Life is full of second chances, even for readers of this column. If you missed European stocks when I wrote about them two years ago, don't despair. Back then, I wrote: "For the first time in maybe two decades, I am actually excited about the stock-market prospects in Europe." It was a good call. Vanguard European Index fund (symbol VEURX), which I recommended as one of two good ways to buy the Continent, has returned a total of 55% for the two years ending April 11. The other recommendation, iShares S&P Europe 350 (IEV), an exchange-traded fund that tracks the Europe 350 index of large-cap stocks, is up 49%. By comparison, Spiders, the ETF that mimics Standard & Poor's 500-stock index (the U.S. equivalent of the Europe 350), returned just 26%.

Still cookin'

In that June 2005 column, I gave three reasons for optimism. One was the changing political dynamic within the European Union because of the admission of ten new, aspiring countries that would push the older, more complacent member nations to compete. Another was a consensus among European policymakers that taxes needed to be lowered, pension laws reformed and labor markets made more flexible. And third was relatively low stock valuations.

All of the reasons for liking European stocks when I wrote about them two years ago still apply. Two more countries, Bulgaria and Romania, joined the EU in January. Taxes on business are falling, both because of the 12 new members (whose corporate tax levels are about half those of the incumbents) and because of intensified global competition. As I write, Germany is about to cut its corporate tax rate by nine percentage points, to 29%. According to an analysis by Kevin Hassett, of the American Enterprise Institute, France, Italy, Spain and the U.K. have all reduced their corporate tax rates below the U.S. level of 39%. Poland has a rate of just 19%; Ireland, 13%.

While European stock prices have risen faster than U.S. prices, so have valuations. But European stocks remain cheaper than U.S. stocks. Compare Vanguard European Index fund with its U.S. analog, Vanguard 500 Index (VFINX), which tracks the S&P 500. Morningstar reports that the average stock in the European fund has a prospective price-earnings ratio, based on year-end profit estimates, of 14, compared with a P/E of 16 for the U.S. fund. The European fund's dividend yield is 3.2%, compared with 1.8% for the U.S. fund.

Two years ago, I singled out Allied Irish Banks (AIB) as a well-run, fast-growing, Europe-wide company with a relatively low P/E compared with a similar U.S.-based bank, Wells Fargo. Since then, shares of Allied Irish have returned 46%, but its P/E (based on the previous 12 months' earnings) has actually dropped, from 13 to 9, as earnings have soared. Wells Fargo, which returned only 23% in two years, still has a P/E of 14. A report by Lydian Wealth Management predicts that European stocks could experience a rise in P/Es (and prices) "because the current valuations are below the long-term average, and historically bull markets in Europe have included multiples expansion" -- in other words, the average P/E rose.

So Europe is becoming more business-friendly, and European stocks are still inexpensive. To those incentives, add a new one: European companies are experiencing a wave of consolidations and buyouts that could lift prices significantly. The German energy giant E.ON was thwarted in April in its effort to buy the Spanish company Endesa (and thereby create the world's largest utility), but the die has been cast.

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