Online Original: Is Europe "Last Year's Story" For Investors?

Some top funds that focus over there are fairly flat. But don't abandon all hope

Europe is out. Japan is in. For investors in international markets, the story is about that simple. Europe's best years recently were 1997 and 1998, but "Europhoria" faded after last January's launch of the euro, Europe's common currency. Indeed, the toppling of the Berlin Wall marked the end of the old Europe. But the birth of the new European economy was highlighted by an event nearly as stark: Not long after the euro debuted, investors went elsewhere in search of greener pastures.

Part of the problem was excessive expectations. "There was so much optimism already priced into the market," says Bridget Hughes, a mutual-fund analyst at Morningstar. "When the euro actually came and the transition didn't immediately lead to the realization of all these [economic] benefits, a little air got let out of the balloon."

Already-high stock prices, combined with the effects of a weak euro, have added up to low mutual-fund returns for U.S. shareholders. The Vanguard European Stock Index Fund (VEURX), which matches the Morgan Stanley Capital International Europe Index, is flat for the year after being up 29% in 1998 and up 24% in 1997. By contrast, the Vanguard Pacific Stock Index Fund (VPACX), which tracks the MSCI Pacific Index, is up 37% year-to-date after gaining only 2% in 1998 and losing 26% in 1997.

CUTTING BACK. "The house view is that Europe is last year's story," says Mark Halperin, an international portfolio manager at Federated Investors. He currently has only 17% of the assets in the global financial-services fund he manages in European stocks (vs. a 40% weighting for an unmanaged index of international stocks), and he may go down from there. "Europe's improving economy and the whole theme of European industry restructuring is fully reflected in stock prices," he says.

Still, an argument can be made for keeping a portion of an investment portfolio in Europe. "I regard a good European fund as part of a core portfolio," says Sheldon Jacobs, editor of the newsletter No-Load Fund Investor. He suggests that investors put 7.5% of assets in a Europe fund, such as T. Rowe Price European Stock (PRESX) or Scudder Greater Europe Growth (SCGEX), and 7.5% in an Asian fund.

Jacobs' case for Europe: Stock prices are cheaper than in the U.S., and productivity improvements at European companies should lead to better returns for shareholders. "If you take a long-term view, it just simply has to get better," he says. Morgan Stanley Dean Witter strategists agree with Jacobs. They recommend that investors overweight Europe because they forecast accelerating economic growth, improving returns on equity, and a strengthening euro.

BRITISH BUYS. Some value investors are already benefiting by uncovering cheap stocks in Europe. As in the U.S., there's a huge gap in valuations in European markets between large, liquid stocks and small- and mid-cap stocks, says Michael Welsh, co-portfolio manager of Oakmark's two international funds. Oakmark International (OAKIX) is up 27% this year, and Oakmark International Small Cap (OAKEX) is up 45%, mainly thanks to management's early move into Japan. Recently, Welsh has been finding inexpensive stocks to buy in Britain. "To us, it makes sense to look over there and see if we can find cheap stocks," he says.

Based partly on a buy-low strategy, some mutual funds that focus on Europe have held their own this year. The irony is that the strategies that are working best now hurt the funds last year. The best-performing diversified Europe fund this year is Mutual European (TEMIX), which is up 16%. In 1998, the fund returned only 4% and was in the bottom 10% of all European funds. The fund's emphasis on inexpensive stocks has put it into cyclical names that have benefited from improving economic conditions this year. Also, the fund fully hedges currency risk, which hurt returns in 1998 but has protected gains in 1999.

By contrast, Scudder Greater Europe Growth, which has returned an average of 21% a year over the past three years, placing it in the top 5% of all Europe funds, is up a mere 3% this year. This fund doesn't hedge currency exposure and emphasizes large-cap growth stocks, many of which are quite pricey and have recently moved in sync with U.S. stocks -- mostly down lately.

The case for making Europe the focus of your portfolio isn't too strong now. But if you want to reduce risk long-term by diversifying into international markets and picking modestly priced stocks, Europe deserves a place at the table.

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE