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|  | MARCH 21, 2005
The Bulls Look Overseas The weak dollar is driving much more American money into foreign equities, says S&P's Clive McDonnell. But tread carefully, he advises The bearish outlook for the U.S. dollar has made European and other international equities markets more attractive to American investors. But while U.S. investors can find bargains abroad, the weak dollar is also raising the risk of investing in companies based outside the U.S. with high exposure to the American market. So says Clive McDonnell, who, as Standard & Poor's European equity strategist, works with a team of analysts to come up with a recommended sector-weighted investment portfolio for institutional clients. An economist with 10 years of experience researching and advising on equity and fixed-income markets, McDonnell spoke to BusinessWeek Online reporter Beth Carney about the opportunities and challenges in the European equity market. Following are edited excerpts of their conversation: Note: Clive McDonnell is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this article. All of the views expressed in this article accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts." Q: Is more American money being invested in Europe these days? A: Well, we certainly believe there are fundamental reasons why it should be. Specifically, similar earnings growth on both sides of the Atlantic and a weaker dollar [add up to increased] returns for U.S. investors putting money into international equities. In terms of how much it is happening, we can see on a monthly basis to what extent U.S. investors are putting their money overseas relative to foreign investors putting their money in America. The numbers are released by the Treasury Dept. Since 2001, Americans have been investing more overseas than foreigners have been investing here, but in the past 12 months the outflow has accelerated as a function of the dollar weakness. Q: Do you know if the money is going to Europe? A: We believe Europe has been a beneficiary. But we can't say categorically. Q: What are the advantages for Americans investing in Europe? A: It's cheaper. While growth is similar, valuations are a bit more attractive. There's also the potential positive gain from a weak dollar. Basically, if you invest one U.S. dollar overseas and the exchange rate is 1 euro to $1.20, and then the dollar depreciates so that it moves to $1.30, although the value of the company is unchanged, U.S. investors who sold their shares would get back more in dollar terms. It's important to mention that it would be unwise for an individual investor or even a professional investor to invest purely on the basis of exchange-rate weakness. But given that the outlook for the dollar remains poor, there's the potential for a positive gain on the exchange rate. Nobody is suggesting putting 100% of their assets abroad. S&P is recommending 20% in overseas equities. Q: But doesn't the weak dollar put some European companies at a disadvantage, because their exports are more expensive? A: Yes, particularly, for example, the pharmaceutical sector. But by maintaining a focus on companies that are less exposed to currency fluctuations, investors can overcome the negative impact of a weak dollar on earnings. It's really a question of which companies have the least exposure to a strong euro. The sectors that could be at risk include the energy sector, but that's mitigated by a lot of the companies reporting in dollars. There could also be problems for consumer durables, auto makers, luxury goods, and apparel. Q: Does the weak dollar mean European companies are more likely to buy U.S. companies? A: It does make it cheaper for foreigners to buy U.S. companies, but the question is the cost. [U.S. companies] are expensive, so we haven't seen much of a pickup in U.S. acquisitions by international companies. The valuations are high. Companies are demanding big premiums, so the alternative is to look for growth opportunities domestically, where valuations are not as demanding. Q: How is the price of oil affecting European equities? A: Our own view is that oil prices can't be sustained, but they will have an impact on economic growth. It is difficult to believe oil prices can remain at these high levels for a prolonged period. If they were to do that for the next 12 months, they would have a very negative effect on growth -- and as growth slows, demand for oil would slow, and that would bring down the price. Q: What are the key forecasts that are driving your recommendations? A: One main area we're focusing on is the issue of prices. We think we'll see a return of pricing power in the corporate sector. We know that commodity prices have been rising for some time. However, companies have not passed on fully the price increases to end users [at the same level that is] reflected in the inflation numbers. If input costs are rising but output prices are static, margins are going to be squeezed. We have seen, so far, heavy emphasis on cost-cutting to relieve these pressures. But going forward we think there's a reduced ability to cut costs further. We've seen three years now of cost-cutting. Q: Are there any examples of companies that have already started to raise prices? A: The best is the American example of Procter & Gamble (PG ). Since the start of the year, wholesale coffee prices have jumped 30%. During the second half of February and the first half of March, [P&G] has increased the price of Folgers [coffee] by 12%. They had their second increase in three months to make up for the soaring cost of coffee beans. That's a concrete example of how some higher food prices are feeding through to higher end-user prices. Q: Which sectors are likely to benefit from a return to corporate pricing power? A: It should be good for food, beverage, and tobacco companies. Q: Broadly, which sectors are attractive to you now? A: The main area we're optimistic about is the consumer-staples sector -- food, beverage, and tobacco. Also, the media sector has some positive surprises, and some publishing companies such as Pearson (PSO ) and Reed Elsevier (RUK ) have had good numbers. The media sector is being affected by a couple of things. The first is related in part to food, beverage, and tobacco companies. [They're] under pressure to offset competition from generic brands through advertising, so media companies are reporting a pickup in spending [on advertising]. Also, cyclically, the environment in the U.S. education market has improved. Q: What would you recommend investors scale back on? A: Financials. We've reduced financials from overweight to neutral, and we're recommending investors put that money into consumer staples. [That's] because of expected higher interest rates in the euro zone in the second half of 2005. That will undermine prospects for banks there. 
BW MALL
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