SWITZERLAND
A EUROMONEY SURVEY - MARCH 1996
AN INVESTMENT WITH A DIFFERENCE
In 1995 Switzerland challenged the theory that securities trading is becoming more and more concentrated in three main financial centres, London, New York and Tokyo, by strengthening its position in terms of both market capitalization and trading volume. With a market capitalization in 1995 of Swfr458.6 billion and a turnover of Swfr374 billion, the Swiss equity market currently ranks sixth in international tables and third in Europe, a fair way behind the UK and Germany, but well ahead of Paris.
There are several reasons why the Swiss market manages to perform so well against the international competition. Apart from legal and technical changes, which will bring the Swiss market virtually into line with anglo-saxon stock market standards over the course of this year, the enduringly attractive combination of companies quoted on the Swiss stock exchange also plays a central role. One of the key features of the market is that the share index is dominated by Swiss multinationals and global success stories. The weighting of domestically-oriented companies in the index is small by comparison, and continues to decline. On the other hand, there is still no sign of any noticeable weakening of Swiss multinationals' traditional rooting in the Swiss stock market, despite international equity placements and secondary listings. About two-thirds of shareholders in most blue-chip companies are still Swiss.
Sectoral analysis of the market reveals a rather unbalanced picture. The dominant feature is the overweighting of chemicals/pharmaceuticals, which together account for 38% of the composite Swiss performance index (SPI), and the less substantial weighting of the financial sector (banks 19%, insurers 10%).
By international standards, the SPI shows a significant underweighting of service industries such as transport (0.8%) and retail trade (0.9%). Services, excluding the financial sector, comprise just under 8% of the index. The Swiss market's entire cyclical industrial sector also has interesting characteristics: machinery/metals (2.5%), electrical/engineering/electronics (4.6%, including the watch industry), and other industrials (3.4%), together account for a lower-than-average 10.5% index weighting. By contrast, the weighting of the food industry (12%, with Nestlé accounting for 10.7%), and the construction industry (2%, with 1.3% represented by Holderbank), are about average.
A breakdown by company size is also informative. One distinctive trait is the concentration of market capitalization and transaction volume on a small group of blue-chip shares. For example, the 17 companies in the Swiss large cap index (SMI), accounted for 70% of market capitalization value and 81% of the total trading volume in 1995. Together, the 18 large caps (SMI plus insurance company Bâloise, which will be included in the index from July 1), accounted for 80% of market capitalization and 84% of trading volume. The remaining 235 Swiss companies are divided into 81 mid-caps, together representing 17% of market capitalization, and 154 small caps, which only provide 3% of the entire market capitalization. Categorization by size is important not just for stock liquidity, but also for sector composition. The sector mix of mid- and small caps is very different from that of large caps. Practically all the cyclical services such as leisure, media, business support, transport, and also the predominantly cyclical industrials such as machinery/metals and electrical/engineering/electronics, are to be found in the mid/small cap segment. Large caps, on the other hand, are dominated by pharmaceutical, financial and food stocks, which are not very cyclical. This means that mid/small caps are synonymous with cyclical shares in Switzerland.
FACTORS WHICH MOVE SECTORS
Forex and interest rates are the standard factors in short-term trading. This does not appear to be true over longer periods. Over a day it is often possible to observe a more or less parallel trend between the SPI and Swfr/$ movements, and between the SPI and government bond futures. Over longer periods, ie more than a month, there are however substantial deviations from this rule of thumb.
As a result, the share valuation of blue-chip companies, which typically only earn a small percentage of their turnover in Switzerland itself and also have a very diversified production base, is now dictated more by global sector valuation than by domestic stock market sentiment. This means there is often a close similarity between the PE levels in Switzerland and in the USA, for example, in the pharmaceutical and insurance sectors. Despite substantial price advances in these two sectors last year (Swiss pharmaceuticals +43%, Swiss insurers +36%), there has not been any significant change in Switzerland's valuation compared with other international markets (eg US pharmaceuticals +56%, US insurers +53%). In both these sectors, which together account for 50% of the SPI, investors will find that it pays to take global sector trends into account in their investment decisions.
Despite dominant multinationals, other sectors show protracted deviations from the global trend. The Swiss food industry, which is dominated by Nestlé, is behind its US counterpart (1995: USA +35%, Switzerland +2%). Here we can see evidence of a battle over margins which is particularly fierce in Europe. Other European food producers suffer from the same problem. Despite promising long-term prospects, the global industry currently shows an open split as far as earnings are concerned, between the USA on the one hand and Europe/Japan on the other. Swiss shares are following European valuation trends at the moment.
But taking away company-specific factors and sector developments, what is the overall impact of foreign exchange rates and Swfr interest rates? On balance it can be seen that exchange rate gains or losses do not have a lasting influence on share prices. Although earnings are immediately sensitive to exchange rate swings, share prices only reflect such swings in a very attenuated way. Recently a negative relationship has even crept in. The stable external value of the Swiss franc in recent months has encouraged profit-taking by foreign investors, which has, in turn, triggered a correction in blue-chips.
Nor is the impact as strong as generally assumed as far as Swfr interest rates go. Global and/or European rates are critical for the index. If, for any reason, Swfr rates deviate from them, experience shows that this does not lead to any enduring price movement (with the exception of retail trade). The short-term price reaction typically triggered opens up interesting trading opportunities for investors with long-term horizons.
1995 - AN EXCEPTIONAL YEAR
With its globally reduced growth prospects and low inflation, 1995 focused investors' attention fully on stocks offering above-average volume growth. It was a great year for pharmaceuticals, insurers and information technology. Two of these sectors account for as much as 50% of the Swiss index. On the negative side, the corrections experienced worldwide in the cyclical sector had a proportionately weak impact on the Swiss index. If we take into account the fact that the Swiss franc registered a trade-weighted increase of over 6% in 1995 (+12.1% against the $, +4.5% against the Dm), and that the bond performance of +13.5% was only average compared with the rest of Europe, it becomes clear just how central international sector trends and the very characteristic index-weighting by sector are for the performance of the Swiss share index.
SWISS VALUATIONS TODAY
Because the share price level has been resilient to the negative impact of the stronger Swiss franc, the valuation of the market as a whole, in terms of PE ratio, consistently rose during the course of 1995 compared with the rest of Europe. The market's PE ratio does not, therefore, look particularly attractive at the moment. According to our estimate, which encompasses more than 90% of market capitalization, the 1996 PE ratio comes to 16.0, while the 1997 estimate is 14.3, compared with a historical average of 12. Switzerland's EPS growth of 14.2% (1996) and 12.4% (1997) - below average by European standards - goes hand in hand with a PE ratio that is in the top third of the European table. This could perhaps drag down future index growth. The 1996 estimated earnings yield is 6.2%. This gives a risk premium of 4.5% over the three month Euro-Swiss franc rate, which is particularly low at the moment, and a risk premium of 2.1% (historical average 3.9%) over the average yield on government bonds. The dividend yield of 1.7% confirms Switzerland's usual position at the bottom of the European scale.
MARKET OUTLOOK FOR 1996
It will be interesting to see whether the SPI can manage to stay in the top half of the international performance tables for 1996 as well. It has not been a very promising start to the year so far (SPI +0.6% between January 1 and February 16 1996). In particular, currency-motivated profit-taking by international investors has forced a correction in blue-chips. If the European economy experiences a rebound, we can expect to see the SPI underperform the rest of Europe. It only has a very small weighting of cyclical stocks, and blue-chip growth stocks will lose their attraction. But if the European economy continues to falter as it is doing at the moment, an investment in the Swiss equity market will once again pay off. We expect economic growth to be flat in 1996-97, and the Swiss franc to hold steady against the Dm and $. The potential EPS growth of 14% which this would produce, assuming a worldwide climate of slightly rising interest rates, would run ahead of share prices, ie the Swiss market's PE ratio should return to normal quite quickly. In 1996 Bank Sarasin believes there is potential for the broad SPI to reach 2300 (+8%).
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