Digging Deeper In Europe

October 3, 2011 Marla Brill

As Spain, Italy, Greece and other Southern European countries continue their struggle for fiscal solvency, the possibility of finding even a tidbit of bright economic news in these regions seems remote.

Yet the companies in Europe are an altogether different story, says Stephen Peak, manager of the Henderson European Focus Fund. Remember, we’re not investing in the growth of European economies. We’re investing in the growth of companies located in the European markets, he says.

To Peak and others, strong companies represent a bastion of investment sanity at a time that U.S. government bonds have been downgraded, continued debt woes plague the euro zone and slow economic growth in Western markets continues to darken the mood of global investors.

No area has felt the pain of slow GDP growth and government fiscal imprudence more keenly than Europe, where the European Central Bank’s efforts to shore up the balance sheets of troubled countries such as Spain and Italy have done little to assuage nervous investors, who fear the worst is yet to come.

Peak sees no easy solution. Europe has reached a crossroads in terms of the euro experiment, he says. Member countries might drive linkages deeper, but that could mean giving up individual country rights such as setting tax rates. Another option would be a kind of two-speed euro zone that separates the northern countries from those in the south. In any case, the good thing about all this is the growing pressure to come to a workable solution rather than to just paper over the cracks in the system.

People might point fingers at Europe and its market volatility, but it hasn’t been the only region with problems, Peak says. The U.S. has also had its share of fiscal foibles and stock market swoons. And while the economies of China and other emerging markets have been more robust, their stock markets haven’t been the powerhouses many had hoped for over the past year.

Peak presents a number of arguments in favor of European companies, including their attractive stock valuations. According to his calculations of forward price-earnings ratios and other measures, the valuations of European stocks are the lowest of any stock market in the world.

I think a good portion of fear has already been factored into stock prices, he says. Even though the next six to 12 months will clearly be a struggle for Europe and other markets, I feel fairly confident that the world is in pretty good order. He adds that with the threat of rising interest rates, stocks are a better bet than bonds right now.

Despite the region’s problems, European companies have a durable appeal. It’s the biggest international region, with a vast array of choices in terms of company size, range and complexity, he says.

But investors also need to pick their spots carefully in European markets, he says. The Henderson fund, an all-cap portfolio, has done that by investing in stocks that most analysts don’t cover, and that most European mutual funds don’t invest in.

For example, more than 45% of all mutual funds focusing on Europe have Royal Dutch Shell as a top ten holding, according to Morningstar. Another 43% have a major presence in Nestle, while 40% own Siemens. The Henderson European Focus Fund, which has a median market capitalization of just $4.5 billion, owns none of those stocks. In fact, only three of its top ten holdings overlap with top holdings in other Europe mutual funds. And unlike many of its peers, the Henderson fund has a very small presence in the troubled financial sector.

Most Europe portfolios have the same large-cap, blue-chip names, he says. We get into more offbeat and contrarian situations.

The strategy has clearly made a difference in comparative performance. From its inception in August 2001 to August 1, 2011, a $10,000 investment in the fund would have grown to more than $55,000, while the same investment in the average fund in Morningstar’s 101-member European stock category would have grown to only $20,000. The performance, he says, drives home the point that strong stock returns need not be accompanied by strong economic growth, which has averaged less than 3% annually in Europe over the past decade.

The fund also scores well in terms of risk-adjusted performance, with a standard deviation just slightly higher than the MSCI Europe Index. Since its inception, it has captured more than one-third more upside than the index, but only 87% of its downside.

Based in London, Peak, who Morningstar has labeled a leading specialist in Continental European investment, has a prime perch for scouting out European companies both on and off the radar screens of most analysts. Nearly one-third of stocks in the fund are covered by ten or fewer analysts, compared to only 6% of stocks in the MSCI Europe Index.

Born in a small village 120 miles from London, the 54-year-old manager is one of the few prominent figures in the mutual fund world that skipped college and went straight to work after high school. As an 18-year-old trainee in the equity department of a life insurance company, he learned about investing in equities from a boss who gave me enough rope to grow and develop. In 1987, he was tapped to run a Europe-focused mutual fund by a British investment firm and was later promoted to head of the investment department.