European markets
have been performing well, posting low double-digit returns year-to-date. Europe has leapfrogged the U.S. in terms of gains, and the so-called “valuation discount” separating them has narrowed considerably. Yet managers remain bullish and maintain opportunities still abound.

“Until markets bottomed in late 2002, Europe was at a significant discount to the U.S.,” says Dana Love, manager of Trimark Europlus Fund and vice president of Toronto-based AIM Funds Management Inc. “A lot of the rebound has been driven by the valuation factor, which was slanted in Europe’s favour. Not too many people were enthusiastic about investing in the region.”

Earlier this decade, he says, the region was adversely affected by the rising euro, concerns about Germany’s endless economic malaise and France’s high unemployment levels: “Many Western European economies got flak for high deficits and breaching European Union criteria for satisfactory debt/GDP levels.”

Yet, Love maintains, the markets provided opportunities for those prepared to look beyond the uncertainties. “If you sorted through the noise and looked at individual companies, you could see they were priced very attractively,” he says. “Some are global businesses; some are local. But there were ample opportunities.”

European markets also tend to overreact to negative news. “Because of price and negative sentiment — Europe being an unloved asset class — you find the best opportunities when people are least interested,” he says.

Today, he notes, European stocks are still cheaper than those in the U.S.: 14.8 times earnings and nine times cash flow for Europe, vs 17.4 times earnings and 11 times cash flow in the U.S. The gap is not large when measured on a price/book basis (2.4 for European stocks, vs 2.8 times for U.S. stocks), but European companies are more profitable and report an average 17% return on equity, vs 16% in the U.S.

A bottom-up stock-picker, Love runs a concentrated fund of about 30 names. This past summer, he took advantage of the sell-off and added new names, including Nestle SA, the world’s largest food and beverage company. The Swiss firm is enjoying good growth in several categories. It is also a dominant player in the bottled water industry, with leading brands San Pellegrino and Perrier. “That has to do with the investment that has been made,” Love says. The company has also been developing its chocolate products, including its Kit Kat and Smarties brands, which are growing faster than the overall industry.

Bought at about 400 Swiss francs a share, it recently traded at 438 SFs. Love is reluctant to offer a share price target, but he takes a long-term view. “It is significantly undervalued on a three- to five-year time horizon,” he says.

Another new holding is Banco Bilbao Vizcaya Argenteria (BBVA), one of Spain’s leading banks. “It’s not its acquisition track record that impresses me the most,” says Love. “It’s its capital allocation discipline.” Through its retail banking franchise, BBVA Bancomer, the bank has a 40% market share in Mexico, which Love describes as “massively underpenetrated for financial services.” And the subsidiary contributes 40% of the firm’s profits. “BBVA is one of the most efficient large banks anywhere,” he says. “It has a cost/income ratio of 40%, which would be upward of 50% for most large banks.” Bought at about 15 euros a share, it recently traded at 19 euros. The stock has a dividend yield of almost 5%.



“The fundamentals have been good for some time,” observes Rory Flynn, a portfolio manager at Dublin-based AGF International Advisors Co. Ltd. , who oversees AGF European Equity Class. In local currencies, European markets have outperformed most global markets since early 2003. Going back five years, Europe has outperformed the U.S.: the region’s markets gained 109% on a cumulative basis, vs 37% for the U.S.

Like Love, Flynn notes there is a valuation gap that puts Europe at about a 15% discount to the U.S. On a dividend yield basis, Europe is also more attractive: there is a 50% differential. European stocks yield 2.6% vs 1.7% for the U.S. Admittedly, Flynn adds, part of the problem is that U.S. stocks had a long way to fall from the heady days of 2002, when the average stock boasted a price/earnings ratio of more than 30.

Long criticized for its slow pace of reform, Europe has quietly gone through a period of change and sector consolidation. And that is one of the themes that Flynn and co-manager John Arnold, managing director of AGF International, have pursued.

@page_break@Consequently, they have large holdings in the 50-name fund. Banks include ABN AMRO Holdings NV and Italy’s SanPaolo IMI SpA, both of which have been buying up smaller players. “When you go from having plenty of small markets to one big one, companies adjust the size to which they expect to grow. That’s happening in the banking industry,” says Flynn. More than 40% of the fund’s holdings is in financial services players.

A value-oriented investor, Flynn takes a long-term view on riding out difficult patches. One representative holding is Kingfisher PLC, which operates B&Q, Britain’s largest do-it-yourself hardware and garden centre chain, and Castorama, a DIY operation in France of which Kingfisher recently took control. “You are beginning to see this consolidation take place in Continental Europe. DIY retailing is the going the same way as in Britain and the U.S.”

Flynn bought into Kingfisher five years ago, when it was a diversified retailer that was changing its focus to DIY. But at 258 pence, the share price is little different from his initial purchase price. “The market is concerned about the British consumer for the same reasons as in the U.S.: interest rates are higher and house prices are overextended,” Flynn explains. Yet he is hanging on: “It is having problems. But you look through and in three years it will still be a good business.”

Another favourite is Akzo Nobel NV, a Netherlands-based conglomerate with interests in paints, chemicals and pharmaceuticals. After much deliberation, the company decided to concentrate on the first two businesses. “The stock price has done nicely over the past while,” Flynn says, noting the share price has risen to about 48 euros from 35 euros at the start of the year. “It has a multiple of 12 times earnings and 2.5% dividend yield — a modestly valued company.” The stock was bought over a five-year period, with an average cost of 35 euros.



But issues such as restructuring and reform are immaterial to Rajiv Jain, manager of GGOF European Equity Fund and managing director of New York-based Vontobel Asset Management Inc.

“We want the best, most predictable businesses that are selling at significant discounts to their worth,” says Jain, who tends to hold stocks for three years or longer. “Sustainability is more important. I don’t care what markets are doing — as long as I can find good opportunities.”

Running a 36-name fund, Jain finds most of those opportunities in Britain, which accounts for 36% of the fund’s assets. There is also 16% in Switzerland, 15% in Spain, 7.5% in Ireland and smaller weightings in Belgium, France and Sweden.

From a sector viewpoint, financial services is the largest, at 30%, followed by 25% in consumer staples and smaller holdings in pharmaceuticals and energy.

The largest position is Tesco PLC, a leading British supermarket chain. “It’s one of the best-run retailers around,” says Jain, adding that the firm has a 30% market share in Britain and is growing rapidly in Eastern Europe and Asia, where it has more retail space than in Britain.

The firm has a 17% return on equity and boasts same-store sales growth of 11%-12% a year for the past five years. Jain paid £2.20 a share about four years ago; the stock recently traded at £3.85. He estimates its intrinsic value is £5.10 a share, but says this target is a moving one.

Another favourite is Anglo-Irish Bank Corp. The Dublin-based bank specializes in loans to lawyers, doctors and high net-worth entrepreneurs. Known for its efficiency, the bank has a cost/income ratio of 28%, vs the 40%-45% of most British banks.

“Because of its efficiency, it can take lower margins but still earn almost 30% return on equity,” says Jain.

His initial price four years ago was 3.3 euros a share. The stock recently traded at 13.50 euros. His estimate of its intrinsic value is 18 euros. IE