The 1997 Guide to Germany: Equities

Equities gain acceptance within Germany

Since the middle of last year when the DAX stood at roughly 2,500 points, the market has been the preserve of domestic investors. Foreign investors ­ with the exception of the Telekom placement in November 1996 ­ have been conspicuous by their absence. That the market was able to post a roughly 40% gain without the support of foreign investors ­ under its own steam so to speak ­ is probably unprecedented in its history. The basic reason for this is a shift in the flow of funds away from interest-bearing forms of investment to equities. Above all, German institutional investors are increasing their exposure to equities, and, since the basis was low, this move is likely to be sustained. The advent of the euro, which will broaden investment opportunities by eliminating the exchange rate risk, will shift portfolio structures further in the direction of equities.

Market structure

At the end of 1996, the market capitalization of the CDAX was Dm979 billion, equivalent to 27.7% of Germany’s gross domestic product in 1996. So in terms of economic output, the German equity market has potential to grow despite its current small international position. The corporate landscape in Germany is dominated by sole traders, partnerships and unquoted companies (GmbHs).

On a European comparison, Germany ranks second in terms of market capitalisation with a share of 13.5% of the European index, followed closely by France with 12.6%. The UK remains the unchallenged leader with a proportion of more than one third (34.1%). Europe’s proportion of the world index was 29.2%.

The global share of market capitalization accounted for by German stocks has changed little over the past years. In November 1996 the German equity market accounted for a share of about 3.9% of the world market in terms of Morgan Stanley’s world index. This share is unrepresentative in so far as GDP accounts for a much larger proportion, i.e. 11.6% of the world total.

1996 saw record trading volumes on German stock exchanges. Total equity trading volumes rose by 40.5% compared to the previous year, to Dm1,221billion. The German stock market was turned over more than 1.2 times, which is comparatively high. The share of DAX trading volumes handled by the electronic trading system IBIS, was around 37.9% in 1996, compared to 37.7% in 1995.

Market developments

Share Buy-Back Programmes

The reform of company law (so far only a green paper has been published) has several goals. These include implementation into national law of the EC’s 1976 Second Directive on Company Law, plans to increase the efficiency of supervisory boards (also by reducing their size), inroads into proxy voting rights and abolition of maximum and multiple voting rights. Above all, the planned facilitation of stock buy-back programmes and the introduction of regulations permitting companies to issue stock options are of major importance.

Deutsche borse new market

The new market has now started operation as a sub-segment of the Frankfurt regulated market. The target group of issuers is small and medium-sized growth companies. Because of the considerable risks involved with such firms, increased transparency is required to protect investors. These include financial statements drawn up in line with IAS, US-GAAP or German GoB with a transition to IAS or US-GAAP, quarterly reports which have to be published two months after the end of the quarter at the latest, at least one analysts’ meeting each year and a corporate calendar. The catalogue of preconditions governing access include an issue volume of at least Dm10 million, a free float of at least 15% of the share capital, a listing prospectus based on international standards, and the obligation for old shareholders to hold on to their shares for at least 6 months. The new market is governed by private law regulations.

Xetra

At the end of 1997 the new electronic trading system – Xetra – for the German cash market is to be introduced as the first step of replacing the IBIS system. The Xetra market model provides for two trading forms: auctions and continuous trading. A central order book offers market players equal access to the setting of prices. Equality of opportunity is to also be made possible through decentralized access to the trading system. Additional liquidity is to be provided by market makers.

Market potential

Between 1977 and May 1997, there were 246 IPOs in the German capital market including six privatizations of government-owned companies, 15 spin-offs, 12 large-scale enterprises and 213 IPOs of “Mittelstand”, typically medium-sized companies.

The main event for the German equity market in 1996 was the privatization of Deutsche Telekom, the largest single equity issue in the German financial history. With a volume of nearly Dm20 billion, it represented 97% of the total new issue volume in 1996. This issue reflects the development of the German equity market and the tremendous potential for privatization of government-owned companies, including Deutsche Postbank AG, Deutsche Bahn AG, the remaining privatization of Deutsche Lufthansa AG. The German government intends to continue their successful privatization policy by reducing their holdings in several Companies. The “Mittelstand” represents a large potential for the equity market as well. A large number, nearly 1,500 companies, are expected to float in the future. The restructuring of the German economy gives an additional impetus for spin-offs of subsidiaries from group companies, like the SGL Carbon sale from Hoechst AG.

Equity buyers

In 1996, purchases of shares in Germany totalled Dm 65.2 billion, Dm10 billion more than in the record year 1994. This figure breaks down into Dm34.2 billion for domestic shares and Dm31.0 billion for foreign shares. 46.5% of total purchases were by domestic non-banks, including unit trusts and insurance companies, which normally account for the major proportion of investments. With 19.7% in 1996, banks purchased less than in 1995, when they accounted for 27.0%, the highest proportion since 1980. After foreign investors had been net sellers in 1995 (-2%), they were net buyers in 1996, accounting for 33.8% of total purchases. Foreign purchases equated to Dm22.1 billion, which was the highest amount since 1989. The bulk of the purchases were in May, June and of course November, when the Deutsche Telekom shares were issued.

Indices

Five domestic indices are of relevance for the German stock market: DAX, MDAX, DAX100, CDAX, FAZ-Index. The spectrum of the CDAX is widest, covering all stocks admitted to official trading on the Frankfurt stock exchange. The DAX covers the 30 largest stocks measured by market capitalisation and exchange volumes. The next 70 stocks are included in the MDAX. The DAX100 covers all stocks included in the DAX and MDAX. At the end of 1996, the CDAX market capitalisation was DM 979 billion, of which 88.1% was the DAX100. Of this percentage, 15.0% was the MDAX and 73.1% the DAX. CDAX, DAX100 and FAZ index have sector indices. Indices are available as performance indices (dividend is reinvested) and as price indices.

Such a concentration of market capitalisation on a limited number of stocks is typical of continental Europe. On the large, US and UK markets blue chips play a less dominant role.

Valuation

Average price/earnings ratio (PE ratio) in the German stock market over the last 10 years was 15.1. The five-year average at 17.2 was even higher. PE ratio ranged from 16 to 12 except in 1993. Since autumn 1996 PE ratio has markedly exceeded the upper boundary of 16.

On the German stock market, the sectors that consistently show a below-average PE ratio include car manufacturers, banks, chemicals, electricals, steel and textiles. This is as true of the five-year period as of the 10-year stretch. Car manufacturers, chemicals, paper, steel and utilities have particularly contributed to the PE ratio expansion of the last five years. SAP had a substantial impact on the development of the electricals sector, while the average valuation of the utilities sector was reduced in 1996 by the introduction of the comparatively cheap Deutsche Telekom shares to the sub-index. PE ratio declined most strongly among breweries, insurance companies and mortgage banks, but these sectors are still expensive relative to the market average.

Custody and settlement

Overview

In the securities business German law distinguishes between the initial transaction (purchase or sale) and its settlement (delivery and payment of securities). The settlement period in Germany is two banking days. This also applies to foreign stocks traded in Germany.

Securities transactions which do not concern new issues or bonds must be done by intermediaries (banks or brokers) on commission. The commissioned bank or broker deals in its own name, but for account of customers. Banks can also trade for their own account.

Delivery and payment are effected at the same time. This ensures that each contracting party receives the consideration it is due if it fulfils its own obligation. Not covered are damages caused by late delivery, which can be considerable depending on share price movements.

The central depository, the Deutscher Kassenverein AG (‘DKV’) is responsible for the settlement and collective safe-custody of in excess of 95 per cent of German securities. With a large majority of German securities being issued in bearer form, ownership can be transferred by the book-entry clearing of securities transactions between DKV participant accounts. The delivery of securities is effected by transfer to the accounts concerned, the money settlement is done by the DKV through the Landeszentralbank. The Kassenverein also handles the administrative work in connection with safe custody, e.g. crediting investors’ accounts with the appropriate amount of dividend income at the right time. Settlements of off-stock exchange transactions, both free and against payment, are processed through the CASCADE system.

The remaining securities (mostly German insurance companies) not settled through the DKV are physically registered securities held in the vaults of the local German custodian banks. Settlement is effected by the physical delivery of securities, free or against payment, to the receiving party. Registration takes four to twelve weeks to complete and is required in order to ensure that voting rights are retained.

Through its regional offices in Germany, the Bundesbank provides a near real-time gross settlement system for the clearing of cash between banks.

Latest developments

On 3 March, 1997 CASCADE VNA (formerly known as CARGO – Central Application of Registered shares On-line) was successfully implemented in the German market. The system, designed to introduce restricted registered shares into the central depository environment of collective custody in the DKV, will lead to a significant improvement in settlement efficiency and a reduction of settlement costs. Its introduction will ensure that the settlement of registered securities is placed on an equal footing to that of bearer securities, with the exception that certificate numbers will be maintained. Registration of CASCADE VNA eligible securities takes approximately 48 hours to complete, securities can be delivered at any time.

Since implementation in March, only transactions in Allianz AG have been settled through CASCADE VNA. During the course of June, the second issuer (Munich Reinsurance) will be introduced into the system. Additional companies are expected to transfer their issues on a phased approach upon completion of the necessary application requirements.

Future developments

A new project (‘TRUST’) has been undertaken by the DKV in conjunction with the German securities market. The project, designed to create a ‘true settlement’ facility, is being developed as a series of additional components to the existing settlement processing infrastructure. These include the following:

* Real-Time Gross Settlement (‘RTGS’) with plans to move to a 24 hour processing day;

* Immediate, irrevocable transfer of ownership in securities held in collective safe custody by the DKV;

* Separation of securities related cash clearing and income administration;

* Enhancements to the existing computerized reporting facilities;

* Processing to allow the chaining of settlement instructions;

* Implementation of an electronic interface to transmit cash clearing balances between banks.

TRUST, aimed at increasing settlement efficiency while also reducing settlement risk, will be implemented in a phased approach starting at the end of 1997.

The euro

It is becoming increasingly probable that the introduction of the euro on January 1 1999 will be a major factor determining the development of the European capital markets. It can be assumed that institutional investors will focus even more strongly on blue chips in the individual countries, which will result in a highly liquid market in these stocks. Within Europe, capital ties on the equity markets should become closer on elimination of the exchange rate risk. From the point of view of diversification, that has in some cases already been the policy of German investors when investing in equities, the European focus will increase further. On the other hand, investors from European countries should increase their exposure to German equities. This harbours a latent demand potential for German equities. It highlights the important role of pan -European equity houses.

The euro will also serve as a catalyst for change on stock markets throughout Europe. How many of the more than 30 bourses in Europe will survive in the longer term? German experience has shown how difficult it is to dismantle old, outdated structures in this area as well. Bourses are forging alliances in the run-up to the introduction of the euro. That holds true not only for Germany, but also on a cross-border basis. At home, cooperation between the bourses in Frankfurt, Dusseldorf, Munich and Berlin will put an end to price differences and boost liquidity. On a cross-border basis, the German futures and options exchange (Deutsche Terminbörse ­ DTB) and the Swiss futures exchange (Soffex) are considering a merger, which would increase this system’s cost leadership. Also, the DTB-Soffex system is to be used by players on the CBOE. Naturally we shall see the emergence of products tailored to the euro, such as a European share index.

Implementation of the EU capital adequacy and securities services directives into German law as part of the sixth revision of the German Banking Act will promote the creation of a European single market for the financial services industry. Among other things, it will govern market access for EU securities firms. Numerous securities service firms will then be subject to the same supervision as banks and securities. Going beyond the EU rules, providers of commodity and foreign exchange futures transactions are also to be included.

New forms of equity

The German Aktiengesetz (Companies Act) now permits the issue of shares only in denominations of Dm5 or multiples thereof. Previously, the minimum par value per share was Dm50.

Given that the German stock exchanges have already decided that from the first banking day in 1999 all listed securities will be quoted in euro, there will be pressure to redenominate all the quoted instruments in euro. A conversion mechanism for the existing Deutschmark-denominated shares shall be defined by the German legislator. Assuming a conversion rate of Dm1.88 to one Euro, a Dm5 par value share would become a rounded euro 2.66 share. This would look odd.

As an institution at the forefront of German preparations for monetary union Dresdner Bank has developed models which have received immediate support from German corporates. The elegant solution proposed by Dresdner Bank would consist of the conversion of shares dominated in Deutschmark into shares with no face value at all. The individual share would no longer have a fixed face value, it would merely incorporate a percentage of the company’s equity capital. A monetary amount would be replaced by a percentage figure. Valuation would then be determined only by the number of outstanding shares in a company.

No-par shares offer the advantage that the nominal value of the share would not change on the impending conversion from the Deutschmark to the euro. Therefore, warrant and conversion rights could be serviced without any changes. Equity capital, shareholdings and the weighting if voting rights would not have to be adjusted, thus ensuring a smooth transition to the single European currency and obviating organisation hurdles for equity trading. Depository and clearing systems would have minimised extra work.

The disadvantage is the need to change the legal framework but it is likely that the German legislator will amend the Companies Act in 1997. This would not only solve an aesthetic problem, but also enlarge the German capital market’s product range. Alongside equities with face values expressed in euro, there are likely to be shares without par value. Shares with broken euro par values are unlikely to be accepted. The introduction of the euro will thus spur a development towards more variety in an area where such evolution would otherwise have been less likely.

Market outlook

We see the dollar falling back to Dm1.60 in the second half of the year. While we are still expecting yields on the bond market to reach new lows of less than 5.43%, the yield on the 10-year benchmark bond should climb back up to 6% by the end of the year. We see the German equity market coming under some pressure from both the dollar and interest rates in the coming months.

Against this background we still consider the most likely scenario to be a sideways movement around the current DAX level, with relatively high volatility (mid-year: 3,600; end-year 3,400). Even so, there is a possibility of the DAX temporarily shooting past our 3,600 price target in the meantime. On the back of a continued shift in the asset allocation in favour of equities, the 4,000 mark on the DAX should come under attack next year.