Old World, New Pizzazz

With Europe hitting its global stride, it may be time to pack more Continental stocks into your portfolio

Europe: land of rude waiters, overpriced café au lait, and subpar economic growth. At least that's the stereotype—one that seems to affect the way Americans invest. Even though Western European equities account for 30% of global market cap, they make up only 10% of Americans' stock holdings, according to Citigroup (C). Maybe it's time for U.S. investors to give Europe a rethink.

Edward M. Kerschner, chief investment strategist at Citi Global Wealth Management, is among those arguing that U.S. investors have been giving Europe short shrift. His reasoning: A decade of corporate restructuring, economic integration, and international expansion has created a region with a lot more long-term upside than many realize.

That argument seems counterintuitive, given the U.S. dominance of businesses such as media and software, as well as America's superior growth rates. Even amid the subprime crisis, the U.S. will grow 2% in 2008, vs. Europe's 1.8% rate, Dresdner Bank estimates. European stock markets, which still tend to move with America's, are not immune to instability caused by the mortgage mess. Goldman Sachs (GS) predicts European equities may fall temporarily but end 2008 with a return of 5% to 7%, including dividends. Udo Rosendahl, head of European Equities at DWS, Deutsche Bank's (DB) fund-management unit, sums up the mood: "We're not bearish, but we have become more cautious."

For investors looking beyond the present turmoil, Europe has much to offer. Companies there have spent the past decade whittling down their high-priced domestic labor forces and expanding overseas. Some are now global champions in their markets. The world's two biggest lighting companies are the Netherlands' Philips (PHG) and Germany's Siemens (SI), with U.S.-based General Electric (GE) in third place.

Siemens, in particular, has been an investor favorite: Its shares have soared about 40% this year on optimism that company units selling power plants, mining equipment, and other infrastructure will profit from demand in emerging markets such as China and India. Analysts at private bank M.M. Warburg in Hamburg think another 15% gain is possible in 2008 as new CEO Peter Löscher streamlines the company.

Another leader is Zurich-based UBS (UBS), the world's biggest wealth-management company. Granted, not many analysts are recommending bank shares, and UBS shocked investors on Dec. 10 when it announced a $10 billion write-down related to subprime holdings. But once the smoke clears, the Swiss bank's stock—down more than 24% in 2007—could rebound as investors focus on its business potential in a world with ever more millionaires.

While the U.S. tends to dominate Internet-related technology, Europe boasts the leaders in mobile technology. Nokia (NOK) is by far the biggest maker of mobile handsets, with a 39% share of the global market. The Finnish company's shares have already had an amazing run, rising more than 70% this year, but more gains are possible as Nokia pushes growth in India, China, and Africa. "The Europeans have rediscovered their entrepreneurial spirit," says John McCormick, author of The European Superpower, a new book that makes the case for the Continent's revival.

By necessity, European companies are experts at operating abroad in businesses ranging from construction to cosmetics to beer. Shares of German builder Hochtief, whose order books are full of projects such as a $510 million convention center in Dubai, are recommended by M.M. Warburg.

German cosmetics and household-products maker Henkel, which is profiting from the growing purchasing power of emerging-market consumers, is included in Morgan Stanley's (MS) model European portfolio.

Dutch beermaker Heineken is on Merrill Lynch's (MER) list of companies that have solid growth and low debt and are overlooked by investors. The Amsterdam company, the first to market beer globally in the 1950s, has extensive holdings in Asia, Africa, and Central Europe. Heineken is in a good position to profit from the switch by newly affluent people in emerging markets such as China to premium beers that convey status.

The reason for the global reach? Ambitious European companies bump up against the limits of a domestic market pretty fast. "If you operate in a small country like Austria, with 8 million people, you have to go into other markets," says Andreas Treichl, CEO of Vienna-based Erste Bank, which is now the largest retail bank in several Eastern European countries, including Romania and the Czech Republic. Société Générale analyst Alan Webborn recommends Erste, citing the potential of the fast-growing Romanian market.

Europeans' overseas operating expertise is paying off, particularly in fast-growing countries such as Russia and China. The 27 countries in the European Union account for 38% of world exports of merchandise, vs. only 9% for the U.S. As people in emerging markets grow richer, they are increasingly able to afford European goods and services. One beneficiary could be Germany's Fresenius, which, with $16 billion in sales, is the world's largest supplier of dialysis equipment and services. Fresenius CEO Ulf Schneider has been spending time in China lately in hopes that the country's health-care system will begin covering the cost of dialysis care. Chinese officials "see that a healthier population is a more productive population," says Schneider, whose strategy has won plaudits from analysts such as Christian Cohrs at UniCredit Markets & Investment Banking in Munich. Shares of Bad Homburg-based Fresenius have risen a relatively modest 7.5% this year but have more than doubled since early 2005.

Europe also benefits from the presence of a fast-growing emerging market in its backyard. The newest members of the EU in Central and Eastern Europe have a combined population of more than 100 million, and another 90 million live in countries such as the Ukraine, Belarus, and Albania, which are just starting to attract investment. As U.S. consumer spending falters, European companies are hoping Asian and Central European consumers will take up the slack. Netherlands-based ASML, a leading maker of semiconductor equipment, could benefit if Asians' appetite for consumer electronics props up demand for chips and the machines to make them.

True, the euro's strength vs. the dollar makes it harder for European companies to compete on price with U.S. rivals. Yet the euro, which has neared $1.50, is not the problem it would have been a few years ago. Companies have spread their operations around the globe, so currency fluctuations tend to cancel each other out. And the strong currency reduces the cost of oil and other raw materials priced in dollars.

The strong euro even helps hold down the cost of diamonds, which are priced in dollars, for Bulgari. The Rome-based watch and jewelry maker boosted sales in the first nine months of 2007 by 8.6%, to $1.1 billion. "It's better than we expected," says CEO Francesco Trapani. Although Bulgari shares are down 12% this year, Citi's Kerschner says the long-term prospects for European luxury goods are promising because of the growing affluence in countries such as Russia. Already, Bulgari gets nearly 40% of its sales from Asia, vs. 14% from the U.S. Says Kerschner, "You've got a couple hundred million people who can afford super-luxury goods."

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