Germany has officially plunged into a recession, as the nation’s Federal Statistics Office revealed yesterday (Thursday) that Europe’s largest economy contracted by 0.5% in the three months through September.

The data is worse than many analysts had expected and follows a 0.4% decline in the second quarter. The economy last contracted this much over two consecutive quarters in 1996, making this Germany’s worst recession in more than a decade.

The slide may worsen, too, as German companies are struggling with dwindling export orders.

“If you think today’s numbers are already bad, just wait for the next quarter,” ING Financial Markets’ Carsten Brzeski told Reuters. “The headwinds of the financial crisis and the global economic slowdown are blowing right in the face of the German economy.”

German industrial output fell 3.6% in September from August, while orders for goods produced by the world’s largest exporter fell by 8% in the same time period. Orders from outside Europe fell 11.4%, and domestic orders dropped 4.3%.

“A negative effect on gross domestic product came from foreign trade, with a strong increase in imports and weakening exports,” the statistics office said.

Over 40% of German exports go to other euro area nations, which means other euro nations are scaling back drastically. In that case, Germany’s recession may be the beginning of a economic downturn sweeping through the entire Eurozone.

“The German recession has begun in earnest and it’s very serious,” Holger Schmieding, chief European economist at Bank of America Corp. (BAC), told Bloomberg. “It raises the risk of a German contraction of more than 1% next year and we will have to revise down our forecast for the euro area as well.”

The Eurozone economy contracted by 0.2% in the second quarter, which means it, too, has likely entered into a deep recession. Eurostat, the European Union’s statistics arm, is scheduled to publish third-quarter growth data for the region today (Friday).

The International Monetary Fund (IMF) predicts that the economies of developing nations, including the U.S. and Eurozone, will contract 0.3% next year the first such decline since World War II.

The Organization for Economic Cooperation and Development said yesterday (Thursday) that the Eurozone economy would contract by 0.5% in 2009 – in line with IMF forecasts.

“The OECD area economy appears to have entered recession,” the OECD said. “Projections point to a protracted downturn.”

News and Related Story Links:

• Bloomberg:
  German Economy Enters Worst Recession in 12 Years

• Money Morning:
  ECB Cuts Interest Rate by Half Point as Recession Grips Eurozone

• Money Morning:
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Investors have been watching Berkshire Hathaway Inc. (BRK.A, BRK.B) Chairman Warren Buffett’s moves for years to see which investments are going to take off next.

Back in October, the Oracle of Omaha’s trip to South Korea encouraged our own bullishness on that country’s stock market.

And now Buffett has decided to have a look at Germany.

On a recent trip to Europe, Buffett made stops in Germany, Switzerland, Spain and Italy. But his first priority was to meet with leaders of the German mittelstand – the family-owned, medium-sized companies that are the backbone of the German economy.

"We would like more family owners of German businesses who, when they feel some need to monetize their business, think of Berkshire Hathaway," Buffett said to the Financial Times.

Buying into privately held companies – usually those whose ownership remains in the hands of the founding family – is an investment play Buffett has run time and again – and virtually always successfully. Back in 2006, he made what then was his largest investment ever outside the U.S. market, when he spent $4 billion for an 80% stake of an Israeli metalworking firm that was family operated. At the time, Israel was out of fashion with U.S. investors, though Buffett’s headline-making deal changed those attitudes rather quickly.

Like Israel was then, and like Japan is now, Germany is currently unfashionable with U.S. analysts. As is also true of Japan, it seems to come as a surprise every time Germany comes out with a positive gross domestic product (GDP) number. Both countries had horrible periods in the 1990s, but analysts who think Germany is doomed to slow growth forever haven’t been paying attention.

The Seeds of a German Economic Rebound

Germany’s problems of that period were largely due to the 1990 German reunification, which German Chancellor Helmut Kohl foolishly carried out by equalizing the West and East German currencies and making East German labor hopelessly uncompetitive in the process. The net result was 15 years of huge subsidies from West to East and a series of real estate disasters as Western construction companies overbuilt in the East.

Since about 2005, however, the costs of reunification have begun to decline – they were always likely to be a finite problem, as the Eastern education system was reformed and produced more productive workers – and the German growth rate has begun to increase.

Indeed, over the near-decade since the introduction of the euro, German labor competitiveness has increased by about 20% against its fellow European Union members, a very good performance. German companies have a healthy position in Eastern Europe, too, where economic growth has been rapid and wage rates remain far lower than in the West.

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Germany has a substantial balance of payments surplus – about 5.5% of GDP in 2007, slightly larger than the United States’ deficit – and a budget deficit of only 0.4% of GDP. The Economist estimates that Germany will grow at 1.7% in 2008 and 1.6% in 2009 – not stellar, but still faster than the United States, which will be lucky to eek out 1% GDP growth this year (and much faster per capita if you discount for the 1% annual U.S. population growth).

Unlike some of its EU neighbors, German industry has suffered only moderately because of the euro’s strength. It helps that many German companies have substantial manufacturing operations in central Europe, which has become a haven of German-style (and mostly German-speaking) labor practices and engineering skill, but where labor costs remain low. Add in German companies’ reputations for superb organization and quality control, and you have an industrial machine that is fairly immune to exchange rate fluctuations and even to cheaper emerging market competition.

Even inflation at 2.4% is not much of a problem in Germany, and the strong euro should hold German inflation down by suppressing rises in dollar-denominated energy and commodity prices, while not doing much damage to Germany’s healthy balance of payments surplus.

Profit Plays to Call Now

So, what to buy? Well, be careful with the banks. There are too many banks in Germany, most of them propped up by their local governments, and the banking system’s lack of good ideas for making money has recently been shown by two banks, IKB Deutsche Industriebank AG and Sachsen LB, getting in serious trouble for overexposure to U.S. subprime mortgages. However, most German banks do have an advantage over U.S. banks in their limited exposure to non-mortgage U.S. debt.

Nevertheless, if you want a German financial services play, I would avoid even the mighty Deutsche Bank AG (DB) and go for the banking/insurance conglomerate Allianz AG (ADR: AZ). While Allianz does own Dresdner Bank, which has had its own problems and write-offs, it is also Germany’s largest property, casualty and health insurance company, making it one of the world’s leading insurers. And Allianz is trading at a slightly lower price/earnings (P/E) ratio than Deutsche at about 7, has a nice dividend yield of 4% and is selling at less than 1.2 times book value, a key metric for financial services companies, which tend to sell at 2 or 3 times book.

You should also look at Germany’s great engineering companies. The largest, Siemens AG (ADR: SI), has recovered from its losses of a couple of years ago and is now selling at a P/E ratio of about 8, although its dividend yield is still only 1.6%. Still, Siemens’ powerful worldwide position should allow it to continue its recovery, and there is a good chance of dividend increases – a return to Germany’s traditional conservative 50% dividend payout rate would cause its dividend to treble.

A third possibility is Fresenius Medical Care AG & Co. (ADR: FMS), the world’s largest manufacturer of kidney-dialysis machines, again a global player. This firm has a somewhat higher Price/Earnings ratio, currently about 19 on projected 2008 earnings, but its technological capability and strong market position give it attractive growth potential.

Finally, in the tech sector you might look at the business-software provider, SAP AG (ADR: SAP), whose shares carry a P/E of about 18 on estimated 2008 earnings, though they yield only 1%. SAP is the leading manufacturer and installer of so-called "enterprise resource planning," or ERP, software, a business whose usefulness to companies has greatly increased as its products have matured and the firm’s earlier installation problems have largely been overcome. 

Unlike Buffett, most individual U.S. investors don’t have the opportunity to buy the German mittelstand directly, but even large German companies can offer attractive values.

News and Related Story Links:

• Money Morning:
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• Money Morning:
  How Buying Like Warren Buffett Can Boost Your Portfolio Profits.

• Israel21c:
  Buffett Acquisition of Wertheimer’s Iscar puts Israel on the Investment Map.

• Wikipedia:
  Mittelstand.