Best funds for a European recovery

You'd be forgiven for feeling nervy about the future of the eurozone but what does that mean for your investment outlook in the region?

The investment picture

2015 has been a bullish period for European equities. The market has rallied in 2015 on the back of an injection of central bank liquidity and low oil prices, sending equities on an upwards trajectory. In April European stocks soared to a 15-year high, with the FTSE Eurofirst 300 surpassing its 2007 high and heading towards its record dot-com era peak.

Companies across Europe are on the brink of revealing just how much they have benefited from a weaker euro and cheap oil with earnings season just beginning, but earnings revisions have already turned positive for the first time since 2010.

Mark Nichols, fund manager of F&C European Growth & Income (LU0515381027), says: "We are already seeing improvements in the manufacturing and services sector. We are expecting earnings in the whole market to rise and for the trend to last throughout the remainder of the year."

The growth data coming out of individual countries has also surprised on the upside, with only four countries in the eurozone slipping backwards. The region's recovery at 0.3 per cent beat both the UK and US for the first three months of the year.

However, such a big rise in equities could mean a correction on the horizon. Jason Hollands, managing director at Bestinvest, says: "Arguably, the rebound has been a bit excessive and there are a lot of reasons to question how sustained the recovery is". Paul Taylor, managing director at McCarthy Taylor, says: "We remain concerned despite great economic data. Economic growth in France is higher than the UK, but that is based on consumer spending, not investment, and the country still needs to address borrowing.

"Then there's the question of whether Greece will exit the euro and what disturbance that could cause. Markets don't like uncertainty and confidence in Europe is still shaky."

Should you target value or growth?

One key choice is whether to target value-orientated or growth-orientated European equity funds. While value funds target stocks they feel are undervalued, growth orientated managers look solely for stock price appreciation and focus on businesses with strong cash flow and competitive advantage.

During economic downturns value plays are a good idea, as there will likely be opportunities to invest in cheap stocks which fare better than their peers. With the European market rising and valuations looking more expensive, is a growth strategy a better idea?

Adrian Lowcock, head of investing at AXA Wealth, says: "I think it's probably still a value play".

"Europe is still cheap relative to other markets such as the UK and the US and it is benefiting from an improved economic backdrop. Corporate activity is improving and you've got aggressive ECB action driving that too, so, while it isn't extremely cheap, Europe still has the potential for further good news and valuations aren't pricing that in."

Anthony Rayner, co-manager of Miton's multi asset fund range, says: "We rescreened our basket of mid-cap eurozone equities [this year] and found that with the market and earnings rising aggressively in recent months, valuations have increased, but only marginally. They are still at sensible levels."

Sam Cosh, manager of the F&C European Small Cap Ex UK Fund (GB00BVVB7L88) and European Assets Trust (EAT), agrees that stocks are still relatively cheap. He says: "Although indices have reached new heights recently, European equities are still traded at a discount to their US peers and still have attractive valuations.

"The persistent challenges will certainly fuel volatility. However, we think that volatility also provides buying opportunities and therefore increases the yield return potential for long-term investors."

But Mr Hollands feels the play now should be on growth and you should seek equities with good fundamentals and strong cash flows instead of those which look undervalued. He says: "This time last year European equities looked cheap but I don't think you can say that now. Most markets are trading ahead of their 10-year averages. European equities are not as expensive as the UK but they are definitely out of bargain-basement territory. This is a growth story."

Taking a core and satellite approach

Depending on your risk appetite and the size of your portfolio, you could construct a portfolio with both core and satellite holdings. This kind of portfolio could incorporate more than one investment style and give you exposure to stocks that will react differently under different conditions.

Your core funds could be growth- or value-focused but should be spread across the region. Good satellite funds will hold stocks further down the market cap spectrum. They could be more volatile but might rise more in a recovery.

"In a scenario of a strong recovery in eurozone growth you're more likely to capture it further down the market cap spectrum," says Mr Hollands. "With some larger core funds the holdings are principally global businesses."

Core funds for Europe

Mr Hollands suggests Henderson European Focus I Acc (GB00B54J0L85) and Threadneedle European Select (GB00B8BC5H23). He says: "Henderson has a slightly greater value style bias while Threadneedle is a little more pragmatic and tends to go for global businesses with strong franchises which are less exposed to the eurozone."

Both funds are overweight the healthcare sector, with pharma giants Novartis (Swi: NOVN) and Novo Nordisk (De: NOVOB) making up large positions in both portfolios. However, the fund is more tilted towards value and invests in mid-cap positions where it sees attractive opportunities while Threadneedle focuses on growth by looking at company pricing power and competitive advantage.

Since it launched in 2012 Henderson has outperformed Threadneedle but it has recently struggled to identify value positions. In April the fund's net asset value fell by 1.6 per cent and its share price return dropped by 4.28 per cent.

A growth option suggested by Mr Taylor is Jupiter European fund I acc (GB00B5STJW84). The fund is skewed towards global-facing businesses with strong balance sheets, which have proven resilient over the long term, often with exposure to some of the faster-growing regions of the world. He says: "It is a collection of dynamic long-term growth companies which happen to be based in Europe but are exposed to global trade. It is our key choice but you will get volatility." On a 10-year period its performance is impressive. However, it is a pricier option, with an ongoing charge of 1.03 per cent.

But he also suggests a value-focused option, in Jupiter European Special Situations I Acc (GB00B60WTT90), also chosen by Tom Stevenson, investment director at Fidelity Personal Investing as one of his five funds for Europe's 'quantitative easing (QE) rally'. Mr Taylor says: "It is a bit more of a risk play. It looks for undervalued companies and is a very long-term strategy."

Manager Cédric de Fonclare looks for companies benefiting from mega-trends such as ageing populations and energy efficiency. Mr Stevenson says: "He has a focus on profitability and quality, which he believes leads to higher returns and lower volatility. Above all he looks for good valuations, where the market is too cautious about prospects." However, the fund has underperformed Henderson European Focus in the short term and suffered in 2014.

Another of Mr Stevenson's five chosen funds for a QE rally and a value-focused option is BlackRock's Continental European Fund D Acc (GB00B4VY9893), also suggested by Mr Lowcock. Mr Lowcock says: "It's a long-term value fund. Arguably, it will find fewer opportunities as the economy recovers, but it will identify areas where the market has misread the potential for an earnings recovery and will benefit from earnings surprises."

Mr Hollands says hedging out the currency risk of a weak euro is also key to his decision making. Hedged share classes are hard to come by for European funds and Artemis European Opportunities I hedged Acc (GB00B6WFCS60) is one of the rare options. Artemis's performance has far exceeded its rivals on a one- and three-year basis as well as over the shorter term, proving it could pay to currency hedge.

Core income funds

Mr Lowcock's favoured European fund is Schroder European Alpha Income Z Acc (GB00B7FHV230), which looks to boost returns by investing in value stocks and tracking the market cycle. Manager James Sym picks up stocks in a cyclical manner to be able to adapt to market changes. The fund has a dividend yield of 2.8 per cent and has delivered strong performance in the past three years.

Mr Hollands says: "There are some income products around and that might be a consideration if we get decent earnings growth because then we could start to see rising dividends and you might want to consider raising exposure to European dividends. A fund we like is Standard Life European Equity Income I Inc (GB00B3L7S958). The fund invests mainly in high-yielding equities and equity-type investments of European companies or companies that carry out a substantial part of their operations in Europe. It has a historic yield of 4.15 per cent.

Satellite holding ideas

Mr Hollands suggests F&C European Small Cap ex UK Acc (GB00BVVB7L88) and Mr Taylor suggests Baring German Growth Fund (GB00B9M3QX41) as periphery holdings. Germany has been one of the strongest players in recent years within the eurozone and it has benefited from the weak euro. Mr Taylor says: "For a while we were trying to focus more on Germany when Europe looked a complete basket-case and we had confidence in Germany. Now we feel there's more of a broad based case for Europe."

F&C's small-cap European fund might also be a good way to access a segment of the market focused on more domestic trade. It was only launched in March 2015 but is managed by well-reputed manager Sam Cosh, who also runs highly regarded IC Top 100 fund European Assets Trust (EAT). He says: "As a general rule small companies benefit the most in the first phase of a recovery."

Recommended Europe funds - style and charges

Source: FE Trustnet, as at 15 May 2015