9/3/2013 9:30 PM ET|
4 reasons to invest in Europe -- really
As the US market loses strength, Europe's economies are in the early stages of a recovery, and investors are just starting to catch on. That makes these stocks and funds compelling buys.
Worried about U.S. stocks?
Then send some money into Europe -- European stocks, that is.
Sure, Europe has rallied strongly since I suggested it as a bold contrarian play a year ago because the experts thought it was about to blow up (see "5 stocks to buy on Europe's woes.") Euro stocks are up 16% since then.
But Europe is still a bargain, because many investors still have serious doubts about the continent. You can tell by the cheap stock valuations there, especially compared with U.S. stocks.
European economies are finally turning the corner -- giving us another reason to think the rally will continue.
Follow-through on economic strength, which I expect, will send euro stocks much higher over the next one to three years, and they will probably even outperform U.S. stocks. "Europe is appealing because it is unloved, under-owned and undervalued," says Raymond Vars, a portfolio manager with NorthRoad Capital Management.
So what to buy?
Money managers like Vars who are overweight Europe as a value play favor cyclical stocks such as WPP (WPPGY) in advertising; Total (TOT) in energy; Novartis (NVS) and Sanofi (SNY) in health care; heavily discounted banks such as BNP Paribas (BNPQY) and Intesa Sanpaolo (ISNPY); and cheap insurance giants such as ING Groep (ING) and Aegon (AEG).
For more diversified exposure, you can buy the mutual funds of the pros offering insights and names in this column, since their funds -- including NorthRoad International Fund (NRIEX), RidgeWorth International Equity Fund (STITX) and Advisory Research International Small Cap Value Fund (ADVIX) -- outperform competitors. Another option is European exchange-traded funds (ETFs), such as Vanguard FTSE Europe (VGK).
Before we explore the details of these stocks and a few others that are bargains, let's check out the four main reasons European stocks may do better than U.S. stocks in the future.
Reason No. 1: They're a lot cheaper
This might be the most convincing reason. A price-earnings (P/E) ratio using inflation-adjusted earnings from the prior 10 years, to smooth out ups and downs, stands at 13.5 for Europe, compared with 23.6 for the S&P 500($INX), points out Vars. That's an unusually broad gap on this standard measure of value. The two markets typically trade more in tandem.
One reason is that doubts still linger about the economic viability of Europe and the euro. I'll get to more on that in a second, but you can also think about the discount this way: Europe developed its own financial crisis a few years later than ours. So its economy and stocks are behind ours in terms of their recoveries.
That makes European stocks the type of bargain that U.S. stocks were back in 2010 or 2011, says Cindy Sweeting, the director of portfolio management at Templeton Global Equity Group. European stocks are so cheap, Sweeting describes Europe as a "once-in-a-generation buying opportunity" right now, and a better place to shop for bargains than the U.S. or emerging markets.
Reason No. 2: Postal code discount
Many European companies carry what Sweeting calls a "discount for domicile." This means investors are wrongly shunning big European companies because the home office has a European postal code, even though they do much of their business outside of the continent -- in regions with better growth including the United States or emerging markets.
Reason No. 3: European economies have turned the corner
In the second quarter, the eurozone returned to GDP growth for the first time since early 2011. Growth came in at 1.1%, and even troubled Portugal showed strength. The economies of Spain, Italy and Greece contracted, though less so than in the first quarter.
Now we see follow-through. The region's purchasing managers' index, a measure of business sentiment, rose above 50 for August and July, for the first time since January 2012. Anything above 50 is considered expansionary.
"The bailouts are working," says Marco Priani, a portfolio manager for the Advisory Research International Small Cap Value Fund, which outperformed competitors by 1.8 percentage points over the past three years. In the bailouts, European authorities and its central bank have provided funds to support troubled banks in struggling countries, and pledged to buy their government bonds to keep them from going back into freefall on worries that Europe will implode. The moves seem to have shored up confidence, contributing to improvement in economic strength. "Even though the economic picture is not as rosy as in the United States, that is more than baked into the multiples," says Priani.
Investors don't trust the rebound yet. But that is often the best time to buy -- when there's a trend change that people don't trust. "We have gotten past the worst of it in Europe," says Vars. "It doesn't mean that it is all over, but when you get past the worst of it is often a good time to invest."
After all, if you wait for trend reversal to be 100% confirmed, it will already be priced in to stocks. It will be too late.
Reason No. 4: No euro divorce in store
In late August, German Finance Minister Wolfgang Schaeuble warned that Greece once again needs a bigger bailout to shore up its finances. "A year ago, that would have caused problems in the markets," says Priani. But that didn't happen this time around because it's become clear that Europe will do what it takes to maintain the European Union.
"As long as the overall direction is towards maintaining the union, we will see less extreme downturns in the market," says Jim Kee, the president and chief economist for South Texas Money Management.
Sweeting expects progress in the coming months on changes necessary to keep the union together -- such as pension reforms to curtail national debt growth and labor market reforms to boost growth, among others.
Now let's look at some cheap stocks that will benefit as Europe makes progress on reform and its overall economy gets stronger.
A global advertising agency
WPP (WPPGY), a big advertising agency based in London, looks cheap because it trades at a discount to big ad agencies based in the United States, such as Omnicom (OMC) and Interpublic Group (IPG), says Vars, who helps manage the NorthRoad International Fund, which outperformed competing funds by 2.5 percentage points a year over the past three years, according to Morningstar.
WPP goes for about 13 times next year's earnings, while the two U.S. agencies trade at 14 and 14.7 times earnings, respectively. Yet WPP is posting good results. Billings were up 5% in the second quarter. Profit margins were strong. And the company has room to boost them more, says Vars. Plus, WPP may benefit because Omnicom is merging with the big Paris-based ad agency Publicis (PGPEF). WPP might pick up clients who decide to leave the new giant. For example, after the merger the new company will serve both PepsiCo (PEP) and Coca-Cola (KO). That might be too close for comfort, so one may choose to bolt, says Vars.
The French drug and vaccine company Sanofi (SNY) also looks cheap compared with similar U.S. companies, says Kee of South Texas Money Management. Sanofi has a P/E to growth ratio (PEG) of 2.3, compared with 4.7 for Merck (MRK) and 3.92 for Pfizer (PFE). The PEG ratio, popularized by investing great Peter Lynch, adjusts stock valuations for underlying growth rates to better compare valuations.
Sanofi seems to have a "domicile discount." It is based in Europe, but it does one-third of its business in the faster-growing emerging markets. That makes it a play on emerging middle-class consumers, a trend that will continue even as emerging market growth has slowed, says Kee. "That is still the story of our lifetimes," he says, and Sanofi is a good way to play it.
Novartis (NVS), based in Switzerland, is a pharmaceutical giant with a twist, in that it sells a lot of consumer health care products, such as contact lenses and fluids. This makes it a consumer staples company of sorts, says Vars. Yet it's a lot cheaper than most consumer staples companies. Novartis has a forward P/E of about 13.6, compared with P/E's in the 16 to 18 range for companies like Procter & Gamble (PG) and Colgate-Palmolive (CL). That discount makes Novartis attractive, says Vars.
U.S. bank stocks have had a great run over the past year, and now they don't look so cheap. But European banks still do look cheap. But they may be due for a similar bounce, as confidence in Europe returns and European interest rates rise, believes John Lekas of Leader Capital. Banks typically do better when rates go up, because they can make more on loans.
BNP Paribas will benefit, and it's worth considering as a buy because it is so well-run and well-capitalized, says Scott Carmack, a portfolio manager at Leader Capital. It also looks cheap, trading at around .71 of book value. U.S. banks, such as JPMorgan Chase (JPM) and PNC Financial Services Group (PNC), have already risen to trade at book value again. "We think that over the next couple of years, BNP Paribas will trade at book value," says Carmack. Meanwhile, BNP Paribas pays a 3.1% dividend yield.
Another cheap European bank that looks very attractive is Italy's Intesa Sanpaolo (ISNPY), says Chad Deakins, the portfolio manager of the RidgeWorth International Equity Fund (STITX), which outperformed competing funds by more than a percentage point over the past three to five years. Intesa Sanpaolo trades at .55 times book value on concerns about political and economic risk in Italy. "But it is in the healthy and industrialized northern part of Italy," says Deakins. As Italy eventually comes out of recession, that will improve the bank's earnings and reduce its discount, says Deakins. The bank pays a dividend yield of over 3%.
Basic materials: Energy and chemicals
Energy is one of the cheapest sectors, and Paris-based Total (TOT) is one of the cheapest of the cheap, trading for a forward P/E of just 8. Investors have been troubled by Total's lack of production growth and high costs, but it has been taking steps to fix both, says Vars of NorthRoad Capital Management. Total is starting to deliver production growth which should continue for several years, says Vars. He also thinks cost cutting will boost free cash flow, which should attract investors to the stock. Total pays a 4.8% yield.
Vars also likes Amsterdam-based Akzo Nobel (AKZOY), the largest paints and coatings company in the world and a big specialty chemicals producer. Akzo Nobel trades for just 12.3 times earnings, partly on concerns about Europe, even though it does business in 80 countries and it gets about 40% of revenue from emerging markets. That discount makes it a lot cheaper than similar U.S. companies such as Sherwin-Williams (SHW), which has a P/E of 18.7. Vars expects Akzo Nobel shares to rebound on improved profit margins and growth.
Like European banks, insurance companies on the continent look attractively cheap, says Carmack at Leader Capital. He thinks they will rebound as confidence returns regarding Europe and as interest rates go up, which will allow them to invest premiums at higher rates.
Carmack counts Amsterdam-based ING Groep (ING) among his favorite European insurance companies. Though it's based in Holland, it gets about 38% of its revenue from North America. The stock recently traded at $10.90 a share, almost double its April share price. But Carmack thinks it's still attractive, in part because it should repay a loan to the Dutch government next year. That will allow ING to restore its dividend.
Kee, at South Texas Money Management, agrees that ING is "extremely cheap" at .63 times book value, because it is not getting credit for restructuring that's improving margins and financial strength. "The market has not priced this in yet. It is just a great opportunity," says Kee.
Two other insurers that look attractive are Aegon (AEG), based in Holland, and AXA (AXAHY) based in France, says Deakins of the RidgeWorth International Equity Fund. Both have recently rallied, but they still trade well below book value. These stocks should trade up closer to book value as business continues to improve and investors get more confident on Europe, says Deakins.
Meanwhile, both insurers offer investors a bit of insurance, so to speak, by paying them to wait for their shares to rebound. Aegon offers a dividend yield of 3.5%, and AXA pays a yield of 4.2%.
At the time of publication, Michael Brush owned shares of Coca-Cola and he has suggested Coca-Cola in Brush Up on Stocks, his investment newsletter. Click here to find Brush's most recent articles and blog posts.
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