Crisis Investing in Europe

The Unlikely Winners in the Most Difficult Times

By: Dan Rasmussen & Brian Chingono

The Russian invasion of Ukraine sent shockwaves through Europe. Europe’s dependence on Russian energy and Ukrainian grain have created ongoing concerns for the continent. As of last week, there were 13 European markets with drawdowns of 20% or more from their previous peaks. Germany, the Netherlands and Austria were hovering around 30% drawdowns, while Poland and Hungary were inching toward 40%.

We have spent the better part of the last four years studying crises. And while we’ve written extensively about our findings in the US and in emerging markets, we have not yet shared our research on how to invest in Europe during major economic crises. Today, we are sharing what we’ve learned about crisis investing in Europe.

Market timing is hard, but knowing when you’re in a crisis is easy: it’s on the front page of every newspaper, and your portfolio is awash in red. But to isolate true crises from the panic-of-the-month, we believe investors should be looking at the high-yield spread as an indicator of economic distress. High-yield spreads measure the liquidity available to marginal corporate borrowers, and these spreads tend to spike upward during times of true panic. In the US, we’ve found that when high-yield spreads have crossed 6.5% (roughly one standard deviation above the US long-term median), the crisis was usually nearing its bottom and that markets tended to recover sharply over the next 12 to 24 months. In these recoveries, small value stocks tend to dramatically outperform.

Europe has its own high-yield market that trades slightly wider than that of the US, and we’ve found that 8.5% (roughly one standard deviation above the long-term median for Europe) can be used as a crisis threshold. Since the start of its publishing in 1997, Europe’s high-yield spread has crossed the threshold six times, including ahead of each global recession (in September 2000, August 2008, and March 2020). As of last week, the level is 5.1%, above the 10-year trailing median but still below our crisis threshold.

Below we list all those instances and compare the total returns of small value stocks relative to the total European market as calculated by Ken French. We found that investing immediately after the threshold is triggered is too early, as the markets are still volatile, but waiting two to four months before investing is ideal. Below we assume we would have invested three months after the spread hit 8.5% (i.e., the trigger date).

Figure 1: Crisis Returns by Crisis and Asset Class (12/1997 – 3/2022)

Source: Capital IQ, Bloomberg, FRED, Ken French Data Library, Verdad

Just like in the US, European small value stocks outperformed the market consistently and significantly after crises. The reason for small value stock outperformance in the wake of crisis is simple. As crises unfold, small value stocks experience more severe sell-offs than the broader market. And their operations tend to suffer more in the context of plunging revenues and cash flows, coupled with weaker balance sheets and skyrocketing borrowing costs. However, the same two factors that worked against small value stocks as crises unfolded—plunging valuations and muted growth—are the ones that reward the “survivors” when crises bottom out and markets are poised for recovery. As a result, buyers of small value stocks in times of crisis pay less (thanks to cheaper valuations) and get more (thanks to above-average earnings growth during the recovery), a phenomenon we wrote about here.

Having confirmed that, as in the US, small value works in European crises, we wanted to dig a level deeper into what other factors investors should consider screening for. We looked at value, size, quality, and momentum factors. In the six instances when high-yield spreads crossed the crisis threshold, we downloaded company-level financials across the European stock universe. We then tested the predictive ability of the aforementioned factors by applying the following three tests:

1) Are the factor regressions against forward returns statistically significant?
2) Do we see a linear relationship between factor quintiles and forward excess returns?
3) Does a historic backtest generate returns in excess of the market?

Below we show the return spreads and t-statistics for the factors that passed the bar.

Figure 2: 12M FWD Returns by Factor Quintile and T-Statistics

Source: Capital IQ, Verdad

Our findings mirror other academic research: buying small, cheap, and high-quality stocks works. This should not be controversial, and, as other research shows, these factors hold in good times as well as in crises. Momentum, on the other hand, could raise some eyebrows, as it is a weak factor in reputed papers. Moreover, our internal research confirms that negative momentum is not statistically significant in a full-cycle sample. Crises, however, are different. When coupling negative momentum with size, value and quality factors, investors end up buying the cheapest, highest quality and most beaten-up stocks across the market, including companies that have net cash on their balance sheet. As a result, these stocks have the highest expected future returns.

To that extent, we developed a simple score based on the significant factors we listed above: size, value, quality, and negative momentum. For each instance when the high-yield spread crossed the 8.5% crisis threshold, we applied a score to the investable stock universe in Europe, which we define as companies with a minimum market capitalization of at least $25M and an average daily trading volume of at least $100K. This universe includes both net-cash firms and leveraged companies. Below we show 12-month and 24-month forward excess returns of an equal-weighted portfolio consisting of the 50 top-scoring stocks over an equal-weighted market average during these events. Once again, we assume we would have invested in this crisis portfolio three months after the trigger date. Note that we do not annualize the 24-month forward returns and show total returns instead.

Figure 3: Top 50 Crisis Stock Portfolio 12M FWD and 24M FWD Excess Returns over the Market

Source: Capital IQ, Verdad. Note: The 24M FWD total returns in 2020 computed as of 4/30/2022, while the end-date would be 6/30/2022.

Our crisis portfolio would have outperformed the market in all crises over 12 months and in five out of six crises over 24 months. This is consistent with our findings in the US that getting out too late is a greater risk than getting in too early when it comes to investing in crises, which the 2000 crisis illustrates.

The average crisis portfolio stock would have been a micro-cap bought at roughly 2x EV/EBITDA multiple, with 1.4x asset turnover (defined as revenue growth divided by asset growth), and 12% free cash flow yield. The average company in the portfolio would have been bought at a price that was 55% cheaper than its level 12 months prior. The portfolio would have been invested in industrials, consumer discretionary or materials 60% of the time, with minimal variability across crises. Geographic exposure is equally stable: advanced economies are ranked at the top consistently across crises. Poland is the only exception, ranking higher up in recent crises.

Figure 4: Average Portfolio Statistics (All Crises)

Source: Capital IQ, Verdad

We believe that European small value is an attractive long-term buy-and-hold investment, particularly given the current value-to-growth and the potential for the long-term mean reversion of valuation multiples. But we also believe that crises are ideal times to add significantly to small-cap value exposure, as small-cap value benefits both from a wider-than-usual divergence from the mean and the potential for earnings growth during the cyclical recovery.

We do not know exactly when a European crisis would happen or what could trigger it, even if the war in Ukraine seems to put considerable pressure on Europe. What we do know is that it will inevitably happen at some point. And when it does, the high-yield spread can potentially signal an opportune time to double down on small value equities.