Don’t underestimate the DAX

The winners of the latest rally in the DAX are mostly foreign investors. They have increased their DAX-exposure from 52% at the beginning of the new investment cycle in 2009 to 63% in 2015. During this time German investors, both retail and professional, have decreased their exposure.

It seems as if, paradoxically, domestic investors lack faith in German companies and foreign investors are taking advantage. In the long term, this could come back to bite a great many German investors.

A fundamental question that arises in connection with equity investments concerns the risks and opportunities of country-specific equity markets. There are many strong arguments in favour of the German stock market. Long-term analysis shows it has achieved a geometric return of 6.2% per annum since 1965. This corresponds to a doubling of assets every 12 years.

Positive returns were achieved in 68% of all years during that timeframe. The probability of positive returns increases with the length of the investment horizon, while continuous saving contributions reduce the risk of unfavourable entry points. Even an investment in early 2000, at the peak of overvaluation, would have made up all its losses by 2007. The stock market crashes during both recent financial crises (2000 and 2008) recovered within only a few years.

It remains to be determined whether past returns serve as a good indicator for the future returns of the German equity market. Many people are saying “this time everything is different”, making it harder to draw on experiences of the past. Extremely low interest rates, excess money in the financial system, innovative technologies, the unresolved European sovereign debt crisis, an economic cycle manipulated by central banks and a variety of other factors combined are creating a situation investors have never seen before.

In this environment overreacting and forgetting market basics can prevent investors from accumulating wealth and tempt them to make bad and costly decisions. Investors’ psychology never seems to change, in spite of varying external conditions. Fear and greed may continue to lead to exaggerations in the stock market. In addition to the behavioural explanation for price fluctuations, the stock market often has its own energy, or ‘momentum’.

Shares follow trends and are impacted by a range of factors, often outside of the control of a company’s management, such as the economic cycle, politics and monetary policy, and news on competitor activities and market dynamics. Investors in German equities must accept stochastic fluctuations – short and medium-term price risks – to achieve the impressive growth available when investing in the DAX.

Money supply as oxygen

All paper money in circulation plus demand deposits in instantly accessible bank accounts (M1) increased more than sixfold in the euro zone between 1990 and 2015. This liquidity has fuelled a rise in stock markets, despite recent softening of fundamental data hitting investor sentiment. Rising prices stimulate additional investor interest and prompt buying, pushing up valuations. Looking at the DAX, you can see that even after strong price appreciation since 2009, current valuation levels don’t seem overly expensive. The total value of all listed companies in relation to gross domestic product lies around its long-term average at 42% (since 1990). The valuation of the German stock market has not risen faster than the value creation of its economy, and further price appreciation for German stocks seems likely.

Germany is home to more than 1,500 ‘Hidden Champions’. These are companies with fewer than 10,000 employees that nevertheless hold a world market share of between one and ten percent and have had exceptionally strong sales growth of at least ten percent above their industry average in the past five years. Most Hidden Champions in Germany come from the industrial sector (86%), where mechanical engineering accounts for nearly 25%. Many of these companies are attractively valued. Opportunities also exist outside of the industrial sector and Hidden Champions from different industries include Zooplus (cyclical consumer goods), Ferratum (financial service provider), Takkt (consumer discretionary) and Jenoptik (IT).

The attractiveness of the German stock market is based on its high earnings yield of around 6% (excluding financial and utilities) currently and hence its lower valuation compared to other stock markets. The high current account surplus of the German economy is an indicator of the strong positioning of German companies in the global markets. The importance of country allocation will become the focus of investors again when the current era of synchronized central bank policy comes to an end.

Oliver Maslowski (pictured), German equities portfolio manager at GAM

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