European markets have performed well this year, driven by low interest rates and slow but steady economic growth. Although the weak euro currency has dampened returns for Canadians, and there is some uncertainty about political conditions, most fund
managers remain optimistic about markets in the coming 12 months.

“We think equities are an attractive asset class, relative to fixed-income. And on an absolute basis, European stocks are fairly cheap relative to the rest of the world,” says Greg Gigliotti, lead manager of CI European Fund, and managing partner at New York-based Trilogy Advisors LLC. European stocks are trading at about 13 times earnings, compared with 16 times in the U.S., for example. “The U.S. numbers reflect a premium. We think European markets have suffered a stigma — people are worried about slow growth,” he says.

Gigliotti acknowledges that the European Union is still struggling to reach a political consensus in the face of France’s and the Netherlands’ rejection of the constitution last May, and is holding its breath over the recent impasse in the German elections. But, politics aside, he considers the region rich with investment opportunities. “A lot of people were concerned [the political uncertainty] would have a very negative impact on equity markets,” says Gigliotti. “We think it might be a great time to step up. We are seeing the winds of change, reminiscent of other markets, as the political wherewithal is starting to wear down and companies are starting to act on their own.”

Indeed, he argues, companies should thrive largely because interest rates are not seeing the kind of upward pressure experienced in the U.S. “In fact, rates may stay lower and longer in Europe,” he says.

On the corporate side, Gigliotti points to ongoing restructuring by firms such as Siemens AG and Volkswagen AG, which are reducing their workforces and outsourcing to cheaper jurisdictions in order to compete in a global environment. As well, profitability is improving as “companies find ways to drop costs and establish a lower level of infrastructure and working capital tied up in the business than in the past.” For example, Volvo AB, a heavy-duty truck and construction equipment maker, is much more
efficient and is “seeing higher margins than in the last cycle.”

A bottom-up growth investor who works with co-manager François Campeau, Gigliotti is focused on earnings. “We are also risk-sensitive and conscious of not only monitoring the upside but the downside of each investment. There has to be a risk-adjusted return that makes the investment compelling,” says Gigliotti, who assumed management of the fund a year ago and reduced the number of names from about 100 to 45. Although there is as much as 8.5% in countries such as Norway, which accounts for 1% of the MSCI Europe index, the country weightings are a byproduct of a bottom-up stock selection process. “We try to find the best company, regardless of where it’s domiciled,” says Gigliotti.

One favourite name is Norsk Hydro AS, a Norway-based integrated oil company that
Gigliotti acquired about a year ago. “It’s very well positioned in the energy markets vis-à-vis global players like the BPs and Exxon Mobils of the world. But it has a much higher production profile than its competitors,” says Gigliotti, noting that Norsk’s stock is trading at about a 15% discount to its peers. “Being a smaller, nimbler integrated company means it can manage its growth in a healthier way than its competitors.” The stock is trading at about 730 Norwegian krone, versus the average cost of 427.

Other favourite names include A.P. Moller-Maersk Group, a Denmark-based vertically integrated shipping firm, alcoholic beverage giant Diageo PLC and German luxury carmaker Bayerische Motoren Werk AG.

A more cautious tone is expressed by Vittorio Fegitz, manager of RBC European Equity Fund, and chief investment officer of London-based RBC Asset Management (U.K.) Ltd. Fegitz notes that Europe’s economic cycle is “quite mature” after three years of global GDP growth and that rising interest rates in the U.S. and stubbornly high crude oil prices may slow the pace of expansion. “Going forward, we would not be surprised to see a moderation in the pace of global growth,” he says. “We don’t see a particular threat that would create a really sharp slowdown, however. The outlook is benign.”

@page_break@Yet, on the corporate side, Fegitz argues, profits are already beginning to slow from the sharp rise in 2004. This year should see double-digit growth, but next year earnings growth will decline to about 10% and slip to single-digit levels in 2007. “As the cycle matures, earnings become more dependent on revenue growth rather than profit recovery, which explains why the pace will slow toward historical levels of about 7%,” he says.

Although Fegitz admits high oil prices are acting as a headwind, he says this factor is offset by employment growth in most countries, low interest rates and strong property prices. In Britain, he notes, “The impact [of high oil prices] has been limited to the retail sector, which is a comparatively small part of the market. These are initial warning signs that we’re keeping an eye on, in case things deteriorate faster than expected.”

A bottom-up growth investor who favours the large-cap arena, Fegitz runs a portfolio of about 90 names, although he has added a few names in the mid-cap arena to mitigate some of the risks. “We don’t think mid-caps and small-caps offer particularly good value — but that’s where the action is at the moment. On balance, large-caps tend to offer better liquidity and better value for money than mid- and small-caps.”

Noting that growth stocks are trading at the same multiples as cyclical stocks, which have captured the market’s attention, he says, “You’re no longer paying a premium for growth. We find that comparatively attractive,” adding that he expects selected growth stocks to come back into favour.

One of his top holdings is GlaxoSmithKline PLC. Although it is a leading pharmaceuticals maker, it has gone through a period of poor earnings growth and has suffered from currency issues. “But it has a powerful pipeline of new drugs that should be launched in the next few years,” says Fegitz. “As these products go through various phases and trials, investors will have greater confidence in the resumption of its earnings growth. At the same time, its currency headwinds will start to disappear.” The stock, now £14.50, is trading at 16.9 times 2006 earnings, although Fegitz expects the price could rise to about £18 within 18 months.

Another top holding is Vodafone Group PLC, a global leader in the cellphone industry. Once a high-flying stock, its price/earnings ratio was battered after the telecom meltdown in 2001 and its earnings growth decelerated. It now trades about £1.50 — or 12.5 times earnings, a slight discount to the market.

But Fegitz is optimistic the stock will recover. “Going forward, we expect Vodafone earnings prospects will improve and it will see a turnaround in its problematic Japanese cellphone business,” he says. “As we go into 2006, and Vodafone rolls out its third-generation system across more territories, then its earnings growth will accelerate. When this happens, and the rest of the market decelerates, we think Vodafone will be re-rated upward.” His target is £1.90 within 18 months.

Yet corporate profits could already be peaking, threatening to undermine markets, warns Martin Fahey, manager of Investors European Mid-Cap Fund and Investors European Equity Fund, and head of European equities at Dublin-based I.G. Investment Management Ltd. “Corporate earnings have been strong. But, to be fair, we could be close to the peak in terms of earning momentum. There isn’t much scope for earnings upgrades over the next 12 months,” he says. “Economic activity, on a global basis, might start to slow. Europe will not be immune to that. The best of the earnings upgrades are behind us.”

Oil and gas stocks, which have led the markets and powered many of their gains, could be vulnerable. “The key is oil price security,” says Fahey. “If the oil price stays where it is, then earnings would be upgraded again next year. The risk is that global demand will slow substantially. The oil sector could correct over the next few months.”

Given the average 15% increase in European markets in 2005 (in local currency terms), Fahey suggests that a correction could occur in the next three to four months. “But it might be a buying opportunity to add some stocks,” he says, noting that he has about 5% cash in both funds. Investors European, primarily a large-cap fund, has an overweighted position in energy stocks such as Total Fina SA, Statoil ASA and Royal Dutch Shell PLC, and holds industrial goods names such as building materials supplier Compagnie de St. Gobain SA.

Investors European Mid-Cap, which focuses on companies with a market cap of 500 million-5 billion euros, is dominated by two sectors: 41% in industrials and 41% in consumer discretionary stocks (and, conversely, very small weightings in sectors such as health care and financial services). Larger holdings in the 60-name fund include firms such as German sportswear maker Puma AG, Irish building materials distributor Kingspan Group PLC and Britain-based insurer Royal & SunAlliance Group.

One of the largest holdings, though, is Boskalis Westminster NV, a Netherlands-based global leader in the dredging industry. “It’s a beneficiary of the trend to develop low-lying areas,” says Fahey, noting that the firm has lucrative contracts building artificial islands in the Arabian Gulf.

Acquired about five years ago, the stock was on a roller coaster in 2003 because of an earnings downgrade. But Fahey kept on buying and was vindicated in the past 12 months as its fortunes have been reversed; the stock has climbed to about 41.6 euros.
While the stock is no longer cheap — its price/earnings ratio has expanded to 20.9 times earnings — Fahey does not have concerns about its prospects for the next 18 months. “The company is driven by spending in the Middle East,” he explains. “These
are long-term projects.” IE