The Case for European Stocks

Stable rates, tempting valuations, and more-flexible labor markets are making investments in Britain and the Continent look promising

By Beth Carney

To investors anxious about U.S. stock markets, Europe may not look like much of a haven these days. Investors in Britain and on the Continent seem to be taking at least some of their cues from across the Atlantic. Although European markets closed higher on Apr. 22, sentiment has recently turned more downbeat, triggered by worries about future American economic growth.

London's FTSE 100 index hit a three-month low on Apr. 21 before gaining a modest 0.62% the following day after a strong Apr. 21 rally on Wall Street. In two weeks the Paris CAC 40 has fallen 3.5%, and Germany's DAX 4%.


  Yet some stock strategists say jittery global investors have reasons to be optimistic about European equities and that they might want to take a second look at European plays in the near term. Cheaper valuations, a more stable interest rate environment, and aggressive corporate cost-cutting are making European stocks appealing, especially in comparison to their more volatile U.S. counterparts. "We don't like the U.S. now as much as [we do] Britain or Continental Europe," says Richard Batty, global investment strategist at Standard Life Investments.

Still, Europe's stock markets remain highly correlated to Wall Street, particularly in their response to American economic data. Here's why: European companies export about 20% of their goods to the U.S., according to Batty, so worries about an economic soft patch in the U.S. naturally affect European stocks.

But so far this year, European stock markets have outperformed those in the U.S. by about six percentage points on a common currency basis, according to Karen Olney, European equity strategist with investment bank Dresdner Kleinwort Wasserstein.


  One appeal of European stocks is that they're cheaper than American offerings. U.S. stocks are trading at a 2005 forward price-earnings ratio of 16.1, or about 20% more than European stocks, whose forward p-e is 13.4, says Olney.

The disparity partly stems from Europe's lower economic growth rate. Yet European companies have performed better than their economies would suggest, Olney points out. In 2004 the euro zone experienced weak gross domestic product growth, about 1.8%, compared with a robust 4.4% in the U.S. The region also suffered from the strong euro, which hurt the Continent's exporters. Despite these obstacles, profit growth for European companies nearly equaled that of the U.S., at about 22%.

"Going forward, the valuation gap doesn't make sense given their ability to generate profits," says Olney, who also favors European stocks over those in the U.S. Nigel Bolton, head of European equities at Scottish Widows Investment Partnership, agrees: "The width of that discount now makes European stocks look much more attractive."


  Despite the sluggish local economy, European companies managed to perform well last year in part because they cut costs. Here they have an advantage over their U.S. counterparts, says Batty. Because the Europeans have a higher fixed-cost base, they have more room for cuts. The relatively high unemployment rate in some European countries has made unions more willing to grant concessions, allowing companies to trim notoriously expensive labor costs. Western European outfits have also shifted some operations into Eastern Europe to take advantage of cheaper labor there.

"There's increased flexibility, and labor costs have been falling," says Batty, who predicts that corporate earnings growth in Europe this year will total 10% to 15%, ahead of U.S. growth, which he predicts will come in at 5% to 10%.

The more stable interest rate environment is providing another boost for European equities, according to strategists. Although Britain has had a series of rate increases in the past year, the European Union hasn't raised rates in the euro zone for 18 months. Neither Britain nor the EU is expected to raise rates much this year.

And inflation poses less of a threat in the region than in the U.S., partly because the strong euro has buffered Europe against some of the effects of higher oil prices, which are denominated in dollars.


  "European consumers haven't had the same sort of cold-water treatment that a lot of Americans have had" from higher gas and energy prices, says John Storkerson, portfolio manager at Putnam Investments in London. He recommends increasing geographic diversification, as he expects volatility to increase across markets.

Not everyone agrees that Europe makes a more attractive investment option than the U.S. Peter van Doesburg, equity strategist with Rabo Securities in Amsterdam, acknowledges a "remarkable discrepancy" between expectations of corporate profits and economic growth in Europe but questions how long it can last. "You can't restructure forever," he says, adding that expectations of economic growth in Europe this year have fallen sharply, from about 2.2% at the beginning of the quarter to about 1.5% now. Thomson Financial also expects European earnings to grow by about 6.8% in 2005, less than its U.S. forecast of 12%.

As in the U.S., the murky economic future is prompting strategists to recommend that investors shift out of consumer cyclical stocks, such as building and materials companies, and into more defensive sectors, such as pharmaceuticals and food and beverages.


  Do any European countries stand out as particularly attractive in the current climate? Olney recommends investing in Britain as a defensive move. More than 50% of that market's earnings are concentrated in banks, energy companies, telecoms, and pharmaceuticals, which either benefit from, or are unaffected by, high oil prices. In addition, it's not likely at all that Britain will raise rates.

Whether the current edgy mood in the U.S. markets will continue depends on economic data and corporate outlooks, strategists say. But some see an upside to the downturn in outlook. "If we continue to see weakness, we'd be looking for opportunities to be pushing more aggressively into equities," says Paul Niven, head of strategy at F&C Asset Management. "The more markets fall, the better prospective returns become." And turning to Europe while U.S. markets stew could prove to be a shrewd move.

Carney is a correspondent for BusinessWeek Online in London

Edited by Beth Belton

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