Like many regional markets, Europe has been caught in the liquidity crisis induced by the subprime mortgage debacle in the U.S. Some fund managers maintain this is a temporary event; markets will pull through, thanks to solid economic growth in the region and other parts of the world.

“Tighter financial markets, tighter credit conditions and more risk controls will be with all markets for some time,” says Fehim Sever, a portfolio manager with Fidelity Investments in London, who oversees Fidelity Europe Fund. “But we have to keep in mind there is significant global growth, driven by the ‘BRIC’ countries [Brazil, Russia, India and China] and the integration of emerging countries on the back of higher commodity prices into the world economy. Europe is in a position to benefit, as well.”

Two of Europe’s strengths, he adds, are its manufacturing and infrastructure sectors, which are enjoying strong exports.

“It’s an interesting time with two dynamics at play,” says Sever. “On the one hand, you have tighter credit conditions and a slightly de-leveraging consumer. On the other, you have significant global growth opportunities. The European economy is still in quite good shape. The consumer is less leveraged than in the U.S. and benefits from the global growth curve.”

In addition, Sever notes, Europe is benefiting from closer economic ties with countries in eastern and southeastern Europe, such as Poland and Turkey. “If you combine global growth with the integration of these countries into Europe, you have a powerful economic force,” he says. “If you take a one- to two-year view, there are strong long-term drivers out there I believe will dominate.”

A bottom-up, growth investor, Sever looks for companies trading at reasonable valuations with robust long-term earnings attributable to either their geographical location or sector. In some cases, Sever will identify particular themes and select stocks with the best prospects. On a geographical basis, which is a byproduct of the investment process, Germany is the largest market, at 25% of the fund, followed by Greece at 14% and Turkey at 7% (with smaller holdings in France and Britain).

One of the largest holdings in a 44-name portfolio is E.On AG, a leading German utility. The firm is benefiting from long-term growth in electricity prices, rising demand and tighter energy sources. “Being one of the largest power generators in Europe, E.On is in a position to benefit from these trends,” says Sever.

Moreover, he argues, the stock has an unjustified double-digit discount compared with its peers. Acquired at the beginning of the year when a share was trading at about 104 euros, E.On recently traded at 128 euros a share. He has no stated target, but says any stock that does not have the potential to appreciate 20% over the next 12-24 months is unattractive.

Another favourite is Fourlis Holdings SA, one of several Greek non-food retailers benefiting from the strong Greek economy and growth in the Balkans. Fourlis is distinctive because it is the licensee for IKEA in Greece and the Balkans, and the only listed IKEA franchisee in the world. Acquired at the beginning of 2007 at 16 euros a share, it recently traded at 26.7 euros.



On the other hand, some managers argue that the slowdown may continue as the four-year-old bull market runs out of steam.

“It may last a few more years, but who knows?” says Clas Olsson, senior portfolio manager at Austin, Tex.-based AIM Investment Management Inc. and lead manager of AIM European Growth. (Other team members are Jason Holzer, Borge Endresen and Matthew Dennis.) “At some point, things will slow down. When that happens, markets may change character as volatility picks up and there is less breadth.”

The economic expansion has been going on for several years, he adds, and corporate profit margins are at record highs: “It is difficult to imagine more profit expansion in Europe. Companies are still seeing good growth, but it is not as buoyant as in past years.”

Indeed, he notes, valuations are getting stretched and returns will probably not be as robust.

Olsson and the team are bottom-up investors and focus on firms that are not too dependent on the economic cycle, with strong returns on capital or equity, so they can weather any storms. Recent portfolio changes were made on the grounds that valuations had gone too far and it was time to take profits.

@page_break@The team is underweighting financial services, at 17% vs 28% in the benchmark MSCI Europe index. That is not a top-down call, Olsson says, as the team believes there are fewer opportunities in that sector. Conversely, the managers have overweighted consumer discretionary and consumer staples, at 20% and 13%, respectively, vs 10% and 9%. There is also 18.7% in industrials vs 10% in the index, an index-matching 8% in materials and smaller positions in health care and energy.

A top holding in the 87-name fund is Porsche AG. The German sports carmaker is one of the few automakers to have high returns on invested capital and lots of cash (US$3 billion). “It also doubled its volume in the past decade, which is unusual in the automotive industry,” says Olsson. “It outsources manufacturing of some models to other companies, meaning it ties up less capital.” Porsche also has a strong brand, which gives it pricing power.

In 2005, Porsche had a 17% operating margin, which has expanded to 22%. In 2006, it boasted 34% ROE.

“It’s a strong growth stock, generating high returns,” says Olsson. Bought in June 2005 at around 604 euros a share, the stock recently traded at 1,645 euros a share. Olsson is reluctant to discuss a target price but believes there is more upside, based on its rapid growth in emerging markets and its 30% stake in Volkswagen AG, which has been restructuring.

Another favourite is InBev SA. Based in Belgium, it is one of the world’s largest brewers, best known for brands such as Brahma and Stella Artois. InBev brought together fast-growing Brazilian operator AmBev with a conservative operator Interbrew. As the Brazilian side of the business has grown to dominate the company, it has become more cost-effective. In 2006, InBev had a 14% return on capital and sales growth of 14%. Bought in July 2005 at around 28.9 euros a share, it recently traded at 64.5 euros.

Olsson also likes Siemens AG, one of Germany’s largest conglomerates. It has restructured and is focusing on three areas: power generation, medical devices and automation and control equipment. “The company is doing quite well. It is moving forward with a number of divestitures, while creating joint ventures with other businesses,” says Olsson. Although Siemens is under a cloud because of a bribery scandal, its new CEO, Peter Loscher, appears to be resolving the matter.

Earnings are expected to grow 56% in 2007. Bought in July 2006 at around 67.4 euros a share, the stock recently traded at 97.6 euros.



We’ve probably seen the worst of the correction, says Martin Fahey, manager of Investors European Mid-Cap Equity Fund and head of European equities at I.G. Investment Management Ltd. in Dublin. “If more negative news comes out, we’ll take another hit. But November is coming when, from a seasonal perspective, the market should pick up.”

Fahey expects more volatility in coming weeks, but sees this as a buying opportunity because the fundamentals are solid. “The overall global economy will grow 4%-plus,” he says. “Some markets, such as the U.S., will grow below trend. But other countries will compensate for these weaknesses.”

It is becoming difficult to find good value in the mid-cap market segment on which the fund is focused, Fahey says. The average market cap in the fund is 7 billion euros. Last spring, mid-caps traded at a 25% premium to large-caps, vs a 50% discount in 2000. But, he says, that premium is narrowing as the market is less disposed to the more cyclical mid-caps than the more stable large-caps, which have started to outperform.

A bottom-up investor, Fahey favours industrial and consumer discretionary stocks. The sectors account for 38% and 24%, respectively, of the fund. There is also 13.5% in materials, 9.5% in financials, 6% in consumer durables, 5.5% in energy and the rest in cash.

One of his largest holdings is Outotec OYJ of Finland, a major designer and developer of plants and equipment for the metals and minerals industry. Fahey acquired the firm in the second half of 2006, when it was spun out of Outokompu Technology OYJ. Purchased at 15 euros a share, the stock has risen to 50.5 eros. But Fahey is hanging on, as growth has been driven by earnings upgrades, which he expects to continue. IE