Their investment products are out of fashion and their region is out of favour, but European equity mutual fund managers aren’t out of ideas. Investors who are ignoring the area may be doing so at their peril.

In the past few years, Canadian investors have eagerly dumped their foreign equity mutual funds and plowed money into some popular alternatives. Many have abandoned mutual funds altogether for complicated structured products, while those sticking with funds have turned in overwhelming numbers to income-yielding products. Any attention that the foreign equity category is receiving is largely focused on the growth prospects of China and India.

Europe couldn’t be a much colder story. It doesn’t offer the yield of income trusts, can’t promise the growth of Asia and the region’s image as an investment opportunity is sullied by the perception that it’s inherently unproductive, inefficient and unacceptably socialist. The impression is built largely upon the clichéd images of the French fancy for strikes, the Germans’ corporate complacency and the European Union’s legendary bureaucracy.

The current macro situation will do little to alleviate the image of Eurozone stagnation.
In late May, European Central Bank president Jean-Claude Trichet told the European parliament that lacklustre economic growth would probably persist through the first half of 2005 — and signs of strengthening have yet to appear. Trichet was quickly followed by Jean-Philippe Cotis, chief economist of the Organization for Economic Co-operation and Development, who also warned that growth prospects in Europe look “weak and uncertain,” while Asia appears to be solid and the U.S. is average.

The only silver lining amid all of the doom and gloom is the performance of the region’s stock markets. Notwithstanding weak underlying economies, Europe’s markets have been delivering the hottest returns this year. Through the first five months of 2005, France’s CAC 40 index was up 7.8%, the FT100 gained 3.1% and the German DAX was up 4.8% (as measured in local currency terms). All three markets have gained more than 12% in the past 12 months.

What of the world’s economic growth leaders? Through the first five months of 2005, the Nasdaq was down about 5%, the Dow Jones industrial index was off 3% and the Standard & Poor’s 500 dropped 2%. In Japan, the Nikkei was off by about 2% as well.

If markets are truly forward-looking, they seem to be calling for brighter prospects for Europe than the European Central Bank, the OECD or most other economists. Yet common wisdom has it that European firms are inherently less efficient than American companies, and that all the big growth comes from Asia.

Except those aren’t the facts. Investors may be surprised to find that the European record is much better than they believe. John Arnold, managing director and chief investment officer at Dublin-based AGF International Advisors Co. Ltd., points out that from the start of 1995 to April 30, 2005, publicly traded companies in Europe (excluding Britain) have generated average annual earnings growth of 10.3%, outpacing both the U.S. (8.1%) and Asia (7.1%). Yet investors have largely failed to recognize European firms’ superior performance.
Throughout the 10-year period, European markets have traded at a notable discount to the U.S. and Asian markets. Europe (ex-Britain) boasts a historical price/ earnings ratio of 14.9. Britain sits at 15.1, whereas the U.S typically trades at 20.5 and Asia at 19.7.

Given the fundamentals, it appears that many investors are missing out on the European opportunity. There may be some legitimate reasons, such as persistent risk aversion since the bursting of the market bubble in 2000-01, home country bias or the impact of strong commodity prices and a strong dollar on Canadian stocks. However, if investors are skipping Europe because they believe it offers stagnation while the U.S. promises efficiency and Asia equals growth, Arnold would like to correct that impression.

He sees the investment world as divided into three largely equal segments — the U.S., Europe and everywhere else.
Notwithstanding recent strong growth in parts of Asia, he maintains that the buying power of 500 million well-off Europeans or 350 million rich Americans still trumps that of billions of Chinese and Indians, and will for some time.

As for the differences between European and American styles of capitalism, he insists, the differences are diminishing — and sometimes the European model is superior, anyway. The typical knock on European business is that it’s not entrepreneurial enough, employees don’t work hard enough, managers are not sufficiently motivated, the bottom-line focus is fuzzy and European social policies are a huge drag on efficiency.

@page_break@There’s some truth to the charges, although things are changing. The profit motive has moved more to the forefront of managers’ thinking in Europe, for a variety of reasons.
Some examples: executive compensation has risen toward U.S. levels and is increasingly leveraged to share performance; institutional investors, such as hedge funds and private equity firms, have become much more active in Europe, pushing firms toward greater efficiency; and while labour policies may be unduly restrictive in some regions, that’s not the case everywhere, and the places that are very labour-friendly are being pushed to reform.

In the past, European CEOs got their kicks from leading companies, but they weren’t richly paid and weren’t merciless managers, Arnold says. However, during the 1990s, the area saw the “rise of American-speaking European executives” — managers who went off to the U.S for their education. They have since moved into the executive suites of Europe’s companies, bringing a U.S.
brand of ruthlessness to their businesses.

That means more companies are following the U.S. example of maximizing efficiencies by streamlining their operations, and outsourcing to lower-cost, often offshore centres. Sometimes this means Southeast Asia, and sometimes it means central and eastern Europe. “It’s not rape and pillage in the American sense — if you did that in Europe, the unions would fight you into the ground,” Arnold says. Instead, managers call the unions in early, explain the profit problems, negotiate layoffs and maintain production. “It’s all done very quietly,” he says. And that’s unlike in the U.S. — where management cuts its fat so ruthlessly, it often cuts muscle, too.

The softer European version of capitalism also means that companies often have much better labour relations than U.S. firms, which preserves their flexibility. The cyclical ups and downs of production can be handled more easily, as can job-cutting and restructuring. As well, the more co-operative approach in Europe can also mean better feedback from the shop floor, which leads to productivity improvements.

So, while U.S. companies may lead the way in raw, brutal capital efficiency, Rory Flynn, fund manager at AGF International, says there’s often more to profits. He says U.S.
companies that were once dominant are
now having their hats handed to them by European companies — for example, Boeing Co. getting its comeuppance from France’s Airbus.

“Efficiency may look like the dominant factor, but other things creep in there,” Flynn says. “If you have the right products, you can have earnings growth and revenue growth over a sustained period.”

The importance of having the right products also means that while European companies are becoming more cost-conscious, not all of their manufacturing is going to Asia.
Arnold notes that the importance of maintaining the integrity of the supply chain means that qualities such as proximity to markets and production quality keep some local manufacturing on competitive footing with the low-cost labour centres.

The Spanish fashion retailer Zara is one example, says Flynn. He notes that while its basic items are sewn in Asia, many of Zara’s trendier garments are manufactured in Europe (largely at traditional family-owned manufacturers in northern Spain) because its young, fashion-conscious clientele will pay a premium to get the newest look today rather than in three weeks’ time. “This just-in-time [demand] applies to $100-million aircraft, $20,000 cars or $20 shirts,” says Flynn.

Many Canadian investors, however, have been sold on the superiority of the brutal efficiency of the U.S. and the Asian growth story. As a result, they’ve bought U.S. and global funds for their foreign-content allocations. Arnold laments that they’ve underweighted Europe at a time when that region has outperformed the rest of the world.

He blames part of this on the fund industry itself. “The majority of my competitors have done a very poor job on their European funds,” Arnold says. “I think a lot of the European funds in Canada have abused the Canadian public because they’ve used [the region] as a training ground [for rookie managers], and a lot of people have failed.”
In a group that produces numerous losers, investors tend to sour on the asset class as much as the manager, which makes it a tough go for European funds generally.

As a result, many investors have missed out on the few good funds in the group, including AGF’s European equity fund, which, according to Morningstar Canada data, has had an average annual compound return of 11.7% for the 10 years ended May 31, vs 8.5% for the benchmark index — performance that puts it in the first quartile in every period from 10 years down to one month.

There are also the funds of I.G. International Management Ltd. (the other Canadian mutual fund manager with a shop in Dublin).
Its European mid-cap fund, run by Martin Fahey, partner and head of European equities at I.G. International, has only been around for a few years, but it has already put up strong numbers — returning almost 24% in 2003 and 15.7% in 2004. So far in 2005, it’s trouncing the index once again.

I.G.’s managers generate their returns through a combination of top-down macro/thematic considerations and bottom-up stock-picking of the companies that offer value. “We tend to look for companies that have grown shareholder value over time, but we don’t like paying up for them,” says Peter O’Reilly, partner and global fund manager at I.G. International.

Europe’s companies have done a better than expected job of growing shareholder value, and the region offers its share of bargains, too. O’Reilly suggests European markets are also not as efficiently priced as North American markets right now. While there is plenty of capital in the region, the ratio of investment dollars to companies may not be as high, meaning that the sort of mispricing opportunities that fund managers covet are more plentiful.

Fahey says that there are about 12,000 companies listed in Europe, half of which are too small to consider. Of the rest, about 15% account for 85% of the market cap, so there’s a very long tail of smaller companies that are often undercovered by analysts and investors. This is exacerbated by the fact that sell-side analysts have been cutting coverage as a cost-saving measure, and an influx of central and eastern European companies has lengthened that tail even further, keeping the crop of opportunities well stocked.

Among such opportunities, I.G. has been playing a variety of themes — booming property markets had it buying homebuilders, particularly in Britain and Ireland. Increased enforcement of environmental regulations put it into businesses such as residential insulation.
And strong growth in the gaming industry, fed partly by a spike in online gaming, has drawn it to gaming stocks.

Looking further out, I.G.’s European managers are seeking clever ways to participate in some of the longer-term themes that they see percolating in the region. Persistently high oil prices have them looking at alternative fuel plays such as Johnson Matthey PLC, and the prospect of resurgent demand for nuclear energy is a story it’s playing through Areva, a French company that is one of the world’s leading reactor builders.

Another story brewing is Turkey and its drift toward the EU. While Turkey’s ascension to the EU appears a long way off — particularly after the European constitution was effectively killed in France and Holland — the country is heading that way and offers a potentially huge demographic lift to aging Europe, with its young population of about 71 million. So far, the only viable way to play the Turkey story is through the financial institutions that are operating there, says O’Reilly.

Even forgetting about the themes and opportunities in Europe, O’Reilly says, it’s a great time for Canadian investors to buy Europe, both for diversification and to take advantage of the strength in the Canadian dollar. He expects that Canadian investors are going to have to see outperformance from overseas assets, which will probably require some help from the loonie, before they really start looking at European funds once again. Smart investors would be better off following the fund managers’ example, and buying on the cheap. IE