Europe Still Sizzles

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%.

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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.

Urge to merge

There will be more strategic acquisitions, as giant European companies seek economies of scale across borders, and more purchases as well by private-equity firms based in Europe and the U.S. Even Netherlands-based Unilever (UN), the maker of Dove soap and Lipton tea, Hellmann's mayonnaise and other packaged foods, is "within reach" as a takeover target for buyout firms, according to a Bloomberg News report. Acquisition talk helped push Unilever's stock price up nearly 20% between early March and early April -- although the stock still trades at a P/E of 14. Through the first quarter, mergers in Europe have totaled $504 billion, according to Bloomberg. That's well ahead of last year's pace, which produced a record $1.4 trillion in deals.

Rising stock prices in Europe are nothing new. Returns for the MSCI Europe index have exceeded those for the S&P 500 for the past five years in a row. Between 1970 and 2006, the European index returned an annualized 12.3%, compared with 10.8% for the S&P and 11.2% for the MSCI Pacific index.

Price of success

But, as usual, higher returns come with higher risk. Ibbotson Associates reports that the annual standard deviation (a measure of volatility) for European large-company stocks is about one-fourth greater than for their U.S. counterparts. Your portfolio's overall volatility can be dampened by owning stocks that don't move up and down in tandem -- stocks that have, as they say, low correlations. Unfortunately, the trend for U.S. and European stocks (and for all international stocks, in fact) is toward higher correlations, so simply owning chunks of both sectors won't reduce your portfolio's volatility very much.

But diversification by geography is not the reason to own European stocks. You should own them because there are a lot of excellent European companies and because Europe is getting its economic act together, the euro is proving to be a durable, well-managed currency, and European stocks are relatively cheap.

Limiting your portfolio to U.S. stocks makes as much sense as limiting it to companies that begin with the letters a through m. Although European markets still have a smaller capitalization than U.S. markets, investors have thousands of companies to choose from, including some of the biggest players in key global sectors.

To rank the 2,000 largest public companies worldwide, Forbes used a composite of four factors: market capitalization, sales, profits and assets. It found that in the banking sector, seven of the ten biggest companies are European; in construction and in capital goods, nine of ten; utilities, eight of ten. Two of the three largest transportation companies, three of the four largest food-market chains, and all three of the largest materials and minerals firms are European.

So you have two choices: Either pick individual European stocks or buy funds and ETFs. Look beyond the Vanguard and iShares index portfolios and you'll find funds with spectacular records. Among them is Henderson European Focus (HFEAX), which owns a broader mix of midsize companies than its name implies (79 holdings, with none representing more than 3% of assets). Top stocks include TradeDoubler, a digital-marketing company based in Sweden, and Wavin NV, a Dutch plastic-pipe maker. This fund is sold through brokers, and Class A shares carry a maximum sales charge of 5.75%.Fidelity runs two no-load funds that focus on this region. Fidelity Europe is the biggest by asset size. More interesting to me is Fidelity Europe Capital Appreciation (FECAX). Manager Darren Maupin beat his peer group during 2006, his first year at the helm, with a 35% return.

Europe still has serious economic and social problems, but I am impressed by the progress. As economist Tyler Cowen recently wrote on his Web site, www.marginalrevolution.com: "Europe benefits more from America being American than America does from Europe being European. Ideas -- America's strong point -- are more likely to be international public goods than good governance -- Europe's strong point." Europeans are putting many American ideas, including better corporate management and economic stewardship, into action. On the governance side, Europe is adept at building infrastructure, especially in transportation, that has a strong economic payoff.

Room to grow

Yes, unemployment rates are high by U.S. and Japanese standards -- recently, 8.6% in France, 9.2% in Germany and 6.5% in Italy. And although European gross domestic product has been accelerating, its growth rate still trails that of the U.S. by about a half percentage point. The U.S. GDP per capita, a good measure of a nation's standard of living, is more than one-third higher than Europe's.

But for investors, this gap is probably a good thing. Europe still has a ways to go, but it appears to be on the right track. Lucky for you, the chance remains.

James K. Glassman is a senior fellow at the American Enterprise Institute and editor in chielf of its magazine, The American.