Probably the last place on earth you want to invest at the moment is continental Europe, with its political paralysis and sovereign debt worries. But overlooking the funds offering exposure to this troubled region could cost you strong returns.
Although Europe ex-UK has been unpopular with investors for more than a decade, investment professionals are pointing to a number of positives. First, the problems largely concern sovereign debt, but with a Europe fund you are buying equities listed on a stock market - not government debt. Equities are not automatically correlated to the state of the country where they are listed, but rather are affected by the fortunes of their industry and where they trade.
The real macro picture
The sovereign debt problems do not affect all of Europe, but mainly the so-called "PIIGS" (Portugal, Italy, Ireland, Greece and Spain). The situation in Northern Europe, above all Germany, is very different. In this country gross domestic product (GDP) growth was stronger than expected last year, while unemployment is at 19-year lows. Both Germany and Sweden have robust consumer environments. Multi-nationals and exporters, with the latter particularly well represented on the German market, are benefiting from the weak euro currency.
Profits and cash flows for companies listed in northern Europe and Switzerland are in general strong, which Rory Bateman, head of European equities at asset manager Schroders, says should enable greater returns to shareholders and boost mergers and acquisitions activity. "We have seen robust earnings growth over the last 12 months, and we believe there is room for double-digit earnings growth in 2011, with figures still sitting below trend," says Mr Bateman. "Corporate cash flows continue to be very strong and company balance sheets are looking particularly robust."
Many European-quoted companies make significant proportions of their earnings outside Europe, including the fast-growing emerging markets. "Europe has great depth and strength in terms of global businesses," says Alister Hibbert, manager of the BlackRock European Dynamic Fund. "Luxury goods, for example, are a growing trend among the new wealthy in emerging markets, who favour Swiss watches and French and Italian products."
The valuation story
European equity valuations, due to concerns about sovereign debt, are historically low making it possible to buy into some world class companies at bargain valuations. "If we take the one-year forward price-to-earnings (PE) multiple, there is some way to go before getting back to the average trend line over the last 20 or so years," adds Mr Bateman.
European equities trade at a substantial discount to developed markets including Japan and the US, so it is not just Europe fund managers who are positive on Europe. James Smith, manager of the Ignis Global Growth Fund, likes UK and European stocks, relative to the US and Asia-ex-Japan. "UK and European equities are trading at bargain valuations and I am significantly overweight those two areas," he says. "Vodafone, GKN, Allianz and BNP Paribas are key holdings."
While investors have been favouring perceived safe havens such as gold, currencies, and US government bonds, as they become aware of the attractiveness of European equities they might return, helping to push share prices and valuations up.
The downside
However, if sovereign debt problems in the PIIGs intensify, then even if listed companies are doing well, negative investor sentiment could cause stock markets both in those countries and other parts of Europe to fall. "Investors should be aware that in the short term they are likely to see increased volatility in markets and further weakness in the euro may well impact on performance," warns Adrian Lowcock, senior investment adviser at independent financial adviser Bestinvest.
He believes that on a risk-return basis the UK and Japan are more attractive, because of the ongoing sovereign debt problems in certain parts of Europe. Julian Chillingworth, chief investment officer at Rathbone Unit Trust Management also argues that the US is more attractive and that there are also good UK opportunities, which do not involve currency risk.
If you invest in Europe funds you should have at least a medium-term investment outlook, and a medium to high risk appetite.
Sovereign debt problems could result in further devaluation of the euro, which is already weak. This would boost continental exporters, but for UK investors, who have to translate profits back to sterling, a weaker euro detracts from returns and is one of the biggest risks in non-hedged funds.
Best managers
One of the attractions of Europe funds, according to broker and adviser Hargreaves Lansdown, is that they are run by "some of the finest fund managers around, and there have been some who have been able to generate good returns for investors despite Europe's ongoing woes".
When choosing a Europe fund, you should look for a quality manager with a good long-term track record, according to Ben Yearsley, investment manager at Hargreaves Lansdown. This is more important than looking at the underlying holdings - for example, avoiding funds that offer exposure to southern Europe, as a successful manager will have a good reason for any exposure they have there. For sake of diversity, Mr Yearsley advises that you have two or three Europe funds.
He suggests that Europe funds could account for 5 to 10 per cent of your portfolio.
Over 2010, the third best-performing fund sector was European Smaller Companies, after North American Smaller Companies and UK Smaller Companies.
The strong performance was partly due to the fact that the equity sectors which did well in 2010 are well represented among small- and mid-cap stocks, according to Alister Hibbert, fund manager of the BlackRock European Dynamic Fund. "Smaller companies remain the better bet because quite a few of these sectors will continue to do well, such as industrials and oil services," says Mr Hibbert. "The sectors with the highest average market capitalisation do not have much many growth prospects."
This is also the view of Ian Ormiston, manager of the Ignis European Smaller Companies Fund. "Small caps are particularly attractive as takeover candidates as they represent less risk in terms of integration and can often be funded out of larger companies' cash flow rather than requiring finance from banks or the bond market. The key attraction of small caps in a world sagging under the weight of government debt is that growth opportunities are relatively abundant in this asset class," he says.
However, a problem with smaller companies is that they are typically more exposed to their domestic economies than large caps. Small caps bounced last year as is usual during a recovery. But with an uncertain environment ahead they might not do so well, and even if these companies to trade well, their share price may not rise further as they have had their run.
But if you are interested, smaller company funds with good performance records include Threadneedle Pan European Smaller Companies, Threadneedle European Smaller Companies and Baillie Gifford European Smaller Companies.
Income story
Don't forget the great income story in Europe. With the partial disappearance of bank dividends and the suspension of BP's dividend, income investors need to consider overseas sources, and there are some attractive options among Europe ex-UK funds.
Among Europe including UK funds, Premier European Optimum Income yields 6.5 per cent and Threadneedle Pan European Equity Dividend more than 4 per cent.
Among investment trusts, you can currently get a yield of nearly 5 per cent on JPM European's income share class, while BNP Paribas Enhanced Income and European Assets respectively offer 7.8 and 5.7 per cent.
