Equities

GERMANY

A EUROMONEY SURVEY – June 1996

THE EQUITY MARKET STRUCTURE

In 1995, more than Dm250 million was turned over every day in each of the top three shares (Daimler Benz, Siemens and Deutsche Bank). Even the fifteenth-largest stock in terms of turnover (Schering) posted a daily volume of just under Dm75 million. The top 30 DAX stocks posted an average daily volume of around Dm2.5 billion in 1995. This means that the DAX stocks account for approximately 80% of total turnover on the German stock exchanges (cf. Table 2).

Thanks to its high level of liquidity, the German market is becoming increasingly attractive for international IPOs. Examples are the National Power/PowerGen issues or more recently Railtrack.

Since the beginning of this year, the 70 next largest shares after the DAX stocks have been represented in the MDAX (mid-cap index). This index includes several interesting growth stocks. These might, however, be less attractive than the well-known DAX stocks especially to foreign investors because of their more limited liquidity. This segment of the market will become more attractive after the introduction of MDAX derivatives on the German futures exchange (DTB).

The sectoral composition of the German equity market is clearly reflected in the WestLB Share Index. Chemicals, automobiles, utilities, banks and insurance companies represent 65% of the index. In other words: investors can ‘buy the German economy’ with between 10 and 15 stocks and these are stocks in which large positions of between 50,000 and 100,000 shares can be turned over whatever the state of the market.

Foreign investors play a major role in Germany’s equity markets. In terms of shareholding structure, they occupy fourth place. Generally speaking, however, they play a far greater role in active trading than they do as long-term shareholders. An analysis of the relevant statistics shows that foreign investors account for around one fifth of total turnover in domestic shares on Germany’s stock exchanges. The lion’s share of domestic investors’ shareholdings, in contrast, tends to be held longer and to change hands less often. Overall, measured in terms of the stock turnover rate, the German equity market occupies pole position (cf. chart 1).

STOCKS AS A FINANCING INSTRUMENT>

This is partly because tax legislation, for example, still makes it cheaper to borrow in Germany than to raise capital by issuing shares. In addition, Germany is traditionally more oriented towards credit than securities. However, the weakness of the primary market is in no way attributable to a lack of companies eligible for stock exchange listing – as will be discussed later. It is far rather the case that potential issuers often shy away from higher taxes and more stringent disclosure requirements.

There are also structural reasons for restraint on the investor side. The private German investor has a reputation for being averse to risk and for preferring to invest in secure fixed-interest paper. Only 6% or less of the population are shareholders. However, attitudes are now changing, especially among the younger generation of Germans.

German institutional investors still follow a rather conservative investment policy, too. But as investment regulations are progressively liberalized, a greater orientation towards performance will assert itself. At the same time, the volume of funds in search of placement is relatively small in international terms (e.g. fewer pension funds).

But the markets are moving. Above all, the market participants have seen the writing on the wall and are taking the initiative.

The terms “shareholder value”, “corporate governance” and “investor relations” have become part of German investors’ vocabulary. The large listed companies were early to recognize these trends and are increasingly tailoring their corporate policies to accommodate the concept of shareholder value. Mannesmann, VEBA and Hoechst are pioneers in this area. As the share price development of these companies shows (cf. charts), the stock exchanges ­ and especially the performance-driven portfolio managers ­ are increasingly paying tribute to this approach. This holds particularly true for foreign investor groups, as performance considerations are often far more to the fore there than they are among domestic investors.

International customs have also been adopted as far as share issues are concerned. Of the 20 new issues launched in 1995, twelve were carried out according to the Anglo-Saxon bookbuilding procedure. This has established itself as an alternative to the fixed-price approach, wherein the crucial criterion is undoubtedly the volume of the issue.

At the moment, there is intense discussion of major reform proposals. Such proposals include the possibility of companies buying back their own shares. The development of a private equity savings plan is also on the agenda. Share buy-backs by companies represent an opportunity to increase the return on an investment as the buy-back regularly leads to a rise in the share price. At the same time, the buy-back means that additional assets previously tied up in the company can be released. A relevant amendment to the German Stock Corporation Act would wipe out a major competitive disadvantage for the German market.

Interesting developments are also taking place in the area of shareholder democracy. The ‘one share one vote’ principle also holds true in Germany. However, this principle has been diluted by a large number of exceptions such as maximum voting rights. In the meantime, many companies are abolishing their restrictions on voting rights as such weapons have proved ineffective in fighting off hostile takeovers. Moreover, they no longer fit into the modern stock exchange landscape.

A nominal share value of Dm5 is now a fixed component of the market. The higher trading liquidity it brings has won the day. Against the backdrop of the globalization of the capital markets and the objective of European monetary union, this par value corresponds to the international standard, even though the nominal value debate will undoubtedly be re-opened with regard to the “Euro”. The abandonment of the nominal value principle should not harm the German equity market.

German balance sheet rules are being adapted to international standards (IAS or GAAP), enhancing the comparability of German and international balance sheets. This will reveal that the profitability of most German listed companies is better than previous balance sheet rules led one to believe. It will also make a contribution to shareholder value and analysts and investors will appreciate the greater transparency and comparability. For the stock market as a whole, this development can only be welcomed as it represents a dramatic change in corporate philosophy: it allows greater openness and better control by shareholders and the general public.

The debate currently being waged here with regard to the German system of management remuneration should also be seen in this context. The fixed salary system and, in principle, fixed bonuses, still prevail. Voices are, however, increasingly being raised in favour of performance-related remuneration geared in the long term to shareholder value, which would ultimately result in a higher return for the shareholder. Some companies have already announced their intention to offer board members share options as a component of their salary package.

GERMANY’S MARKETS MODERNIZING

Just a few years ago, Germany’s financial markets were reproached, especially from abroad, with backwardness as far as supervision, transparency and liquidity were concerned. At the moment they are catching up fast, perhaps even overtaking.

Finanzplatz Deutschland has undergone considerable innovation since the introduction of the Second Financial Markets Promotion Act in 1994/95. The new legislation provides a statutory framework for preventing insider trading and has created a new supervisory structure. Germany’s financial markets now have the new Federal Supervisory Office for Securities Dealing as the central authority as well as regional supervisory authorities in the Länder and the stock exchanges’ own supervisory offices for securities dealing. The new regulations are implemented by market participants in the form of compliance structures. The requirements of ad hoc disclosure have already led to a new information culture.

In addition, the new Takeover Code of the Stock Exchange Commission at the Federal Ministry of Finance has been in force since October 1 1995. The objective of this voluntary takeover code is to enhance transparency for takeovers of listed companies on the basis of public takeover bids and to ensure the equitable treatment of all parties involved in such takeovers. At the same time, the new code, which is closer to international standards, is also intended to improve Germany’s reputation as a financial centre.

Efforts to modernize Germany’s financial markets are currently focused on the German equity market. The German stock exchange has elaborated a strategic program to further develop the securities markets it organizes. Recently it was decided to replace the IBIS dealing system with a new electronic dealing system (EHS) based on a new market model. The necessity for this forward-looking step results from the efforts being made to improve market quality, to strengthen the competitiveness of German securities dealing, and to ensure an efficient and inexpensive infrastructure for dealing. One essential objective is to concentrate liquidity.

The Frankfurt, Düsseldorf, Munich and Berlin stock exchanges set themselves this target in the co-operation agreement they signed at the beginning of this year. The intention is to combat tendencies towards fragmentation and to foster efficient, transparent and uniform pricing. Above all, however, the stock exchanges want to recruit a greater number of small and medium-sized companies. To achieve this, they will be providing, for example, support services for new issues. Besides aiming to increase the number of new issues, they are also making efforts to achieve significant growth in the volume of trading and liquidity in companies with small and medium-sized market capitalization. The above-mentioned MDAX will contribute to this. A major role has, however, also been earmarked for the planned sponsor. His task will be to increase liquidity precisely in these stocks, in which he will quote prices on request. Thanks to his specialized knowledge, the sponsor will be a preferred trading partner and will thus create additional liquidity.

Finally, as part of a more investor-oriented segmentation there are plans to set up a growth market. This new segment is to accommodate innovative companies with high-grade credit ratings. It is important that this independent segment be embedded in existing dealing, settlement and supervisory systems.

PRIVATIZATIONS AND IPOS

Following the host of privatizations carried out in other European countries in recent years, a wave of privatizations is now due to unfurl over Germany over the next few years. The full privatization of Lufthansa and the stock exchange launch of Deutsche Telekom AG, Deutsche Postbank AG, Deutsche Post AG and Deutsche Bahn AG will greatly swell the volume of new issues.

The Deutsche Telekom share issue scheduled for November this year will set new standards for the German equity market. The issue volume announced in the press beats all previous records in the German equity-issuing business and is also one of the largest in international terms. There will be considerable interest around the globe as the issue involves a highly attractive sector and Europe’s largest telecom company. Institutional investors in Germany and abroad will not be able to ignore this new share on account of its market weight and their benchmark orientation. At the same time, it offers the opportunity to access new groups of investors and thus to make the share a more popular form of investment, as it is abroad.

Alongside the forthcoming privatizations, however, there is also a huge number of candidates for stock exchange listing from the private sector. 1995 was a record year for domestic launches with a total volume of around Dm8bn. The outlook for the future is good as well. Out of 3,300 joint-stock companies (AGs), only about one-fifth of them have gone public so far. Germany has around half a million private limited companies (GmbHs). Especially among these medium-sized companies, which are rightly regarded as the backbone of the German economy, there is a large number of enterprises which are in principle ripe for the stock exchange. Generation-induced problems of succession and changes of ownership as well as increased external financing requirements mean that in the long term there are around 2,000 candidates for a stock exchange listing. The supply of capital is unlikely to cause a bottleneck here. German private households with their yearly savings of at least Dm230bn and annual investment income of over Dm600bn represent a source of considerable potential demand for German equities.

It can be assumed that the forthcoming privatizations and going-public issues in the private sector will trigger a quantum leap forward in Germany’s equity culture. The increase in stock market capitalization will further expand the liquidity on the German equity market. The capital market will attract even more foreign investors than before. Fears that the German equity market is incapable of absorbing the expected issuing volumes are unfounded.

INVESTMENT OUTLOOK: STRONG BUY

There are several good reasons to be bullish about the German equity market in the long term:

* Germany is ideally positioned geographically between the economically strong EU and the emerging markets in central and eastern Europe.

* The transition to the Euro currency will provide German companies with more stable exchange rates and thus put an end to the permanent erosion of competitiveness with which they have had to struggle as a result of the appreciation of the Deutschmark.

* Economic policy in Germany is aiming at easing the burdens on companies and thus to improve their international competitiveness.

* Low inflation rates, low interest rates and a reasonable wage policy will create a good climate for the bond market in the next two to three years – and for equities as well.

Over the past 20 years, the German equity market has posted an average performance of 8.6% per year. Most foreign investors have been able to show an even better performance as the Deutschmark has appreciated steadily (cf. Table 4).

In the future, the performance of German equities – in Deutschmark or Euro terms – will increase greatly in structural terms. A long-term performance of between 12% and 14% would not be surprising considering the positive underlying conditions in the German equity market.

Foreign investors will, however, book lower currency gains in future on German capital investments than they have in the past. However, this relative deterioration is merely the mirror image of the improved performance of German equities in Deutschmark or Euro terms. On balance, German equities will be an attractive investment for both domestic and foreign investors – the reflection of an economy which will overcome the burdens of reunification in the next few years and go on to profit fully from its strategic position at the heart of Europe.

To sum up, the structural environment for equity investments in Germany is changing fundamentally for the better from many points of view. The fundamental climate is also favourable. A moderate economic recovery is expected, buoyed up by the reduction in the Deutschmark’s overvaluation and the revival in demand from abroad. The relatively sluggish domestic economic cycle with its subdued consumer demand and the energetic measures being taken by the government to prune back the welfare state will counter inflationary tendencies so that the level of interest rates can be kept low. At the same time, the outlook for corporate profits remains encouraging. All this together indisputably provides a healthy environment for the equity market.

Table 1: Turnover and capitalization in Germany