Politics & Policy

Bargains Abroad

European stocks are cheap. Are they worth it?

The U.S. economy has been sputtering for the past two years but compared with Europe it’s a well-oiled machine. When I was in Paris recently, the French government was announcing that gross domestic product — the sum of the country’s output of goods and services — had declined in the fourth quarter of last year. French GDP is expected to grow just 1 percent this year, and that may be optimistic.

Germany is even worse. Economists estimate that output won’t even beat the 0.5 percent growth of 2002. While American unemployment rose to 6 percent in April, that’s practically paradise compared with current rates of over 10 percent in Germany, Spain, and Belgium, and 9 percent in Italy and France. Britain looks better, but it still significantly trails the United States in economic growth.

But in April, despite these gloomy statistics, the FTSE Eurotop 300 index, which measures the performance of the 300 largest European companies, surged 10.6 percent, its best month since 1986.

And smart people who follow European stocks tell me that many companies look very, very attractive.

How can that be? “Comparable assets are trading at lower valuations than in the States,” says Matthew Haynes, co-manager of the Mutual European Fund (TEMIX). In other words, European stocks are cheap.

For example, while the Dow Jones industrial average is down one-fourth from its all-time high, the Eurotop is still off by half and Germany’s DAX by 63 percent. Partly as a result, Haynes has been able to put together a portfolio of European shares with an average price-to-earnings (P/E) ratio of just 12, less than half the level of the Dow.

But what about Europe’s lousy economy?

First, it’s likely to get better, even if it continues to trail the economy of the United States. My guess is that domestic political pressure and the admission of Eastern European countries into the European Union will force economic reforms, to allow more labor mobility and entrepreneurship — though the process may be slow.

Second, many European companies sell their goods beyond Europe’s borders. Haynes, for instance, owns shares of London-based Cadbury Schweppes (CSG), which sells 42 percent of its candy and beverages (such familiar brands as 7Up, Hawaiian Punch, and Snapple) in the United States, 21 percent in the United Kingdom, and 27 percent in the rest of Europe.

Then what about Europe’s oppressive regulatory policies? They won’t end overnight.

It’s true, says William V. Fries, who as manager of Thornburg International Value Fund (TGVAX) currently has more than half his assets in European stocks, that Europe’s firms “do not have structurally the kind of — let’s call it freedom — to adjust their workforce” (that is, fire people and close unproductive plants) that American firms have. But many European businesses can overcome such obstacles. They’re well-run, they’re shareholder-friendly, and they have good balance sheets.

Haynes sees the best deals among small-cap and mid-cap companies you’ve probably never heard of. He and co-manager David J. Winters develop their portfolio from the bottom up: That is, they look at companies, not countries. But, as it turns out, many of those companies can be found not in what U.S. Defense Secretary Donald H. Rumsfeld called “Old Europe” but in Ireland, Scandinavia, and Spain.

Among the fund’s top eight holdings are four Spanish stocks and two Norwegian. Three of the Spanish companies are in the construction business, beneficiaries of the billions of euros flooding into new public infrastructure: Actividades de Construcciones y Servicios, Fomento de Construcciones y Contratas, and Acciona. “These stocks,” says Haynes, “are trading at nine or 10 times earnings and have stable cash flows.” The fourth Spanish stock, Altadis, sells cigarettes in France and Spain and is the world’s largest cigar company, owning Consolidated and Havatampa in the United States. (By the way, none of these stocks trade on a major U.S. exchange.) “Generally,” Haynes says, “we own fairly obscure companies.” But there are familiar names as well: Nestle, the global food company, based in Switzerland; France’s Groupe Danone (DA), famous for its yogurt; and U.K.-based British American Tobacco (BTI) and Cadbury. “We look at valuations, not market cap,” he says.

It’s an approach that has paid off. For the five years that ended May 1, the fund has produced average annual returns of 5.9 percent, an incredible 11 percentage points better than the Morgan Stanley international (that is, world except United States) index that’s used as a benchmark. And Morningstar rates the fund’s risk “low,” with volatility (that is, the extremes of its ups and downs) about half that of the Standard & Poor’s 500 stock index. For the past five years, it has finished in the top quarter of its peer group. “This omnivorous value hunter has thrived in all kinds of conditions,” writes Morningstar’s William Samuel Rocco.

Such performance does not come cheap, however. The fund’s A shares carry a front load of 5.75 percent and an annual expense ratio of 1.4 percent.

Of course, Haynes’s enthusiasm for European stocks may be a function of his occupation — as a European-stock portfolio manager. Fries has more latitude. He can buy shares anywhere in the world, and right now he’s drawn to Europe.

While Europe’s own economy languishes, Fries sees America’s recovering and such European companies as Bayerische Motoren Werke (that is, BMW), which sells to Americans, benefiting.

BMW shares hit a low of 21 euros ($21.18) on the Frankfurt exchange in March but then soared above 30 euros ($32.95) by the end of April, still far below last year’s high of 47.5 ($43.32) “With expanding market share, a company like BMW doesn’t have the regulatory problems that mature European businesses have,” says Fries. “With BMW, you get a long-term call on a great franchise at a reasonable price.” Its P/E, based on 2003 projected earnings, is less than 10.

“Our philosophy,” says Fries, “is to own promising companies at a discount.” Many of those are firms, like BMW, that get beaten up when the business cycle turns down. He balances such holdings with consistent earners, such as Tesco, Britain’s largest supermarket chain, and with younger companies such as Switzerland’s Bachem, which manufactures peptides for use by drug firms.

In smaller European markets, Fries tends to own broad-based businesses such as Gedeon Richter, a Hungarian pharmaceutical company, and Bank of Ireland (IRE).

Also, Europe often provides unusual opportunities. “American investors can’t buy a U.S. airport,” says Fries, but his fund owns Flughafen Frankfurt/Main, Europe’s second-largest airport and a stock he expects to rise as normal travel resumes.

Thornburg International, based in Santa Fe, N.M., has also whipped its benchmark, also has below-average risk, and also isn’t cheap: The A shares carry a 4.5 load and annual expenses of 1.6 percent. It is, of course, not a pure European play, with, at last report, 56 percent of its assets in Europe, 9 percent in Japan, and 14 percent in the rest of Asia.

Investing in international stocks of any sort raises the thorny question of currency. It’s hard enough to pick winning companies without having to predict whether the euro or the pound will rise or fall against the dollar. So far this year, for instance, French stocks have fallen in euros but are in positive territory in dollar terms since the euro has surged against the greenback.

Some mutual funds stay fully hedged, which means that they remove the element of currency fluctuations altogether. Haynes and Fries both employ partial hedging. Right now, their funds are about 50 percent hedged — an indication that, despite the decline of the dollar, they don’t see U.S. currency as undervalued.

Besides the vagaries of currency, there’s another reason to be wary of European stocks: In recent years, their returns have been tightly correlated with those of U.S. stocks, so they don’t provide the main benefit of diversification. Between 1970 and 2001, stocks returned an annual average of 11.6 percent in the United States, 10.9 percent in Germany, and 12.0 percent in Britain. Not much difference.

But there is another reason that favors investing in Europe. It has become home to some very good companies, trading at very good prices. European accounting has gotten more transparent, and European managements have finally begun to align their interests with those of their shareholders.

Still, European stocks are often difficult for Americans to buy. Dozens of larger foreign companies offer American depositary receipts (ADRs), which trade just like U.S. stocks on the major exchanges, but for small- and mid-cap companies, it can be expensive and inconvenient to buy and sell shares abroad.

That leaves mutual funds, most of whose managers have a preference for mega-caps like oil company BP (BP), cell-phone maker Nokia (NOK), or consumer-goods purveyor Unilever (UL). Better values reside in stocks that operate below the radar screen.

To find them, you may have to buy a broader international fund such as AXA Rosenberg International Small Cap (RISIX) or First Eagle Overseas (FESOX), both of which win five-star ratings from Morningstar.

Rosenberg, with a high expense ratio (1.8 percent) but no load, returned 3.5 percent in 2002 and is having a spectacular year in 2003, up 7.2 percent through May 2. Manager Kenneth Reid and his colleagues have put a hefty 68 percent of their assets into European stocks, including Denmark’s Sydbank and Spain’s Obrascon Huarte Lain, another construction company, trading at a P/E of 5.

The First Eagle fund has been managed by the legendary Jean-Marie Eveillard for the past decade. He has a broad mandate, allowing him to buy stocks and bonds anywhere in the world, but, for now anyway, the majority of his assets are in European equities. His top stock at last report was Financiera Alba, a Spanish holding company with interests all over Europe in finance, technology, and retailing.

Eveillard’s annual returns since 1998 have averaged nearly 9 percent, and at low risk. The A shares, however, carry a 5 percent load and annual expenses of about 1.4 percent. In this case, you get what you pay for (though, of course, no guarantees).

In the end, you can be dismayed or even outraged by what’s happening in the European economy but still love many European stocks. After all, Europe, with a population that’s greater than that of the United States and a GDP that’s about the same, has a total market capitalization that’s 40 percent smaller. In a quick and dirty way, that’s the definition of a bargain.

James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. This column originally appeared in the Washington Post.

James K. Glassman, former Under Secretary of State for Public Diplomacy under President George W. Bush, is a member of the advisory board of the Infrastructure Bank for America, a proposed private institution to invest in U.S. infrastructure.


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