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In Europe, Small Stocks Loom Large

The $400 million AIM European Growth Fund/A (AEDAX) faces the daunting task of finding growth stocks in a global climate that seems to be providing anything but growth. Fund managers Jason Holzer and Clas Olsson have focused on small- and mid-cap companies on the Continent and in Britain that have delivered above-average growth. As a result, the fund has been outperforming its peers in a difficult environment.

For the one-year period ended Oct. 31, AIM European Growth slipped 5.6%, vs. a loss of 13.4% for stock funds that invest only in Europe. For the three-year period ended Oct. 31, the fund edged down just 1.7% on an average annualized basis, while the peer group declined 11.3%. Based on risk and return characteristics over the past three years, Standard & Poor's has assigned the fund an

overall ranking of 3 STARS.

On July 1, 2002, the fund was renamed from AIM European Development Fund. And in September, the AIM Euroland Growth Fund/A (GTGEX) was merged into AIM European Growth. Palash Ghosh of S&P's Fund Advisor recently spoke with Holzer and Olsson about investing in the region and the fund's strategy. Edited excerpts from their conversation follow:

Q: After you reorganized this fund earlier this year, did you change the investment approach?

A: No. The European Growth fund has the same investment philosophy as the former European Development Fund. We still use a bottom-up approach to find stocks with accelerating earnings growth and attractive valuations. We invest without regard to market capitalization, and we don't concern ourselves with any top-down, macroeconomic analyses.

Q: What about the Euroland Growth fund? How does it come into the picture?

A: The AIM Euroland Growth fund was reorganized because its asset base was declining, and it had generally underperformed the AIM European Growth Fund in recent periods. In addition, AIM Euroland Growth was a niche product that failed to attract investor interest. By merging the two funds, shareholders in Euroland Growth could benefit from a fund with the ability to invest in a broader range of European growth stocks.

Q: Because the markets have been so volatile and global economies so weak, did you have to change your criteria for growth shares?

A: We have not changed our investment criteria. However, a company that can grow above 5% annually would be considered above-average these days, whereas a few years ago, one could easily find stocks growing at 20% to 30% annually.

Q: Although you can invest without regard to cap size, does one size dominate the fund?

A: Small- and mid-caps dominate the fund, reflecting the fact that smaller companies can deliver higher rates of growth. At the end of October, we had about 30% of our assets in small-cap stocks (below $2 billion in market capitalization), about 39% in mid caps (between $2 billion and $8.5 billion), and the remaining 31% in large-caps. The fund's median market cap is about $4.3 billion.

Q: What are your top holdings?

A: As of Oct. 31: Anglo Irish Bank Corp. (AGIBY), 3.02%; Altana AG (AAA), 2.62%; ENI Spa, 2.33%; Grupo Ferrovial SA, 2.26%; Banco Popular Espanol, 2.12%; Banco Popolare Di Verona, 2.06%; Total Fina Elf (TOT), 2.01%; Merloni Elettrodomestici, 1.96%; Autostrade SPA, 1.94%; and Reckitt Benckiser Plc (RKBKF), 1.91%. These 10 largest holdings accounted for 22.23% of the fund's total assets.

Q: Tell me about the Italian energy company ENI, which just agreed to buy a Norwegian oil exploration and production company for $1.08 billion.

A: ENI and one of our other top holdings, Total Fina Elf, are the two fastest-growing major oil companies in the world. Even better, they're also two of the cheaper oil stocks. While most oil firms would kill for 4% annual production growth, ENI is delivering something like 8% growth annually.

This latest acquisition of Fortum's Norwegian oil and gas assets is not really a big deal for ENI in the grand scheme of things. Of much greater significance to ENI is the success it has derived from its oil fields in Russia.

Q: Anglo Irish Bank has performed very well this year.

A: Anglo Irish is a leading lender to the small-business sector in Ireland. Now, about half of their business is in the United Kingdom, where they have successfully expanded. The company is very conservative with respect to underwriting and provisioning, and has benefited from the strong economic growth in Ireland.

It has a very low income-to-cost ratio of about 30% -- as well as a 30% return-on-equity, which is about the best you can find among European banks. However, the stock remains inexpensive, trading at about a 11 p-e. Economic growth in Ireland is tapering off a bit, but it's still well above average. Most forecasts are calling for a 4% GDP growth [in Ireland for 2002].

Q: Tell me about Grupo Ferrovial.

A: Ferrovial is a major Spanish engineering and construction company. There is currently a big EU-sponsored infrastructure program in Spain, which is fueling a lot of construction projects there. Ferrovial is a principal beneficiary of these contracts. The company has been taking the high cash flow generated from the construction business and channeling it into higher-return areas like concessions, toll-road operations, parking-lot management, and airport-infrastructure development. It recently won a concession to operate an Irish toll motorway. Ferrovial is also profiting from Spain's strong economic growth.

Q: What are your top sectors?

A: As of Oct. 31: financials, 25.7%; consumer discretionary, 23.3%; industrials, 15.9%; health care, 12.3%; consumer staples, 11%; energy, 5.8%; information technology, 2.2%; telecommunication services, 1.7%; utilities, 1.5%; and materials, 0.7%.

Although financials is our No. 1 sector, our allocation actually represents a slight underweight relative to our benchmark, the MSCI Europe Index.

Within financials, we are focused on domestic-oriented banks like Anglo Irish, Banco Popular Espanol, and Royal Bank of Scotland. We also like insurance-brokerage companies such as Jardine Lloyd Thompson and Willis Group (WSH).

Q: Your exposure to technology and telecom seems quite small.

A: We have actually been increasing our exposure to European telecom stocks recently. The industry as a whole appears to have realized it's not in a massive growth business. So, instead of throwing tons of money into such things as third-generation wireless, ISPs and Internet companies, etc., [telecoms] have really buckled down and focused on cash flow. They have started serious restructuring and have been cutting back on capital expenditures. They're starting to do the right things, and they're now again appearing on our radar screens.

In addition, lower interest rates and faster debt repayment have provided European telecoms some nice leverage in terms of profitability.

Q: Generally speaking, how is the pace of corporate restructuring in Europe proceeding?

A: Not as rapidly as we would like. Indeed, some companies are under the gun and are being forced to operate tighter, more efficient businesses. However, there remain several impediments to restructuring, particularly in Germany and Italy, where you have powerful labor unions and rigid labor regimens. It's nearly impossible to lay off people en masse.

Q: Why do you have no exposure in Russia or Eastern Europe, since these markets have performed better than their Western counterparts?

A: We aren't forbidden to invest in these countries by mandate, but we have shied away from them for various reasons. In Russia, they have problems with poor corporate governance. Even though the Russian markets have performed very well over the past two years, and Russian corporations are beginning to reform, you still have huge gulfs in disclosure and corporate reporting.

We currently own one Russian stock, VimpelCom (VIP), which is a cellular operator known for strong communication and which recently reported better-than-expected third-quarter earnings. Admittedly, not having greater exposure to Russia has certainly hurt our fund's performance this year.

With respect to Eastern Europe, there are really very few companies that can be invested in, and almost none of significant size. Moreover, their markets still lack liquidity and the earnings backdrop is not too good. In the past, however, we have had as much as 5% of our assets in Russia and Eastern Europe.

Q: What's your outlook on Europe for 2003?

A: We have been disappointed with the performance of the European markets this year. There's no doubt economic conditions there are weakening. However, we're positive about Europe's outlook, primarily because there's a massive valuation gap relative to the U.S. stock market. Aside from that, we don't expect to see corporate earnings rebounding this year and, consequently, we are not forecasting a major recovery in Europe in 2003.

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