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Sunday, 08/25/2013 12:24:12 PM

Sunday, August 25, 2013 12:24:12 PM

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Stock Investors Embark on a European Tour (8/23/13)

Experts Say There Are Stock Bargains to Be Found as EU Economies Rebound

By LIAM PLEVEN and SARAH KROUSE

Things are starting to come together for the continent that almost fell apart.

The economy in the 17-member euro zone is growing again—slowly—after contracting for more than a year. Signs of revival are showing up in data on business activity and consumer confidence. As in the U.S., central bankers' extraordinary commitment to injecting cheap money into their economies has so far helped avert disaster. The euro zone hasn't splintered, as some feared, and no country has dropped the common currency.

As worries ease, markets are up from Ireland to Italy. Benchmark national indexes in the U.K., France and Germany have climbed at least 10% this year. The pan-European Stoxx Europe 600—akin to the S&P 500 in the U.S.—is up 19% in the 13 months since Mario Draghi said the European Central Bank, which he heads, was "willing to do whatever it takes to preserve the euro."

Investors planning their own grand investing tour of Europe's stocks should know there still are discounts available. But as many a shopper in the markets of London, Paris or Rome will agree, it can pay to be choosy. For instance, many fund managers see more near-term upside in consumer goods and banks than in European utilities or energy firms.

There are several options for investors. Low-cost index funds, such as the Vanguard FTSE Europe exchange-traded fund—which charges 0.12% in fees, or $12 for every $10,000 invested—offer broad exposure that includes many of the region's global heavyweights. There also are actively managed, Europe-focused funds run by stock pickers who try to beat benchmark indexes, and global funds that feature a hefty dose of European exposure.

In addition, many European companies issue American depositary receipts that trade like shares on U.S. exchanges. Some firms only trade on home-country exchanges, which U.S. investors can access through brokers or international accounts, though this typically involves taking on currency risk and navigating complicated tax rules.

Global fund managers now have more of their portfolios in euro-zone equities than at any point since January 2008, according to a monthly survey Bank of America Merrill Lynch conducted in early August. U.S. investors had poured $3.7 billion into Europe-focused equity funds this month through Wednesday, according to data-provider EPFR Global—more than in any full month this year.

Nevertheless, European stocks have generally lagged behind their U.S. counterparts this year. Some investors think Europe's shares could climb higher.

"Europe is in a recovery cycle. It's in a bull-market cycle. And it's earlier in the cycle than the U.S. is," says Michael Shaoul, chairman of Marketfield Asset Management, in New York. He says the firm, which manages $13 billion, has more funds allocated to Europe than any other region outside the U.S.

Companies that focus on domestic European markets may also be in a better position to benefit from any uptick in demand from long-suffering consumers.

"There are much more opportunities in a Spanish media stock, or Europe-focused banks that will benefit from a European recovery, than a global company that has done well through the crisis and has been supported by emerging-market sales," says Dean Tenerelli, a London-based European equity manager at T. Rowe Price Group who manages €1.2 billion ($1.6 billion) in assets.

But the recent rebound also highlights two major risks.

First, many individual stocks have already risen sharply, particularly Europe-based multinationals that get much of their revenue abroad. German insurer Allianz is up 30% over the past year, as is Dutch electronics giant Koninklijke Philips Electronics.

"The easy money has been made," says Philippe Brugère-Trélat, portfolio manager of the Mutual European Fund at Franklin Templeton Investments. The fund has about $2 billion in assets and charges 1.43%. It has gained 23% over the past year through Thursday, according to Morningstar.

The second risk is that Europe's deep problems haven't been solved.

Persistent unemployment, particularly among the young, hampers the outlook for consumer spending and growth. Coming elections in Germany and elsewhere are reminders of the potential for upheaval, and weakness in Europe's export markets could also hit Europe-based stocks.

"There are still plenty of pitfalls," says Tim Stevenson, a manager of the €2.2 billion Henderson Horizon Pan European Equity Fund at Henderson Global Investors in London. The fund isn't open to investors in the U.S.

Stock buyers also need to be alert to how central-bank actions could affect currency movements—and returns. If the U.S. Federal Reserve tightens monetary policy sooner than the European Central Bank, the dollar could strengthen against the euro, reducing returns for U.S. investors—though the shift could also boost the prospects of European companies, particularly exporters.

Despite the caveats, further signs that the old world's economy has new life, such as a rise in corporate earnings, could send European stocks higher, fund managers say.

Here is what investors need to know about industries that could benefit, and the developments that could propel stocks in those areas higher:

Catering to consumers. Any investor betting on a European revival should understand how bad things seem to the average consumer there. Here is a simple way to look at it: 55% of respondents in the biannual Eurobarometer survey released last month believe "the worst is still to come" for the job market.

That counted as good news. In the fall of 2012, 62% of respondents felt that way.

Ordinary Europeans have been so battered during years of crisis that the threshold for improvement is low. That means companies catering to those beleaguered consumers could be among the first to feel the impact if the fledgling economic recovery takes hold.

Among the candidates are firms such as consumer-goods giant Unilever and cosmetics firm L'Oréal, fund managers say. Both are sprawling multinationals, but they also rely on Europe for a significant portion of their sales.

Companies that sell products to relatively well-heeled consumers also could profit from an improving economy, if their customers feel freer to spend. Risteard Hogan, who manages the Fidelity Europe Fund, likes Christian Dior, whose shares are trading at a lower multiple of earnings over the past 12 months than the Stoxx Europe 600, based on FactSet data. Dior's shares are up 17% over the past year.

Mr. Hogan also likes Marr, an Italian food distributor, which he says is "benefiting from consolidation in the domestic market." Marr's shares are up 25% over the past year. The Fidelity mutual fund has $756 million in assets and charges 0.80% in fees, according to Morningstar.

Firms such as Spain's Industria de Diseño Textil, or Inditex, which owns fashion stores such as Zara and Massimo Dutti, illustrate the opportunity and the risk for investors considering buying shares now. The company's shares are up 19% over the past year, in Spanish trading, and are trading at a higher multiple of earnings than the Europe index, according to FactSet.

"Inditex has impressively been able to retain sales growth despite being a Spanish company," says Franz Weis, a fund manager for the €1.2 billion Comgest Growth Europe fund, which isn't distributed in the U.S. He says the company has been able to do this by opening stores in new markets internationally.

Yet Mr. Weis says he reduced his stake in recent months because the stock had become more expensive.

"Sales have been strong, but if there was a recovery, there would be further growth," he says.

Socking money away. The global financial crisis pounded European banks in 2008. They got pummeled again when debt woes seemed poised to torpedo the euro more recently.

That helps explain why some investors think there is still opportunity for European bank stocks to climb higher, even though the Stoxx Europe 600 Banks, an index that tracks the performance of 47 large banks, has already risen 29% over the past year.

But given the persistent and often unpredictable risks banks face—and the fact not all of them maximized the opportunity to boost their capital in recent years—this is one sector where it is particularly important to be picky. Regulatory pressure to shore up balance sheets and sell assets also poses challenges for the region's banks.

Mr. Tenerelli of T. Rowe Price highlighted Société Générale as one strong bank stock. The French bank said earlier this month that second-quarter net profit more than doubled from a year prior. "I think financials are still a great opportunity, and I think they are going to be multiyear recovery stocks," he says.

The bank's shares have risen 68% in the past year but are trading at a lower multiple of earnings than the Stoxx Europe 600, according to FactSet.

Ann Steele, a London-based fund manager at Threadneedle Investments, a unit of Ameriprise Financial, says she has increased holdings of Swiss bank UBS over the past year, and it now represents 3% of the portfolio in the Threadneedle Pan European Fund she manages. The fund isn't available to U.S. investors.

UBS restructured its investment bank last year and is increasingly focused on wealth and asset management, which she thinks improves the bank's outlook. Shares in UBS are up 74% over the past year.

"I think there's much more room" for the stock to rise, she says. Ms. Steele says that, even though UBS trades "like an expensive bank" today, she thinks its focus on wealth management gives it further potential for gains.

Nicholette MacDonald-Brown, a London-based fund manager who runs the Schroder ISF European Total Return fund, favors DNB, a Norwegian financial-services group. Shares are up 46% in the past year in Oslo trading. By some measures, shares are trading at a lower valuation than the Europe index.

For investors seeking broad exposure, the iShares MSCI Europe Financials ETF holds shares of many of the region's largest financial firms, including banks and insurers. The fund has $183 million in assets and charges 0.48% in fees. Shares are up 39% over the past year.

Hitting the road. High unemployment, austerity measures and recession also have kept many Europeans closer to home.

Fund managers who are bullish on the sector are betting livelier consumers may get out and about more often, generating business for airlines, toll-road operators and the like.

Toll-road operators in Spain, Italy and Portugal all reported drops in traffic volumes in the first half of the year, a trend highlighted in a recent note from Moody's Investors Service. The ratings firm highlighted first-half traffic figures from Atlantia ATL.MI 0.00%in Italy, Brisa Concessão Rodoviária in Portugal and Società Iniziative Autostradali e Servizi as challenges for the firms.

Some fund managers say this presents a buying opportunity for those companies, because traffic is down disproportionately to declines in gross-domestic-product growth in those markets.

Atlantia is one of the biggest holdings in the Europe fund that Ms. MacDonald-Brown runs. Its shares are up 25% over the past year. The firm is "very exposed to any form of recovery," she says.

Discount airlines such as Ryanair Holdings and easyJet remain popular choices in the airline sector. Ms. Steele of Threadneedle says International Consolidated Airlines Group has upside following the restructuring of Iberia, one of its airline brands, and signs of a mild recovery in Spain.

"Iberia has the potential to contribute more than it has to date," she says. Shares have more than doubled over the past year, in London trading.

Mr. Brugère-Trélat's Franklin fund has French hotel firm Accor as one of its top holdings. As the company increasingly licenses its hotel brands, such as Sofitel and Ibis, and lowers the proportion of properties it runs, it will see a "significant increase in the return on capital employed," he says.

Keeping aging Europeans healthy. While many fund managers focus on which sectors will benefit if the economy keeps improving, others are finding opportunities in the continent's aging population and its rising health-care needs.

Simon Edelsten, fund manager of the £36 million ($56 million) Artemis Global Select Fund, said European health-care stocks look like a better value than other sectors there. The fund invests globally, but about 20% of its assets are invested in European stocks. The fund isn't distributed to U.S. investors.

"It's the more cyclical areas that we've been cautious about," Mr. Edelsten said.

Thorsten Winkelmann, manager of the €4.4 billion Allianz Europe Equity Growth fund at Allianz Global Investors, favors Novo Nordisk . The Nordic pharmaceuticals company recently raised its earnings estimates and said it is expecting sales growth of 11% to 13% for the year. One of its strengths is in products for people with diabetes.

Novo Nordisk's shares have risen 4% over the past year, in Danish trading. The Allianz fund isn't available to U.S. investors.

U.K. health-care company GlaxoSmithKline, Germany's Bayer, French drug company Sanofi and Swiss pharmaceutical company Novartis were other top picks for European equity-fund managers.

The stocks are often among the top holdings of ETFs offering sector-specific exposure globally. For example, BlackRock's iShares and State Street Global Advisors' SPDR ETF unit both offer funds for U.S. investors that give investors exposure to the health-care sector world-wide.

Write to Liam Pleven at liam.pleven@wsj.com

A version of this article appeared August 24, 2013, on page B7 in the U.S. edition of The Wall Street Journal, with the headline: Stock Investors Embark on a European Tour.

http://online.wsj.com/article/SB10001424127887323980604579028843275327248.html?KEYWORDS=investors+embark

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