European stock funds are coming back en vogue

Staff Writer
Columbus CEO

NEW YORK (AP) — The world is warming up to Europe again.

Stocks from Germany, France and other countries in the region are rallying, just two years after worries about Europe's debt crisis helped send global markets plunging. Investors are buying into the promise made a year ago that the European Central Bank would do "whatever it takes" to preserve the euro currency. The 17 countries that use the euro also are showing signs that they can break out of their longest-running recession.

"Yes, the worst is over," says Philippe Brugere-Trelat, portfolio manager of the Mutual Global Discovery fund (TEDIX), which has a five-star rating from Morningstar. "And I don't think that markets have priced in this fact."

Brugere-Trelat is among the European stock fund managers who say the region's stocks can climb still further, even though several risks remain. Among the encouraging signs:

— Strengthening business conditions. A closely watched measure of business activity in the eurozone, the Purchasing Managers' index, grew last month for the first time since January 2012.

— Expectations for a stronger economy. Europe's economy has shrunk for six straight quarters, but economists expect the recession to break this year. Deutsche Bank says growth may have resumed as early as the second quarter. The European Commission will release on Wednesday the first official estimate on Europe's second-quarter economic performance.

— The European Central Bank is supporting the recovery. The bank's leader, Mario Draghi, said in July 2012 that he would do whatever it takes to keep the eurozone from breaking up. Inflation has also remained low in Europe. It was at an annual rate of 1.6 percent in July. That gives the ECB leeway to keep interest rates low to stimulate the economy.

— The region still looks attractive relative to other parts of the world. Stocks in the MSCI Europe index trade at 14.5 times their earnings per share over the last 12 months. That's less expensive than the MSCI USA index, which trades at 17.4 times. European stocks also offer higher dividend yields: 3.5 percent versus 2.1 percent for U.S. stocks.

Mutual funds that focus only on European stocks are up 27.5 percent over the last 12 months, including dividends, according to Morningstar. That beats the 23.8 percent return for the Standard & Poor's 500 index over the same period. Germany's stock index is close to a record, and the broad MSCI Europe index is near its highest level since 2008.

The improved performance means investors are no longer fleeing European stock funds as much as they once were. Investors pulled $6 million out of the category in June, according to the most recent data from Morningstar. That's a much milder pace than the average $100 million that investors were pulling out of European stock funds monthly in 2011.

Among the first stocks to recover following the European stock sell-off in the summer of 2011 were those based in the region but that do business all over the world. They were thought to be better bets because they could rely on growth from Asia and other areas to offset European weakness. "Those big global exporters are last year's story," says Brugere-Trelat.

He's focusing instead on companies that do much of their business within Europe, saying that they offer better values. He owns retailers like Kingfisher, a London-based home-improvement chain, and German retailer Metro, for example.

"It's not too late at all to buy European stocks, but don't buy something just because it's European," Brugere-Trelat says. "There are some value traps and pitfalls."

As with other regional stock funds, investors should keep only a small portion of their portfolios in a European stock mutual fund, says Karin Anderson, a senior fund analyst with Morningstar. That's particularly the case if they already own broad global or world stock mutual funds, which often have hefty investments in European stocks.

Investors also still face risks in the region. The unemployment rate remains high at 12.1 percent for the 17 countries that use the euro currency. Earnings for stocks in the S&P Europe 350 index are expected to be flat in 2013 from a year earlier, according to S&P Capital IQ. And even optimists say that they can't rule out another political breakdown or unexpected shock that could renew worries about European governments' still-heavy debt burdens.

But the list of concerns could actually be a reason to consider European stocks, because it shows that expectations haven't climbed too high.

Just as the market underestimates how much earnings can fall into a recession, it often underestimates the recovery, says Andrew Clifton, portfolio specialist for European equities at T. Rowe Price.

"As always, it's about where expectations are," he says, "and we would say they've been too pessimistic."