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Finding High Ground During the European Debt Crisis

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Finding high ground in the European sovereign debt crisis, I am here today with Dave Sekera, our bond strategist, and Paul Larson, our chief equity strategist. We'll take a closer look at the crisis and also offer some investment ideas.

Gentlemen, thanks for joining me today.

Dave Sekera: Good to be here, Jeremy.

Glaser: So, Dave, let's actually start by taking a look at this crisis that it seems to be neverending. Can you just give us a little bit of background about exactly how long this has been occurring?

Sekera: Well, you know, it really started in the spring of 2010 when we first started to see some rumblings in Greece. We saw that it had some accounting issues, and we saw that the gross domestic product was really a lot higher than what people had expected. The bonds started to sell off, and we've all lived through this since then. Here it is the end of 2011, and we're finally starting to take at least some of the right steps going into 2012.

We've seen a lot of different bailout measures that the different governments in the European Union have tried to implement. We've written for a long time now that they've been providing liquidity, doing the right thing to keep the markets moving along, but they really have never addressed the underlying causes of the problems, really the solvency of the individual sovereign nations that are at risk and the potential contagion to the banks.

Glaser: So, if we're maybe just now getting started as far as underlying issues, let's talk about what are some of the potential outcomes are. We might not know exactly what's going to happen, but what are some scenarios, what are some end games of how this crisis finally comes to an end?

Sekera: Sure. As we are going into 2012, we just had the most recent December summit, and in this summit the real agreement that the EU leaders came to is that they're going to start improving the fiscal discipline of the individual nations and start addressing a lot of the structural issues.

So that's going to give us a lot of headwind going into 2012 as they start looking at cutting some of the deficits in those countries and start looking at some additional austerity measures. And then, they also have to put some structural issues in place in order to, for example, work on some of the work rules within the different countries and address the current account balances in those countries.

So I think probably the best that I would expect would just be another muddle-along kind of scenario, probably a low-growth to no-growth environment across the eurozone as a whole. A country such as Germany, which has higher productivity, should still be able to eke out a couple percent of real GDP growth, but some of the other countries I do think are in for potentially a bit of a recession.

So the real question is if we are going into recession in Europe. Of course, we don't really have any better insight because we don't rate sovereign debt here at Morningstar; we really stick with the corporate credit as a fundamental bottom-up analysis. But for a recession, is it just really more of a typical recession, a garden-variety, or are we looking at what could be a deep and protracted long-term recession in Europe?

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Glaser: So if we see that, maybe the best-case scenario is slow growth and the worst-scenario is a horrible recession or a very bad recession, Paul, when we look at firms, we're looking at the stocks of firms and like Dave said we're rating firms, who can succeed in that kind of environment? Who is going to be affected the most, and who is able to be successful through that?

Paul Larson: Well, I may sound like a broken record, but I think the wide-moat names are the ones where the companies are best-positioned to maybe be protected from a flood that is coming from Europe, as you pointed out, the companies that are really on the high ground from a competitive standpoint. Also the wide-moat firms tend to be relatively healthy on their balance sheets. So they tend not to have a lot of debt, which is something that is going to be attractive should we get this significant European slowdown that we are concerned about.

Glaser: Certainly, the balance sheet point seems pretty relevant because in our last recession 2008, one of the things that I think surprised us was how quickly access to credit got cut off from a number of firms. Are we seeing any problems with companies being able to gain access to the credit market right now?

Sekera: From what I’ve seen, we haven’t seen problems of the companies being able to access the credit markets. The credit markets are still open. Especially here in the U.S, we have seen a lot of issuers come to the market, in the U.S. corporate bond market over the past couple of months. However, we are definitely seeing intrabank credit being constrained right now, and we’re also seeing some anecdotal evidence of the European banks really pulling in their capital. So we see them going out of some of their secondary and tertiary markets, closing down the lending that they have like maybe in Asia.

I have noticed some of the European bond trading desks here in the United States have really whittled down the inventory that they are willing to keep, and all that capital I believe is going back to Europe. So in a garden-variety recession, I would expect that to continue, that they are really looking to bolster their capital ratios, and that will put some pressure on the banks. We do see them really trying to bolster their capital ratios. So, as such, in a garden-variety recession, we'll see them kind of pull in the reins, and we won’t have as much credit available out there for individual companies.

Glaser: So it certainly sounds like financials are going to probably see the brunt of the impact, but obviously, that lack of lending can hurt a lot of firms. But the balance sheets have obviously changed a lot in the past couple of years. What kind of effort have corporations made to kind of improve their balance sheets or positions from 2008 until today?

Sekera: So on the U.S. corporate side, they've really learned their lesson. We’ve seen metrics such as debt coverage, debt/capital ratios, and so forth, really improve quite a bit since the 2007, 2008 credit crisis. So a lot of companies are holding a lot more cash on their balance sheet. They are making sure that they have unfunded revolvers with different banks that they can draw on. In fact, a lot of companies are even going so far down the line that they're making sure that the revolvers that they have, which is kind of like their checking account that they can go in and draw money from the banks, that those are actually a lot more U.S. banks than European banks, such that if there really is another credit crisis in Europe that the companies don't have to worry that their counterparty is not going to be there.

Larson: And you also see this in the inventories, too. The inventories are running exceptionally lean right now, and we've seen how this can come back and bite some of the companies. Whether it was the auto industry, earlier this year with the tsunami in Japan, or more recently in Thailand with the flooding and the disk drive shortages, that's where the very thin inventories have come back to hurt the companies. But in general the balance sheets are arguably the best that they've been in a very long time, with record cash balances.

Glaser: Let's take a look at some individual ideas then. We are looking at stocks that potentially have a wide economic moat, that have strong balance sheets. What names do you think look attractive right now?

Larson: Sure. One of the names that I like that leans nondiscretionary, which is one of the ways you want to lean if you want to be a little bit more conservative is to stay away from discretionary names, and also has a decent balance sheet, is Abbott Laboratories. This is a leading health-care firm, and the stock is trading at only about 12 times earnings in the low $50s here. We think, it's worth $68.

Glaser: Now Abbott Labs is about to have a spin-off. It's going to break up into two different companies. Does that have an impact on the investment thesis there, or is it still an attractive name?

Larson: Yeah. Actually, we think it's basically a value-neutral transaction. Whatever value the firm may unlock by splitting the two companies apart, it might have to pay for in terms of now it has duplicate overhead costs for two firms. So, we think it’s basically value-neutral.

Glaser: Are there any other names you think that look attractive?

Larson: Sure, there are a couple of names that have very strong balance sheets. One is eBay, and this is a firm that has no debt on its balance sheet, it actually went out and raised cash recently for an unknown reason. The firm is flush with cash, and it continues to generate more. So it's an extremely conservative balance sheet. Our fair value estimate here is $42, and with the stock trading near $30, we think that there is sufficient margin of safety to consider buying it today.

Another Internet name that's very conservatively capitalized, with an excellent balance sheet and very strong secular growth behind it, is Google. We think the stock is worth $744. The stock is trading in the low $600s, and again with that secular growth, where you have revenue growing at a 30%-plus rate in recent periods and trading only about 13 or 14 times of forward earnings, that’s a pretty attractive multiple to pay for such a relatively high-quality wide-moat firm.

Glaser: And then on the fixed-income side, are there some corporations' bonds that we think look pretty attractive, given such the low-yield environment with everything that's happening in Europe?

Sekera: Yeah, so we've recommended investors to stick with U.S. corporate bonds pretty much for the last two years, and that’s really outperformed what we've seen in Europe. With the European corporate bonds, the credit spreads have continually widened out further and faster than what we've seen here in the U.S. Taking a look generally at credit spreads in the U.S. right now, I think that they are pretty attractive for what we see is the probability of default risk over the next year or two, which we still think is going to be pretty low. In fact, credit spreads right now are probably pricing in a very high probability of a recession. Credit spreads are generally at the widest that we've seen since probably June of 2009 when we're really still recovering from the credit crisis.

Just like Paul, we also look for companies that have a wide or narrow economic moat and have long-term sustainable competitive advantages. One that I like right now is Clorox. The firm's 10-year bonds are out trading at about 3.7% right now, just about 175 basis points over Treasuries. So even though the all-in yield may not sound like that much, it is still quite a big pickup that you get over the underlying Treasury rates for taking on a little bit more default risk. We rate Clorox an A- for our issuer credit rating.

Glaser: Are there any other names that stand out to you right now?

Sekera: Sure. For example, Kellogg's 10-year bonds would be another one that I think look attractive right now. Kellogg is also another narrow moat company; we rate it at A-, as well. It's 10-year bond is trading at 3.25%, which is 150 basis points over Treasuries. Health care is another industry where we take a look at it, and our credit ratings are differentiated than what we see from the rating agencies. So, for example, another one Amgen, we're taking a look at those bonds, and in fact those bonds are trading at about 4%. That's 200 basis points over Treasuries. So, essentially for an individual investor, he could almost essentially double the amount of income that he would be able to generate as opposed to being invested in just 10-year Treasury bonds.

Glaser: Certainly, it seems like overall, we don't know exactly what's going to happen in the European sovereign debt crisis. But even if it's anywhere from the low-growth to pretty severe recession scenarios, it sounds like these companies with great balance sheets and wide economic moats will be able to stay relatively dry, no matter what kind of floodwaters come from Europe.

Larson: We'll put.

Sekera: Exactly.

Glaser: Well, Paul, Dave, thank you so much for your thoughts today.

Sekera: Welcome.

Larson: Thank you.

Glaser: From Morningstar, I'm Jeremy Glaser.