By Liu-Yue (Louie) Lam, Co-Founder, Chief Investment Strategist, Oxstones Investment Club
A long time ago, as an idealistic NYU student I expressed my vision of a United Europe to a Dutch graduate student who quickly shot down that idea and said Europe will always be divided. Many years later while studying for my MBA at Georgetown, I had the opportunity to take courses at the University of Oxford and again debated this idealistic vision; this time with Oxford professors during my research on EU expansion. I was surprised to discover that any conversation about EU was met with pessimism. From the academics at Oxford to the bureaucrats in Brussels, almost everyone I met did not believe in EU. Then why do it?
The monetary union was tolerated for the economic benefits that for years benefited the more efficient economies in core Europe, while eastern and southern European countries needed years to build the capitalistic mentality and infrastructure needed to compete with core Europe on more equal footing. Core Europe benefited from a free trade zone and a shared currency. They operated as creditor nations for years while freely lending to deficit nations in the south and the east. Now these years of deficits are coming back with vengeance.
Core Europe is now in self denial, pretending it was none of their own doing; just like the subprime lenders in the US. Cash flow is king in elementary lending 101, and if you know your customers do not have enough cash flow to make payments, is it really good business practice to lend to them? Did they expect these debtor nations to stop accepting their money? All you have to do is take a look at past credit history (ex. Greece has a history of defaults) to know if they were a good credit risk. Of course both sides are at fault. In the rush to increase transactional lending that would augment their bonuses, many greedy bankers failed to conduct proper due diligence. At the same time there were intentional frauds committed by corrupt politicians of debtor nations to hide and manipulate their books.
The less credit worthy nations should never have had the opportunity to borrow at artificially low interest rates simply because they were now part of the Euro Zone. There were too few checks and balances to control bad behavior and risky lending practices. There are no winners in this situation. But as J. Paul Getty once said If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem. In this case, we’re talking about owing hundreds of billions. So who do you really think has the leverage?
The Euro was always a flawed experiment. You cannot have monetary union without political and fiscal union. You also cannot have one size fits all monetary policy when different nations are governed with different economic policies, national agendas, and also are at different stages of development. In the end, I think the best case scenario is for EU to break up into different regions where nations share a common culture or language such as the Benelux, Germanic, Eastern Europe, and Scandinavia.
Life Time Opportunity for Investors
Although, I’m now an idealistic-realist when it comes to the future of Europe, I am still an eternal optimist in terms of investing. Crisis always creates opportunities. The next five years will be one of the biggest fire sales in generations. Current EU banks are extremely over-levered. EU banks are holding trillions of devaluing sovereign debts on their balance sheets. They are also holding hundreds of billions of bad real estate debts. With Basel III implementation, new capital requirements, and ongoing deflation in multiple real estate markets, EU banks will not only need to dramatically cut back lending, but also need to divest of assets totaling roughly $2 trillion. There is no better time to be an investor. You can either invest directly by buying foreclosed real estate in G.I.I.P.S. from banks or buy high quality European stocks that I mentioned in a previous commentary http://oxstones.com/oxstones-food-for-thought-july-2012-e-u-crisis-the-never-ending-story/.
Emerging European Corporations
Alternatively, you can invest indirectly by buying equity in the next global European corporate dynamos (Eastern European corporations), who will be buying real estate and other non-core assets from banks at fire-sale prices. Sberbank (SBRCY) the largest lender in Eastern Europe is already taking advantage of the EU crisis by buying Dexia’s Turkish subsidiary (Denizbank) in order to expand its global footprint. Russian energy giant – Gasprom (OGZPY) may also be on the hunt for bargains in Europe. You can buy the world’s largest natural gas player at less than ½ its book value with a trailing P/E of just 2.5x which amounts to an amazing earnings yield of 40%. As the world continues to shift to cleaner energy you can be certain natural gas usage will continue to increase.
Another Russian giant VimpelCom (VIP) has already invested in core Europe by buying Italian telecom assets. (VIP) is not only one of the largest telecom players in Russia, but also has operations throughout high growth frontier markets in CIS, MENA, and South East Asia. With over 205 million mobile subscribers, it’s currently trading below book value due to continue infighting between its institutional shareholders that has also prevented the distribution of its 2011 dividends. Although politics are hard to analyze I don’t expect the infighting to continue forever as it benefits no one. Investors can take advantage of this uncertainty by picking up this frontier telecom player on the cheap.
Emerging Europe – The New Frontier
I also believe some of the most attractive regions for investments in Europe are in Romania and in Ukraine. Microsoft and many top software companies are already invested in these countries. Not only are Romania and Ukraine top global outsourcing destinations for software development, but they also benefit from fertile farmlands which provide bright futures as breadbaskets for feeding Europe and MENA as well as for the development of alternative bio-fuels.
Another region that is an extremely interesting opportunity is the Balkans (Croatia, Bosnia-Herzegovina, Montenegro etc.). Having travelled extensively throughout the Balkans, I was not only amazed at the beauty of the land, but also astounded at the amount of infrastructure development still needed decades after the war. However, with young populations, affordable real estate, and strategic proximity to MENA I believe they are finally ready to fulfill their centuries-old promise to become the bridge to connect Europe, Central Asia, and Africa. Not only do frontier markets tend to be less correlated with developed markets, but also offer unique opportunities for outsized gains by participating in the early stage growth of these local economies. The key areas to focus on in these frontier markets are in housing and infrastructure development projects such as power generation (hydro etc.), rail system, roads, airports, and the large untapped mineral wealth (coal etc.).
The EU crisis will either bring all EU nations closer together or they will eventually break up into regionalism. In the end, monetary union without fiscal and political union does not work. The unfortunate thing is the greed of the few corrupt politicians, lobbyists, and bankers have harmed many innocent people.
As bad as things have been the past few years it’s just beginning. At a recent family gathering with some of my extended family in Eastern Europe, I mentioned that EU nations have already suffered for a few years, but things are just about to get a lot worst. In response one family member said ‘don’t worry about us because things have always been bad and can’t get any worse’. I realized that he was right, as bad as things have been in recent years for some EU nations this is still nothing compare to what other nations have suffered through over the past decades. Can you imagine how much lower salaries and benefits will have to decline in G.I.I.P.S. in order to narrow the income gaps? It is a scary thought. However, as one door is closing on the future of EU and the Euro, another door full of opportunities is now opening, and I plan to continue to bet that the future of Europe lies eastward.(Eastern European corporations), airports, balkans, bank de-leveraging, bank divestitures, Basel III implementation, Benelux, best case scenario is for EU to break up into different regions, bio-fuels, Bosnia-Herzegovina, breadbaskets for feeding europe, buy high quality European stocks, buying foreclosed real estate in G.I.I.P.S., By Liu-Yue (Louie) Lam, CIS, coal, core europe, croatia, cut back on lending, deflation in multiple real estate markets, devaluing sovereign debts, early stage growth in local economies, Eastern Europe, emerging corporates, emerging CRE, emerging europe, emerging market farmland, emerging markets, EU banks are extremely over-levered, European regionalism, farmland, frontier markets, Georgetown MBA, Germanic, global IT outsourcing destinations, hydro electric, infrastructure development in emerging markets, infrastructure development projects, large untapped mineral wealth, Life Time Opportunity for Investors, Liu-Yue (Louie) Lam, Liu-Yue Lam, MENA, Montenegro, new capital requirements, NYU, Oxstones Food For Thought – August 2012, Oxstones Investment Commentary, power generation, rail system, roads, romania, russia, Russian energy giant - Gasprom (OGZPY), Sberbank (SBRCY), Scandinavia, South East Asia, the future of Europe lies eastward, ukraine, uncorrelated markets, University of Oxford, VimpelCom (VIP), VIP