Value Added


The Case for European Stocks

Steven Goldberg

They're cheaper than U.S. stocks and safer than emerging markets stocks.



The U.S. consumer has finally run out of gas. Overleveraged and under-employed, American consumers simply don’t have the wherewithal to buy vast quantities of goods and services, whether home-made or from abroad. That will cripple both the U.S. economy and Asia’s emerging nations, which have become dependent on exports to the U.S. for their growth.

So says Rudolph-Riad Younes, co-manager of Artio International Equity II (symbol JETAX), a member of the Kiplinger 25. Younes is an astute global stock market forecaster -- which makes him well worth a listen.

Younes fully subscribes to “the new normal,” a phrase coined by Pimco’s Bill Gross, to describe a multi-year period of anemic growth in the U.S. The U.S. economy won’t grow at more than 3% to 4% annually, including inflation, for as far as the eye can see, Younes says. “We have to accept slower growth at home.”

The U.S. is in much worse economic shape than Europe, he contends. Huge government debt, massive trade imbalances and consumer debt beset our economy. Although European nations also run large government deficits, the shortfalls are not as high, relative to gross domestic product, as they are in the U.S. European consumers, meanwhile, aren’t nearly as tapped out as their American counterparts. And on balance, Europe is running a trade surplus with the rest of the world.

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Despite the furious stock market rally since March 9, European stocks remain cheap. Based on operating earnings for the previous 12 months, the price-earnings ratio of Standard & Poor’s 500-stock index as of December 7 was 28. According to MSCI, European stocks traded at just 17 times the past year’s operating earnings (operating earnings exclude one-time events, such as writeoffs). The S&P 500 yields 2.0%; European stocks yield 2.7%.

Weakness in the U.S. leaves Asian emerging markets on perilously thin ice, Younes says. China, in particular, shows alarming signs of overcapacity. The country continues to build far too many factories -- even as demand from abroad dwindles. Younes likens these emerging markets to Internet stocks a decade ago. Both represent real and enduring changes in the global economy -- but that doesn’t mean you could pay any price for Internet stocks, and we may soon learn the same lesson with regard to Chinese stocks.

Price-earnings ratios in emerging markets show only slight signs of strain so far. The MSCI Emerging Markets stock index recently traded at a P/E of 21. But further dramatic declines in U.S. imports, which Younes anticipates, would put pressure on profits.

Younes doesn’t see all emerging markets as victims of the same malady. He’s bullish on eastern European markets, as those economies recover from their current troubles and resume their integration into developed Europe.

Latin American emerging markets are pricey but stand to benefit from commodity exports, he says.

Over the medium term, Younes favors stocks of multinational companies that are expanding sales to consumers in emerging markets. He likes defensive sectors, such as food and beverage companies, plus drug makers. He’s bearish on companies, such as Caterpillar that rely on exports to emerging markets to fuel growth.

Younes doesn’t think the U.S. will accept slow growth -- so he expects more government stimulus. That means more dollars chasing fewer goods, which will ultimately trigger inflation. In such an environment, he says, “Stocks and commodities are better bets than long-term bonds. I think stocks will continue to rally in the U.S. even if you have inflation. Earnings will rise, and companies own land and factories.” How long the rally will last, however, is an open question.

For my money, I’ve become convinced that “the new normal” is, indeed, our fate for the next several years. And I agree with Younes that European stocks are more attractive than U.S. stocks.

But I don’t buy his pessimism toward Asian emerging markets. When the Internet bubble popped, many stocks were trading at triple-digit P/Es. Many of those high flyers had no earnings; some had no revenues.

Emerging-markets stocks seem fairly valued to me when you factor in the companies’ earnings growth rates. The trick, of course, will be to transform the Asian middle class into consumers—neither a quick nor simple process. So, as always in emerging markets, expect bumps along the way.

In running his fund, Younes is more likely than many managers to invest based on momentum and other short-term factors -- even if that means investing in stocks he thinks are overvalued and headed for trouble. For instance, he currently has sizable holdings in emerging markets in Asia and Latin America. But he’s ready to push the sell button at the first sign of problems.

Younes has been accurate more often than not in making such short-term trades. Indeed, for all his gloom, Younes’s fund has close to 100% of its assets in stocks.

The long-term records of the fund, and a near-clone, Artio International Equity I (JIEIX), which is closed to new investors, are superb. Over the past three years ago through December 7, International Equity II has lost an annualized 4.2%, which puts it ahead of 68% of foreign large-company funds that invest in a mix of growth and value stocks. Over the past ten years, International Equity I has returned an annualized 5.8%. That beats 92% of its peers and is an average of almost five percentage points per year better than the MSCI EAFE index.

That said, the funds haven’t been stellar performers over the past year. Because Younes was slow to jump into stocks when they turned up, International Equity II returned just 25.7%, lagging 82% of its peers. But it’s hard to bet against Younes over the long term.

Steven T. Goldberg is an investment adviser.



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