TCS Daily

Buy Europe or Bye Europe?

By James K. Glassman - August 13, 2002 12:00 AM

Should you be investing in European stocks? My answer: an emphatic "maybe."

I have put off this column for months, ever since I returned in February from the first of three trips to Europe this year. Although I thought I had a decent grasp of Europe's economies, businesses and stock markets, I lacked something definitive to say, a catchy headline-grabbing idea, like "Buy Europe!" or "Shun Europe!"

There were two problems: First, Europe has huge potential, but it also faces huge obstacles. Second, Europe's stock markets have closely tracked U.S. markets in recent years. Just as there is little need to own a fund that mimics the Dow Jones industrial average if you own a fund that mimics the Standard & Poor's 500-stock index, it appears there's little need to own Europe if you own America.

These are the simple themes that led me to an inclusive conclusion. But the details are fascinating.

There's a lot to like about European stocks. For example, they have lower valuations (such as price-to-earnings ratios) than U.S. stocks, and they are more liquid (more buyers and sellers) and transparent (financially candid) than they used to be. For Americans, it's never been easier to buy international stocks -- in mutual fund portfolios, as American depositary receipts (ADRs) or as ordinary shares that trade on U.S. exchanges, or even on foreign exchanges through your broker.

But, in general, European companies are less dynamic and entrepreneurial than U.S. companies, and they have a reputation for taking a high-handed approach to their shareholders. Meanwhile, European governments aren't helping. It's not an ideological judgment but a fact that European businesses are burdened by high taxes, stultifying work rules and cultural constraints that deter growth and innovation.

One result is that, while European economies, like the U.S. economy, are growing slowly right now, European unemployment is 8.3 percent while the U.S. rate is 5.9 percent. Worse yet, in Germany, Belgium, Greece and Italy, more than half of unemployed workers have been out of a job for more than a year. In the United States, the comparable figure is just 6 percent. Roughly, Europe's economies are growing one full percentage point a year slower than the U.S. economy.

For investors, however, bad news can be good news. Nothing encourages progress in businesses and economies more than trouble, and trouble is already priced into European stocks. But it may be that the news in Europe is not bad enough for real reform.

"There's a lot of complacency," says German-born Thomas Mengel, who manages Waddell & Reed International Growth Fund, based in Shawnee Mission, Kan. Consider this front-page headline in Thursday's Wall Street Journal: "Short Work Hours Undercut Europe in Economic Drive." In the United States, the average employee works more than 1,800 hours a year; in Italy, 1,600 hours; in Germany, fewer than 1,500 hours. Europeans like their vacations -- and who can blame them? -- but look at what it does to productivity.

Countries such as the Netherlands, Sweden and Ireland -- smaller nations on the fringes of Europe -- "have turned the corner nicely," Mengel says, "but big countries are moving at a slower pace." What is true for economies is true for businesses. "What a U.S. company could do in the 1980s and 1990s in one or two years" -- for instance, renovate itself from top to bottom to serve shareholders and boost the return on their investments -- "might today take 10 years for Europeans," he says.

Such conditions might still be ripe for serious investment. After all, the markets may have overdone their negative view of Europe's chances. Unfortunately, European companies that have tried to break out of the complacency have not fared well lately.

Some, including Finland-based Nokia (U.S. symbol: NOK), were crushed -- perhaps temporarily -- by the telecommunications crash. Others, like Vivendi Universal (V), may simply have expanded too quickly and sloppily. Vivendi started life as an old-line French water company (Compagnie Generale des Eaux), then expanded into telecom, environmental services, and sexier lines such as movies, TV and music. But after trading as high as $59 in the past year, Vivendi's ADRs fell to just over $16 last week. The firm's chief executive, who had an aggressive American style, departed ignominiously -- as though a bold experiment in U.S. capitalism had been tried on the Continent and failed.

Mengel also notes that the corporate scandals in the United States have been a setback for Europe. Establishment business leaders can chide advocates of American modes of finance and management and say: "You see where cowboy capitalism leads? Straight to Enron and disaster." That's a shame and a distortion, but I heard similar phrases many times in Europe.

Still, Mengel, whose mandate is to invest his fund's money wherever he wants outside the United States, has 81 percent of his assets, at last count, in European stocks. France was his No. 1 country, with 18 percent of holdings, followed by Germany, 16 percent; Italy, 15 percent; and Britain, 11 percent. "Europeans are going in the right direction," he says, "but it will take time."

Lately, he has been buying consumer stocks, like Reckitt Benckiser PLC (RKBKF), which makes dishwashing detergents (Electrasol, Calgonit), other cleaning products (Lysol, Easy Off) and food (French's mustard). A typically stateless European company, it was formed by the merger of a British and a German company, each started in the early 19th century. The stock trades mainly on the London and Frankfurt exchanges. With relatively low volatility, it peaked earlier this year at 1,300 pence in Britain and now trades around 1,000 pence. Its profits are growing at better than 10 percent annually, Mengel says.

Stocks of better-known consumer-products companies that Mengel owns include Unilever PLC (UL), headquartered in both the Netherlands and Britain, and Swiss-based Nestle (NSRGY), a company, he says, "that is restructuring but that still has visible earnings" -- that is, real, growing profits. His portfolio also includes Interbrew (IBRWF), the Brussels-based global beer giant (Stella Artois, Beck's, Bass, Rolling Rock) and several retail banks, such as BNP Paribas (BNPQF), and insurance companies, including Muenchener Rueckvers (MURGF) in Germany.

Mengel's fund returned a whopping 62 percent in 1999 but has since slightly trailed the benchmark international index, the Morgan Stanley EAFE. For the past five years, the fund has returned an annual average of about 1.5 percent, or about five points ahead of the EAFE. Mengel told me he is still cautious about the pace of Europe's recovery and would rather play defense with safer stocks than take chances.

Top-ranked among European-only mutual funds by Morningstar is Mutual Shares European, run by David Winters. Holdings include Acciona SA (ACXIF), a Spanish real estate developer, and Lagardere SA (LGDDY), a French media and Internet company whose stock has risen by about one-third since last September. Other international stock funds with the vast majority of their assets in European shares include ING International Small-Cap Growth, Julius Baer International Equity and Artisan International. All are rated five stars -- Morningstar's highest rating.

Ambivalence over Europe's growth prospects seems justified -- even with elections coming up in Germany next month that could produce a more pro-business government, as in France and Italy. But shouldn't all American investors own European stocks simply for diversification? Not really. In the past, European stocks could offer ballast in difficult times because they tended to move in different directions from U.S. stocks. Thanks to this lack of high correlation, a portfolio of both U.S. and European stocks could return nearly as much as an all-U.S. portfolio, but at lower volatility levels. In other words, you got a smoother ride and made nearly as much money.

Now, as Mengel says, "We are living in a very synchronized world." The United States is the "locomotive of the world economy," and it pulls European stocks both uphill and downhill, in tandem with U.S. stocks. You can see that day to day on global stock exchanges. When the markets closed on Thursday, for example, the S&P 500, the American benchmark, was down 21 percent for the year. The Bloomberg European 500 index was down 18 percent (in dollar terms, as are all other European figures here). The CAC 40, France's benchmark, was down 20 percent; the German DAX was down 23 percent. The only minor outrider was Britain's FTSE, down 14 percent.

Mengel believes that this situation -- which has prevailed since the mid-1990s -- is anomalous and will change when America's super-dominant economic position diminishes. I am not so sure. Businesses have become global. What, after all, is Nokia? A company that is based in Finland, makes and sells products all over the world, and is majority-owned by small investors in the United States. Or Unilever? One-third of its shareholders are American and one-fourth of its sales are generated in the United States with such brand names as Dove soap, Hellmann's mayonnaise and Calvin Klein perfume. And what about Coca-Cola (KO), which earns two-thirds of its profits outside the United States?

So here is my unspectacular Euro conclusion: Instead of owning countries, investors should own companies. Find the best of breed, wherever it is headquartered. Yes, national economic policies and local business cultures count, but good management and good products count far more. Think of mutual fund managers like Mengel and Winters as talent scouts, scouting Europe for the best companies in the world -- and there are lots of them.



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