Get the right balance in Europe

"Europe was very cheap a couple of years ago when companies got sold down but now the easy money has been made," says Darius McDermott, managing director at Chelsea Financial Services. "But it is still cheaper than the US and the UK, and its run is not over yet. Europe is also home to quality companies."

"We still like European equities and, although they have had a great run, we still like the structural under valuation we see in some countries such as Italy," adds Tim Gregory, head of global equities at PSigma. "There is an opportunity for Italian and Spanish companies to significantly improve their return on equity over the medium to long term - investors haven't missed that."

William Hobbs, head of equity strategy at Barclays Wealth and Investment Management, says that while equity markets have gone a long way towards factoring in recovery, return on equity is still a way below trend, especially compared with the US. "As European Central Bank action becomes more meaningful we will see a brisker pace of recovery in the periphery [Italy, Spain, Greece and Portugal]," he says.

Sam Cosh, manager of IC Top 100 Fund European Assets Trust (EAT), points out that profits have not recovered from the crisis and European earnings are significantly below their peak. He also says corporate fundamentals are good and have strengthened through the downturn, reflected in improving payouts to shareholders via dividends and share buy-backs. "Companies that have navigated their way through the crisis well have learned to conserve and generate cash," he says.

Read the full interview

Opportunities

Europe is also under-owned among UK investors because they tend to look at the politics ahead of the investment situation. "It is very important to separate that out because there are some world-leading companies domiciled there and it is a really good hunting ground for investors," argues Adrian Lowcock, an independent financial adviser.

Investors have been excited about cyclical shares, particularly those in the periphery - Italy, Spain, Greece and Portugal. "Our portfolios are currently overweight the European periphery, where we particularly favour the equity markets in Spain and Italy," says Tom Becket, chief investment officer, Psigma Investment Management. "We admire the cheap valuations and long-term profit recovery potential that the periphery promises, and today's moves by the European Central Bank should help to support those markets.

"There is the potential for European corporate profits to follow the same trajectory that their US peers took over the last three years. While general European valuations now look up with events, there is certainly the possibility that improving earnings, as the economy recovers, could make valuations actually much more palatable. We currently favour those sectors, companies and regions where valuations are attractive and the recovery potential seems highest. That leads us to the financial sector, industrial companies and consumer discretionary businesses."

But analysts such as Marcus Morris-Eyton, portfolio management associate at Allianz, argue that with value having outperformed quality shares since 2012 higher-quality European companies are trading at 20-year lows relative to the market. "Investors now find themselves in the unusual situation of not having to pay a valuation premium for high-quality stocks," he says. "We are arguably therefore at a once-in-a-cycle opportunity to buy high-quality - shares with a high return on invested capital, high gross profit margin and low share price volatility."

He adds that the outperformance of much of the lower-quality end of the market has shown little correlation with either genuine earnings or earnings per share (EPS) revisions. "From an earnings perspective, it was once again the higher-quality end of the market that appeared most stable, despite significantly underperforming," he says. "As Europe enters the next stage of the cycle we consequently expect real earnings growth to be the key driver of returns. Particularly among those that can deliver sustainable earnings growth and those priced for a stronger profit recovery than reality suggests is occurring."

Risks

Growth in Europe is still slow compared with the US and UK, although gross domestic product is not particularly related to markets. "Banks face more stress tests, and if this does not go so well there could be short-term market volatility," adds Mr McDermott.

Deflation is still a threat but Europe may implement some form of quantitative easing which would be good for markets, according to Mr Lowcock.

Problems in the periphery countries could return, though, which would have a downward effect on European markets. Public and private sector debt remains high and in some cases it is still rising. At the same time, access to credit is still difficult for much of the private sector, and likely to remain so, according to Mr Hobbs.

Luca Paolini, chief strategist at Pictet Asset Management, is "cautious on European equities that are very expensive, while economic growth is slowing and corporate earnings remain sluggish".

Trim or add?

"If you have around 15 per cent or more exposure to Europe it could be an opportunity to trim," says Mr McDermott. "But if you do not already have any exposure to Europe, you could reallocate because it is cheaper than some other developed markets."

He says, as a rough guide, cautious equity investors could allocate up to about 7.5 per cent, balanced risk appetite investors could have up to 10 per cent, and higher-risk investors could have up to 15 per cent.

Mr Gregory suggests that if you are investing from scratch it might be better to take a cautious approach and drip-feed in because markets have had a good run and there could be a pause. He doesn't think investors with existing holdings should trim unless they are significantly overweight.

Best funds for exposure to Europe

Depending on which view you agree with, you need to choose a fund to reflect that. However, calling an outcome is uncertain, so advisers such as Mr McDermott suggest that rather than trying to guess which focus to buy, you should hold both funds which are more invested in quality shares, and ones that are more cyclical.

"Identify good managers and what their styles are, have patience and hold them for the long term," he says. "Investors with larger portfolios might want two managers and we are generally style agnostic because both styles can work over time."

Mr Hobbs says you should get exposure to a mix of both core and peripheral equities because periphery earnings have further to go but are more volatile, so holdings in core areas such as Germany and France could smooth this. He says you could hold funds that provide exposure to quality companies listed in core European countries, and alongside these some exchange traded funds (ETFs) providing exposure to the periphery.

For exposure to Italy he recommends iShares FTSE MIB UCITS ETF (IMIB), which uses physical replication and has an ongoing charge of 0.35 per cent. This provides considerable exposure to banks.

Funds providing exposure to the periphery include Neptune European Opportunities (GB0032308594). Ben Gutteridge, head of fund research at broker Brewin Dolphin, likes its substantial allocation to banks which are dependent on a domestic recovery in countries such as Italy. The fund is in the first quartile of its sector in terms of performance over one year, boosted by its allocation, but is third quartile over three years and fourth quartile over five.

Read more on this

Mr Gregory recommends River & Mercantile World Recovery (GB00B9428D30), which has a high weighting to Europe in particular the periphery. The fund has done well since launch in 2013 and manager Hugh Sergeant has a strong record with his longer running River & Mercantile UK Equity Long Term Recovery Fund (GB00B1YHLP55).

Read our tip on this

Mr Gutteridge also suggests Baring German Growth (GB0000822576). "Germany has been very strong and there has been better domestic data out of here," he says.

Read our interview with the manager

Another option is db x-trackers Mittelstand & MidCap Germany UCITS ETF (XDGM). This has recently listed in London and provides exposure to small- and medium-sized enterprises that are typically known for their concentration on niche market segments, for having a long-term business development outlook with close ties between the founder, or founding family, the management and the company, and often with international product distribution. It buys the underlying physical shares in the index (rather than replicating it synthetically via derivatives) and has an all-in fee of 0.4 per cent.

Read more on this

Mr Lowcock recommends FP Argonaut European Alpha (GB00B4ZRCD05), which is focused on "European domestic cyclicals which have aggressively restructured during the downturn and now offer the most compelling opportunities give the scope for profit recovery", according manager Barry Norris.

Mr Lowcock adds that the fund's focus on earnings rather than a particular style such as value or growth is a good approach.

For more of a focus on core Europe, IC Top 100 Fund Jupiter European Opportunities Trust (JEO) invests in companies where the ownership and management structures are conducive to generating superior long-term earnings growth. Manager Alexander Darwall favours companies with attributes including:

• a strong management record and team;

• a sustainable competitive advantage; and

• structural changes that are likely to benefit prospects.

This investment trust is the leader among its peers over three and five years and well ahead of its benchmark, but lags over one year because of its focus on less cyclical quality shares. It trades at a premium to NAV of 1.43 per cent, although this is tighter than its 12-month average and smaller than earlier this year and parts of last year.

Read our interview with Mr Darwall

Mr Lowcock says FP Argonaut European Alpha and Mr Darwall's approach complement each other as one is focused on earnings and the other on traditional growth.

Threadneedle European Select (GB0001529345) run by Dave Dudding (a former IC journalist) focuses on high-quality, growth-seeking companies with buying power and high barriers to entry. Like other funds focused on quality, it has not done so well against its IMA Europe ex UK sector peers over one year, but is among the top performers in the sector over three and five years.

"There will be periods of time when a fund manager's style is out of favour and it is hard to time correctly," says Mr McDermott. "It is better to pick a good manager and stick with him through the cycle. Over time, for example, David Dudding will deliver."

Read our interview with David Dudding

PERFORMANCE OF RECOMMENDED INVESTMENT TRUSTS

Source: Morningstar as at 4 July 2014

PERFORMANCE OF RECOMMENDED FUNDS

Source: Morningstar as at 4 July 2014