Beware Rally in Europe’s Cheapest Stocks, Argonaut Says

Investors should pick European stocks with the highest potential for earnings growth over those with the cheapest valuations even as central-bank support boosts risk appetite, according to Argonaut Capital Partners.

“There is a big liquidity rush that has made everyone enthusiastic, but it won’t go on for the rest of the year,” Barry Norris, who helps manage $1.2 billion as a partner at Argonaut in London, said in an interview. “Equities will rally because they are the least-worst option among asset classes. But investors have to be very selective and pick companies that can grow profits even in a difficult economic environment.”

The cheapest stocks have led recent gains in equities after European Central Bank President Mario Draghi said in July he would do whatever it takes to preserve the euro. The MSCI Europe Value Index has surged more than twice as much as the MSCI Europe Growth Index since the ECB announcement, pushing the spread between the gauges to the highest level in 11 months, according to data compiled by Bloomberg.

The benchmark Stoxx Europe 600 Index surged 14 percent last year, the biggest gain since 2009’s 28 percent jump. The measure reached a 22-month high last week. While the ECB’s actions diminished the chance the euro area will splinter, they have yet to help the economy recover, Norris said.

“In 2009 too, we saw asset prices recover steeply but it was backed by real economic growth and preceded by a sharp decline,” said Norris, whose Argonaut European Alpha Fund has beaten 86 percent of peers over the past five years, according to Bloomberg data. “That’s not the case this time.”

Economy Shrinks

The euro-area economy contracted 0.5 percent in 2012 and will shrink 0.3 percent this year, according to ECB forecasts. The region’s industrial production unexpectedly declined in November and unemployment rose to a record 11.8 percent. In Greece and Spain, recessions have driven jobless rates to more than 25 percent.

Still, some fund managers including BNP Paribas Investment Partners and Amundi predict that European equities will gain about 10 percent this year.

“All companies in Italy and Spain, no matter what their quality, were penalized by the cost of financing,” said Christian Dargnat, chief investment officer at BNP Paribas Investment Partners. “That has improved and will continue. That favors a revaluation of their stocks.” Dargnat, who helps manage the equivalent of $655 billion, began buying shares in the two countries last month.

Biggest Gains

Stocks in peripheral Europe, which led losses in 2010 and 2011 as the euro area’s debt crisis escalated, have posted the biggest gains among 24 developed markets tracked by Bloomberg this year. Portugal’s benchmark PSI-20 Index has surged 8.5 percent and Spain’s IBEX 35 has advanced 5.3 percent. Germany’s DAX Index has only climbed 1.4 percent.

“I struggle to understand why Spanish markets should be so vibrant,” said Norris. “There are no signs of Spain coming out of recession.”

Norris is bullish on consumer staples, insurance, technology, property and auto-industry stocks. Companies in industrial, materials and utilities industries will underperform the broader market, he said. His preferred stocks include Volkswagen AG, Europe’s biggest carmaker, and Marine Harvest ASA, the world’s largest salmon farmer.

“People who argue that there has been an improvement in the peripheral countries in the last six months are deluded,” said Norris. “Markets underestimate the time it will take for growth to come back to those economies. We’re not at all confident on peripheral outlook.”

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