherlands are two such sufferers, and these countries are home to some major companies with global footprints.

Here is a five-year comparison of the Dow and the major exchange from the Netherlands, the AEX:

And here is the Dow with France's CAC-40:

While both France and the Netherlands have their own specific economic ailments (find me a nation that doesn't), their drastic underperformance relative to the DOW should have some relation to Greece's debt situation.  

Everything considered, these two markets are stricken with "Eurozone crisis" fear and selective contrarian investors should seek companies with durable competitive advantages in these markets because when the fear subsides, the greed should kick in.

To start our search, lets go to each country's index and select easily understood companies that have high weights and big market caps.  The top two companies by weight from the Netherlands' exchange are Royal Dutch Shell (NYSE: RDS-A), and Unilever.  Since Unilever is headquartered in the Netherlands and England we will drop it from our survey.  The next highest weighted company from the AEX is ING Group (NYSE: ING).  From France, the two top weighted companies on its index are Total S.A. (NYSE: TOT) and Sanofi (NYSE: SNY).

Just to recap, we are looking to be selective contrarian investors acting greedily where others are fearful.  We have established that several Eurozone economies have many acting fearful and we have honed in on the Netherlands and France.  From this we have simply selected the top two weighted companies from each nation's index for further examination.  Now we must ask, are the sectors these companies operate in easily understood?

Both Total and Royal Dutch Shell are major integrated oil companies.  They explore for, produce, refine, market, and sell petroleum and other petrochemicals.  Oil keeps lights on, cars running, and manufacturing plants producing.  In sum, I believe that integrated oil companies should be relatively easy to grasp for most investors.  As long as demand continues to grow -- and almost every projection maintains it will -- these companies should fare well.

Next, ING is a financial services company that provides banking, investment, life insurance, and retirement services worldwide.  While the concepts of banking and insurance are easy to grasp, understanding the balance sheets for these types of companies requires specialized knowledge.  The financial crisis of 2008-09 serves to substantiate this claim.  In some cases even the experts misinterpreted types and degrees of debt.  Thus, unless you happen to be a bona-fide expert interpreter of insurance and banking financial statements, skip the insurance and banking companies.  Therefore, ING is removed from further consideration.

Finally, Sanofi engages in the discovery, development, and distribution of therapeutic solutions to improve the lives of everyone.  Some of its patented medications are Allegra (for allergies), Lantus (for diabetes), Lovenox (for thrombosis and heart attacks), and Ambien (for insomnia).  I know it sounds awful, but as long as individuals are suffering from these ailments, Sanofi stands to do well.

From here, let's see if Royal Dutch Shell, Total, or Sanofi hit our durable competitive advantage criteria.

* All figures from Yahoo! Finance. 

The above analysis would lead me to conclude that if any of the above companies enjoys a durable competitive advantage in an easily understood sector in a downtrodden and feared investing environment, it is Total S.A.  Utilize these metrics for yourself -- keep a contrarian temperament and remember: "Be fearful when others are greedy, and be greedy when others are fearful."

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