Europe's A List Stocks

Can the blue chips deliver?

Remember the "Nifty Fifty"? That was the group of blue-chip U.S. stocks that no American investor in the late 1960s wanted to be without. The list was packed with household names such as Coca-Cola, Xerox, and Ford. At the center of the postwar economic boom, these companies had a reputation for steady growth. And as more Americans poured into the stock market, they felt comfortable investing in the big names they knew.

Now, Europe has a Nifty Fifty of its own. All are huge, well-established companies, such as French retailer Carrefour, Germany's DaimlerChrysler, and Italian insurer Generali. All belong to the new Dow Jones EuroStoxx 50, a sector-weighted index of the biggest stocks by market capitalization within the European Monetary Union. Since the common currency was launched on Jan. 1, all have outperformed the broader European indexes by nearly 15%, says Mark Howdle, head of equity strategy at Salomon Smith Barney in London. The big question: How long will these stocks be must-haves for global investors?

For now, demand for the Nifty Fifty looks unstoppable. Throughout the EMU region, investors are rejiggering their portfolios to reflect the unified European financial market, and loading up on top-tier companies outside their home countries. But it could be years before investors are able to judge the Nifty Fifty with sophistication. That's because many of the companies are on the list by virtue of size alone. When the dust settles after the great cross-border asset shuffle, performance rather than sheer bulk will determine their desirability.

Indeed, only 28 stocks in Europe appear on all 11 of the new Europewide indexes. "These companies benefit from every index trade made in Europe," says Bryan Allworthy, Merrill Lynch & Co.'s European equity strategist. That's true regardless of their earnings, management, or business vision.

BEAT THE INDEX. In some ways, Europe's capital markets are going through an unprecedented process. The common currency has created a need for new benchmarks. So indexes that measure performance in the euro zone have proliferated, and money managers must try to match or beat them. That's why the companies included in the main indexes form such an important core.

At the same time, the Continent is maturing financially much as America did 30 years ago. Companies increasingly raise funds through stock and bond issues rather than bank loans. Meanwhile, investors want more bang for their buck than they can realize in savings accounts. Just 26% of all mutual fund assets in the major European nations is invested in equities. Analysts expect that amount to double by 2002.

With millions of euros in cash coming into their portfolios daily, European fund managers need to be able to buy and sell quickly. As a result, they favor Europe's largest, most liquid stocks. So investment will probably remain concentrated in the Nifty Fifty until Europe nurtures a healthy class of fast-growth, high-tech startups like the ones that enchant U.S. investors today.

All these factors point to continuing appetite for these must-have stocks. Yet despite the demand, "they still look fairly valued against their global peers," says Gary Dugan, European equity market strategist at J.P. Morgan & Co. in London. With an average price-earnings ratio of 24 based on estimated 1999 earnings, the EuroStoxx 50 is trading at a 15% premium to the broader Dow Jones Stoxx indexes in Europe. In the U.S., by contrast, premiums on some of the biggest stocks in the Standard & Poor's 500-stock index are almost double the average. That's because indexing is still new in Europe, where only 4% of invested assets are passively managed. As index tracking becomes more popular, the stocks in the indexes should see their valuations rise.

Long-term, the bias toward European blue chips could have a downside. Companies not on the core list could be unfairly undervalued, says J.P. Morgan's Dugan. High-quality companies that don't happen to be the biggest in their home country get left off the Nifty Fifty and could suffer neglect. For instance, Germany's DaimlerChrysler beat Volkswagen for inclusion in the Eurostoxx 50, despite similar profitability. Many investors suspect Volkswagen shares have dropped 6.8% since Jan. 1 as a result, while Daimler's are up 13.6%.

In addition, smaller companies may suffer as managers sell their shares to beef up their core, big-cap holdings. That, of course, undermines the whole point of creating an efficient new equity market in which investor capital is available to all who merit it. For the time being, investors who stick with the Nifty Fifty probably can't go wrong. But as Europe continues along the road to financial integration, expect the must-have stocks to keep changing.