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Global growth remains robust – DAX at 6,000 points – backing value-creating growth

Despite crude oil prices still being high, we still expect the global economy to grow steadily during 2006. Asia and Eastern Europe will remain the major growth regions, while economic expansion in the US is likely to flatten off. Concerns about inflation should recede and we expect to see a turnaround in US monetary policy in the second half of the year.  Conversely, the ECB and the Bank of Japan are, if anything, likely to put a brake on monetary expansion. In this environment, the dollar will be exposed to greater risk as the year progresses.

Given the moderate outlook for the global economy and still-high prices for raw materials, we expect growth in the Eurozone to only pick up slightly to 1.9% in 2006. However, the underlying structure of this growth is likely to be healthier than in 2005. Supported by positive corporate earnings and a still-expansive monetary policy, capital expenditure in particular is likely to increase.

Europe: Nearly double-digit earnings growth
In contrast to the US, the earnings and margin expectations for Europe appear to be quite reliable. In particular, companies with a global perspective are likely to continue to profit from the positive trend set by world trade activity. We expect to see European companies generating earnings growth in the low double digits. For the DAX stocks a figure of around 13% should be possible.

Risk premium only still unusually high for equities
However, the upside potential we forecast not only stems from the expected rise in earnings, but is also based on a fall in the required risk premium. In numerous asset classes like corporate and emerging markets bonds or real estate, the risk premium has either continued to fall or has remained at a low level during 2005. By contrast, the risk premium for European equities has remained high.

One unusual aspect here is also the trend relative to US equities. In the autumn of 2002, the risk premium gap was only 50 basis points. In the meantime, the difference has increased to nearly 250 basis points. For 2006, we are expecting a normalisation and a fall in the difference to 125 basis points.

European equities undervalued – DAX at 6,000 points
All in all, we are confident that Europe – like in 2005 – will be able to distance itself from the trend set by Wall Street. The valuation situation remains favourable for European stocks; the companies are profitable and the prospects for global growth are moderately positive. However, the attractiveness of European stocks is also due to the very low real interest rates available for other asset classes. Due to the rising price of oil, in many countries the rate of inflation rate is above the short-term money market rates - and in some cases markedly so. Investing in equities permits the development of an effective “inflation hedge”. At the end of 2006, we believe the DJ EUROSTOXX50 will stand at 3,900 points and the DAX will be at a level of 6,000 points.

Equity strategy for 2006: Backing value-creating growth
In contrast to the previous two years, investors are likely to call for a more entrepreneurial approach on the part of companies. The focus is shifting away from dividend increases and share buy-back programmes and towards using investment to generate value-creating growth. This investment theme plays a key role in our recommendation list for 2006 as well.

Virtually two-thirds of the companies in the WestLB equities universe are now earning far in excess of their cost of capital. The size of the company is not important in this regard. However, in terms of “style“ a disproportionately high number of growth companies are represented. In particular, companies from the pharmaceuticals, banking and technology sectors offer growth potential. Our list of recommended stocks therefore primarily contains companies from these sectors. These include the Swiss pharmaceuticals giant Roche, the high-tech company SAP, the two financial stocks Deutsche Bank and ING, the industrials conglomerate Siemens and the sporting goods manufacturer adidas-Salomon.

However, we are also on the lookout for other opportunities, such as companies that are particularly appealing takeover candidates (DSV) or are benefiting from the trend towards outsourcing (Capgemini). Dividend surprises (Fortis) and restructuring (Clariant) remain interesting themes, but more from the point of view of portfolio mix.

Time for value-driven growth – new paradigm is long overdue
Following the excesses of 1997 to 2000, the companies’ main priorities were to optimise return on the existing capital stock and repair their balance sheets. The objective was to raise return on capital significantly above the cost of capital by means of cost reductions, relocating production and disposing of or shutting down unprofitable non-core activities.

However, the potential arising from restructuring and optimising the existing capital stock has largely been exploited in many firms, and very successfully at that. Obviously, there is always additional room for improvement. It appears, however, that there is far greater potential for raising income by means of value-enhancing investments. There are signs of a new paradigm: Investors’ attention is shifting away from rising dividends and share buybacks and towards value creating growth through investment.

What is holding up the dawning of a new age?
Why is it that companies currently achieving ROEs well into the double digits are paying out their profits? Why is it that they are not expanding their capital stock via investments? Why is it that investors are raising their return requirements for companies higher and higher, instead of encouraging them to make value-enhancing investments, even if they have a slightly dilutive effect on returns? The answers to these questions revolving around the equity market conundrum of the year 2005 are, at the same time, the signposts pointing the way to the favourites for the investment year 2006.

The paradigms that apply to the capital markets as well as to management styles do not change overnight. We believe that what amounts to a cyclical herd instinct can be seen in both spheres. Between 2001 and 2004, investors’ focus was clearly on restructuring measures, stable cash flows and attractive dividend yields. Private investors’ preference for “safe” returns on the equity market as well has led to an extremely imbalanced call for high dividend yields. This was accompanied by structural market shifts among institutional investors. In particular, insurance companies and pension funds were in some cases obliged by regulatory requirements to reduce their equity allocations or to one-sidedly emphasise value aspects. However, we feel that a shift in sentiment has become apparent among companies and investors over the past few weeks. Despite takeover premiums, compelling acquisitions met with the approval of the capital market. At the same time, companies such as Deutsche Telekom are stressing changes in strategy with a conscious shift towards organic growth. Similar investment plans were aggressively communicated to the market by SAP at the end of 2004 and by Puma in mid-2005.

Worshipping Mammon: a path strewn with obstacles
However, the trend of continuously increasing return targets for companies regardless of the level of cost of capital remains unbroken. Analysts and investors are demanding higher margins and higher RoE and RoCE targets from companies, even though the levels already attained often significantly exceed their cost of capital. In contrast, the potentially far more important issue of new, value-enhancing investment opportunities is raised far too infrequently.

Value-enhancing growth achieved by expanding the capital base through investments is ultimately limited by the exclusive focus on the absolute level of return. Maximising return targets results in an ever-decreasing number of capital spending projects being able to meet the return requirements. However, firms that do not invest will stagnate, and we feel that the stock market’s valuation of these companies will be correspondingly low. It is not sufficient to merely administer and optimise the status quo. Entrepreneurs should be given the opportunity to act as entrepreneurs and not as administrators.

“Best in class” is not always the yardstick
The principle is to compare like with like. Any return target must be in line with the company’s strategy and market positioning. In our view, the focus on value-enhancing core competence areas with clear unique selling points, barriers to market entry and growth potential is more important than the quest for a presence in the most profitable market segment. This is particularly true if a successful market entry into this type of segment entails extremely high start-up costs with highly uncertain results.

No to carte blanche for unfettered growth
Our focus on value-creating growth is no carte blanch for unfettered growth. Companies which have not earned their cost of capital in the past should clearly remain focused on restructuring their core business. In our view, companies that do not have their existing business under control are likely to have difficulty in persuading investors that they can enhance value for them by means of additional investments. We are similarly cautious with regard to investments outside the core business. In addition, the number of capital spending projects that a company can digest is also limited. Accordingly, companies with surplus liquidity that far exceeds the volume of the additional attractive capital spending projects should distribute it among the shareholders.