Europe: Not Too Wild, Not Too Mild

European stocks should see respectable growth -- and even outperform the S&P 500

Is it time to give the old world a new look? With the dollar falling and U.S. growth slowing, Western European stocks may offer investors a good way to hedge the vulnerable greenback. And despite Old Europe's reputation for lackluster growth, the region may well outpace the U.S. in 2007 while offering less volatility than developing countries farther east. Western Europe "is in a sweet spot" because of its access to both cheap labor and fast-growing markets in the old Soviet bloc, says John Bennett, investment director for London-based GAM, a subsidiary of Swiss bank Julius Baer Group.

That's not to say buying into European shares is a sure bet. The Continent's bourses are already high after strong performances in 2006, with Morgan Stanley's (MS ) MSCI Europe index up 13.6% for the year. The two major central banks, the Bank of England and the European Central Bank, are raising interest rates, which could cut into growth. And if the greenback keeps falling, earnings at European companies that depend on exports to the U.S. and Asia could take a big hit.

But many fund managers and strategists say there are still reasons to be bullish. European corporate earnings per share will likely grow by 6% this year, Morgan Stanley predicts. Although that's well below the 12% level of 2006, it's still slightly above the 5.5% increase the bank is predicting for the Standard & Poor's 500. And despite the runup in European shares in 2006, prices for the 600 companies in the MSCI Europe index are still a relatively modest 13.3 times the earnings forecast for 2007, on average. Compare that with the long-run ratio of 14.5 for the index, and there's potentially room to grow. Total returns for the MSCI Europe will likely reach 13%, Morgan Stanley says, compared with a 9.7% rise in the S&P 500.

TAKEOVERS COULD ALSO HELP lift Western European stocks, as companies in the region sport balance sheets heavy with cash. Europe looked set to finish 2006 slightly ahead of the U.S. as a source of deals. This strong flow of acquisitions is likely to continue, unless a big buyout blows up and kills investors' appetite for putting up financing. "Private equity bids and publicly quoted M&A will be a major support for equities going through next year," says Peter Oppenheimer, head of European strategy at Goldman, Sachs & Co. (GS ) in London.

Germany, which has dragged down European growth for a decade, also looks like it's finally getting its mojo back. Years of restructuring and a massive shift of manufacturing to Central and Eastern Europe have helped make German companies more competitive and boosted demand for their products in new markets to the east. Even more important, long-dormant German consumers, who account for about a third of the euro zone market, are waking up thanks to modest real wage growth after four years of decline. Although a rise in the value-added tax to 19% from 16% in January may have a dampening effect, investors still think there's tremendous pent-up demand. "The average age of a car in Germany is eight years, much older than the Europe average," says Christoph Berger, manager of the Fondak Europa fund for cominvest, Commerzbank's (CRZBY ) fund management arm. "The average German bathroom is 20 years old," he says.

There is a lively debate on how investors ought to play this consumer revival. One bet is Swedish clothing retailer H&M, which makes more than a quarter of its sales in Germany, says Teun Draaisma, Morgan Stanley European equity strategist. Another good play might be Madrid-listed Inditex Group, the parent company of retailer Zara, says David Moss, director of European equities at London-based F&C Asset Management PLC (FACAM). "We think the European consumer is in better shape than in a considerable while," he says.

Technology outfits may also present opportunities. Swedish telecom equipment maker L.M. Ericsson is relatively cheap at just 15 times expected 2007 earnings, Moss says. He thinks Ericsson's move to build up a business running networks for carriers will both increase its revenues and provide insurance against the cyclical downturns that have pummeled it in the past. Other fund managers favor British telecom giant BTPLC (BT ), which they say may not be getting as much credit as it deserves for its potential to generate revenues through new services such as broadband and video-on-demand.

Some are betting on old standbys such as property and cars. For his GAM European Small Cap Hedge fund, Bennett is buying German real estate companies such as VIB Vermögen--which invests in office parks and industrial sites in southern Germany--and Deutsche-Wohnen, which has 22,000 residential units around Frankfurt and beyond. He is hoping for a revival in German real estate, which has stagnated even as property in Britain, Ireland, and Spain has boomed. Bennett also likes Porsche. The carmaker's recent accumulation of a 27% stake in Volkswagen could pay off for Porsche shareholders if VW's weak results improve. Porsche is "one of the few genuine growth stocks in Europe," Bennett says.

ONE OF THE STRANGE features of 2006 was a buying frenzy for utilities and infrastructure companies. Even as some traditional growth plays fell out of favor, private equity firms and strategic investors bid for Thames Water, Scottish Power (SPI ), British airport operator BAA, and others, driving up prices in sectors that had been considered dull, if predictable. Now some fund managers seem to be shedding utilities and infrastructure while hunting for bargains in telecommunications, media, and technology--all sectors that have stumbled in recent years. Two picks from Morgan Stanley: cellular carrier Vodafone (VOD ) and Italian broadcaster Mediaset. Unpopular now, both could do well in 2007 as investors look for stocks with growth potential that haven't yet been bid up to the levels of the top performers of recent years.

By Stanley Reed, with Jack Ewing in Frankfurt

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