Tuesday, 29 May 2012

Investing in Shares - European Meltdown: What types of stocks will be hardest hit

In recent weeks we have once again seen markets around the world taking a beating because of issues in Europe.  Currently the issue is whether Greece will exit the Eurozone (the general consensus seems to be that this will not have a massive impact on the Euro or world financial markets) and whether other countries in dire financial trouble such as Spain, Italy and Portugal would do the same (this is referred to as the 'contagion effect' and would definitely have serious repercussions in Europe and financial markets around the world)

While these are very serious issues with the potential to seriously affect investments and investment returns the impact that they are having on world markets seem to be overdone.  When news such as this hits a domestic retailer / industrial company in Australia or the US which has absolutely no earnings / supply or any other ties to Europe then there is the potential to profit from 'Mr Market' being irrational.

The biggest issue that investors face though is identifying which areas are
  • Safe and unlikely to be affected even if the worst does happen
  • Likely to be affected by the worst but will probably trade through
  • Likely to really suffer if the worst does happen
  • Likely to suffer from ongoing uncertainty
Each investor is different and will prefer to invest in different category. 
  • The first category is the least likely to be affected in the short run but will not get the same 'bounce' when the investment return eventually returns to normal. 
  • The second and third categories are where investor judgement comes into the picture and is also where the biggest profits are likely to be made.  If the investment world is placing much higher 'worst case scenario' than you think then you would buy these stocks, wait for the worst to happen or for the situation to muddle through and then take a massive profit once everything returned to normal. 
  • The last category will probably be reserved for investors that are the most sophisticated.  Those that are best able to judge the situation and able to take advantage of whether the market goes up or down.
In this post I am going to identify those stocks which should probably be avoided by most investors with the uncertainty around Europe.  This assumes that most investors have no great insight into Europe and what is going to happen there.  I will therefore focus on those companies in the third and fourth categories.  Stocks which fall into these categories include
  • Stocks listed in the affected countries.  If these countries leave the Eurozone their currency is likely to collapse and investments will collapse with the currency
  • Stocks that derive a large part of their earnings from the affected countries.  Obviously there will be turmoil for several years which will significantly impact the earnings from these regions
  • Stocks that are particularly leveraged to debt markets.  Even if stocks have no earnings links to Europe they may be impacted by the effect that a European crisis has on funding markets.  These include banks which are particularly dependent on overseas funding markets (note not all banks fall within this category).  It also includes infrastructure type assets, utilities and other highly geared assets.  If funding markets dry up then their cost of debt is going to soar.
Note that as mentioned above it is entirely possible to make money from all the above type of stocks but it requires a detailed knowledge and research of each individual company to see whether the market is painting them with a broad brush (e.g. whether the market assumes that because they are a bank they are going to suffer even when they have more than enough liquidity and can tap funding markets even in stressed situations). 

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