Cheap entry to European bargains

Although European shares have rallied since the beginning of the summer, William Hobbs, equity strategist at Barclays Wealth, sees further upside for European markets in general, given still undemanding valuations. "Valuations provide room for equity investors to be handsomely rewarded even if analysts turn out to be too optimistic about earnings, with European price/earnings ratios (PEs) still trading around one standard deviation below 10-year averages," he says.

Stephen Cohen, head of EMEA investment strategies at iShares, adds: "For investors who believe that Europe has avoided a crisis, the attraction of European equities is not hard to understand. They are trading at a big discount, both to their history and to other countries."

But it's not just about bargains. The shares of many world-class European companies are trading at bargain levels precisely because most investors are giving anything associated with the eurozone a wide berth. "No one knows exactly how the European crisis will be resolved, but what we do know is that the market is inexpensive, and that spells opportunity for long-term investors," says broker Hargreaves Lansdown. "If you buy assets when they're cheap it gives you an advantage - the bad news is in the price. And whether the eurozone stays together or breaks up there will always be companies on the continent that prosper."

If you buy into these arguments a quick, simple and cheap way to play this is via a tracker such as an exchange traded fund (ETF). And in particular an ETF that tracks MSCI Europe, a pan European index in which the largest constituent is the UK, at more than a third of assets. In addition, non-eurozone countries Switzerland, Sweden and Denmark account for around a fifth of assets, so if things don't go as well as anticipated you are not totally exposed to companies listed in the eurozone. These non-eurozone countries also have healthier finances and their stock markets include good-quality companies excelling in areas such as luxury goods, engineering and oil services.

In any case, companies do not necessarily focus on the country in which they are listed. Some companies listed in Europe are particularly well placed to benefit from developing markets growth, for example. MSCI Europe includes many blue-chip global multinationals such as top holding Nestlé, or Asia focused HSBC. The index captures large and mid-caps across 16 countries and has 447 constituents.

iShares MSCI Europe uses physical replication and gets its returns by buying some or all of the shares in the index rather than via a swap. To date, this ETF has tracked the index very closely, with only 0.01 per cent difference since launch in 2007.

The 3.22 per cent yield is not bad either, although make sure you buy the distributor share class - its ticker is IMEU. This ETF pays dividends quarterly.

On the downside, tracking European markets is a high-risk strategy as many things could still go wrong in the eurozone, affecting companies' share prices - certainly over the near term - even if they are trading well. Also, a passive ETF cannot eliminate problem shares or cherry pick the best companies like an active fund manager, or meaningfully outperform its index (for an active approach see our IC Top 100 Funds. If you already have a lot of UK exposure, this fund might take you above the level you want.

But if you share the view that European equities have potential, have a high risk appetite, can take some volatility and if necessary wait a considerable time, then with a 0.35 per cent total expense ratio (TER) iShares MSCI Europe is a cheap way to access some world-leading companies. Buy.

Source: iShares

Performance

Source: iShares as at 12 October 2012

Top 10 holdings as at 11 October 2012 (%)

Geographic breakdown (%)