© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the October 2005 edition of BENEFITS CANADA magazine.
Capitalizing on EAFE
Now that the Foreign Property Rule is a thing of the past, Canadian plan sponsors should be looking for investments elsewhere.
By Steve Tyson, Peter Kysel and Stephen Hill

As Canada opens the gates to foreign investment with the elimination of the Foreign Property Rule, many plan sponsors are pondering for the first time what a truly diversified international equity portfolio would look like. That’s because while foreign content was capped at 30%, most Canadian plans had the lion’s share of their foreign exposure to the U.S.

There were good reasons for this: liquidity, proximity, familiarity and the quality of U.S. companies. But that focus on the U.S. kept Canadian investors underexposed to a huge market rivaling the S&P 500 in size and boasting many globally competitive companies of its own. That market is now experiencing new internal and external sources of growth. That market is EAFE.

As we all know, in the investment world, EAFE stands for Europe, Australia and the Far East. An EAFE index published by Morgan Stanley Capital International(MSCI)comprises 21 developed capital markets excluding the U.S. and Canada. As of Sep. 1, 2005, the index had a market capitalization of US$9.4 trillion, compared to US$11.2 trillion for the S&P 500.

In Europe, the index includes 14 members of the 25- state European Union, the largest market in the world, based on Gross Domestic Product and population. The Far East component also includes Japan, still the second largest national economy in the world next to the U.S. While Australia has a weighting of about 5%, EAFE is, for all intents and purposes, Europe, which accounted for 62% of the index as of Sep. 6, and Japan, which alone accounted for 22%.

Each of these markets is a global heavyweight in its own right. In Europe, Canadian investors get exposure to the unlocking of shareholder value through ongoing corporate restructuring and to the dynamism of Eastern Europe. Japan, meanwhile, is recovering from years of economic stagnation.

Investing in EAFE exposes investors to a host of new currencies, predominantly the euro and the yen. To some extent, though, exposure to both major currencies diversifies away currency risk, especially in portfolios that include U.S. equity and U.S. dollar exposures. Correlations among these three currencies are low and history suggests that exposure to all three can minimize the foreign currency impact on the returns of Canadian-based investors over several years(see “Minimizing the impact” below).

For active managers, EAFE represents new sources of alpha for their portfolios. Because EAFE historically has not had as strong an equity culture as in the U.S., transparency is generally lower and the markets are not as efficient. With information less effectively disseminated, it should be easier for the active manager to add value.

Over the next few years, EAFE will also witness fundamental improvements in market and economic conditions. Japan and Europe continue to emerge from years of sluggish growth as corporations embrace shareholder value and governments privatize and dismantle onerous regulatory regimes.

In the popular imagination, Europe is a hidebound region too preoccupied with basking in past glories to break out of the “euro sclerosis” that is choking off the continent’s competitiveness. That’s certainly not true of the United Kingdom, which undertook macroeconomic reforms several years ago. By staying out of the European Monetary Union, the U.K. offers a diversifying influence for investors in EAFE, as its interest rate cycle is different from that on the continent. Often, slowing growth in the U.K. will be offset by accelerating growth on the continent, and vice versa.

Even on the continent, though, companies began dramatic internal reforms around the turn of the millennium when they realized they were losing global competitiveness. Taking their cue from England and the United States, traditional continental conglomerates took the radical step of scrutinizing the viability of individual divisions on a standalone basis and divesting unprofitable units. Now, every unit has to offer an attractive return on capital.

The resulting reduction in leverage has led to an upsurge in European merger and acquisition activity that is expected to continue as cash-rich companies look for takeover targets. And European companies have re-emerged as global leaders. In Germany, there’s Adidas-Salomon, which has announced a takeover of Reebok that should vault it into head-on global competition with Nike. Another example is luxury brand owner Richemont, which owns names like Cartier, Mont Blanc and Dunhill.

Corporate restructuring means that European profits have been able to grow as fast as in the U.S. despite slower economic growth. Because European restructuring started later than in the U.S., there remains more room for margin improvement. Some people worry that anemic economic growth in Europe will drag down corporate performance.

European corporate restructuring is a long-term project that is still in its early stages. It represents a fundamental cultural shift toward greater emphasis on shareholder value that has the potential to continue playing out and bringing benefits for several years to come.

Those benefits are also flowing from a major political development in the region, the expansion of the European Union from 15 to 25 members in 2004. The expansion has turned the EU into a much more dynamic market, including countries with growth rates that are often double those in older EU member states, and cheaper, more flexible labour pools. Also, countries to the south and east of the EU’s new frontiers in Poland, Slovakia, Hungary and Slovenia are deregulating and cutting taxes in an effort to make their economies more attractive for investment from—and potential membership in—the EU. Many core EU states are feeling pressure to follow suit.

The most immediate impact has been on wages. Factory workers earn €24 per hour in Germany and €20 in France, but only €5 in Poland. The difference is significant for a company like auto parts maker Leoni, which produces wire harnesses for cars that take a worker eight hours to make. Leoni, a German firm, has no production in Germany.

The downward pressure on wages due to the absorption of East European labour by West European manufacturers should continue for some years. Once wages in the Czech Republic or Poland catch up with those in Germany and France—a process that will take years— European manufacturers may be able to shift further east to other countries still waiting in the wings for EU membership, such as Bulgaria and Romania. As those markets are absorbed, Ukraine and Russia could follow. By keeping costs down this way, Western European manufacturers will remain competitive, boosting potential returns for investors.

Portfolio managers benchmarked against MSCI’s EAFE index often have leeway to invest directly in non-EAFE component countries, such as the new EU member states or those on the EU’s eastern fringe. However, stock markets in these countries are quite volatile. Their small size makes them sensitive to fund flows and the underlying economies are often dependent on a few industries.

Corporate governance and political interference remain concerns. Since many EAFE companies—particularly in Europe—have taken strategic stakes in East European industries, they offer exposure to emerging European markets along with EAFE’s higher standards of corporate governance and transparency.

Western European companies are also uniquely situated to exploit East European dynamism because of geography. Hungarian-made parts that can be shipped to Germany in a couple of hours may take a day to get to North America. Western European banks also have been at the forefront in buying banks in new EU member states, tapping into the region’s booming mortgage market stimulated by low interest rates and strong local economic growth. To sum up, investing in EAFE gives institutional investors exposure to the economic dynamism of newly-emerging East European markets without a big direct exposure to the risks.

Like Europe, Japanese companies have responded to economic crisis and loss of global competitiveness by adopting a more shareholder-friendly culture. With a bad loans crisis hampering banks’ ability to lend, corporations had to be more responsive to shareholders. A greater reliance on relatively scarce and expensive equity capital has shifted corporate thinking from the traditional Japanese focus on market share to return on assets. Banks have pressured corporate borrowers to eliminate the web of cross-shareholdings that had kept many inefficient operations afloat. Accounting rules have been changed to require parent companies to set subsidiary losses against income. Prominent companies like Nissan and Sony have brought in foreign executives, putting pressure on their Japanese peers to adopt Western management techniques.

Japan is also emerging from 15 years of anemic economic growth. Capital utilization rates have risen to healthy levels, unemployment is falling and shareholder returns are rising. Last year, the recovery was led by exporters enjoying stronger global demand. The Japanese economy is more sensitive to global growth rates than Europe or the U.S. because of a greater share of manufacturing in the overall economy.

The main driver of the domestic economy will be capital spending as companies invest in technology to replace a dwindling labour force. However, there are also signs of a recovery in domestic demand. A rise in employment, job security and real wages has boosted consumer confidence. Japanese are cash rich and have also shown themselves to be early technology adopters. These factors could support growth in consumption in the next few years. For the institutional investor, that means potential gains on Japanese equities will come from a wider variety of sources and could therefore be more sustainable.

All of the above could see Japan finally turn its back on the actual or threatened deflation that has beset the economy for many years. Strengthening wholesale prices could soon filter into retail markets. Rents and property utilization rates have been rising in Tokyo and there are signs that this phenomenon is spreading outside the capital. The Bank of Japan, Japan’s central bank, has said it remains committed to its zero interest rate policy until CPI inflation stays above zero with a very small risk of turning negative.

The Japanese stock market looks very cheap compared to historic multiples, although this reflects in part the improved liquidity among many stocks due to the dismantling of domestic corporate crossholdings. Foreigners have been buying Japanese stocks, but have probably reached their limit at 25% of the domestic market.

The growth of the domestic mutual fund industry has spurred some retail buying. But the next big push must come from domestic institutional investors, who have remained largely on the sidelines, but who may be lured into the market by attractive valuations, especially if inflation kicks in and allows companies to raise prices and grow earnings.

As in Europe, there are many Japanese companies and industries that enjoy leadership roles in the global economy. The best-known players are in the automotive(Toyota, Honda)and electronics (Sony)sectors. But many less wellknown Japanese companies, like Asahi Glass, which supplies auto manufacturers and LCD panel factories worldwide, are also world leaders in their fields. Japanese companies such as Mitsubishi Corp have been investing in natural resources for over 20 years, to ensure a secure supply for Japanese industry, and should benefit from continued robustness in that sector.

One less bullish characteristic that Europe and Japan appear to have in common is aging populations and all the attendant implications for declining productivity and consumption.

By expanding eastward, Europe has tapped into a source of demographic resilience in the younger and more dynamic populations of its new and potential member states. For Japan, which maintains strict immigration policies, the solution is less apparent.

However, aging baby boomers in Japan will be targeted by advertisers to spend on healthcare, retirement services and their families, just as they’re being targeted in North America and Europe. Furthermore, Japan’s demographic decline—if it continues—will be a multi-decade trend that needn’t forestall cyclical recoveries in the Japanese economy that can underpin good stock market performances and attractive returns for active managers.

To outside eyes, another thing that Japan and Europe seem to have in common are intractable politics. In recent years, Japanese governments have struggled to come to terms with the need for reform. In Europe, it’s regulations imposed by regional bureaucrats and labour strife over any effort to dismantle the continent’s cradle-to-grave social policies.

Opinions are divided on whether the Europeans and Japanese will ultimately meet these challenges. But as current experience shows, EAFE companies have found ways to thrive despite politics—just as they do in North America. And at the end of the day, investors are buying companies, not economies or governments. EAFE will continue to offer good investment opportunities, just like the U.S. and Canada. With the end of foreign content limits, Canadian pension plans owe it to themselves to see whether they have optimized their exposure to such a big part of the world.

Steve Tyson, chief investment officer for MFC Global Investment Management(Europe), Peter Kysel, head of European Equities, and Stephen Hill, senior portfolio manager, Japanese Equities, are based in MFC Global’s London office. Steve_Tyson@mfcinvestments.com;
Peter_Kysel@mfcinvestments.com; Stephen_Hill@mfcinvestments.com