Investors must set sights on European big guns

Germany and France must continue to deliver economic reform, says James Daley

Can Continental Europe's run of success continue? While leading European stock markets have delivered double-digit returns in each of the past four calendar years, analysts are divided over the prospects for 2007.

Although economic conditions remain relatively benign - with interest rates and inflation at historic lows, and the two largest economies of France and Germany both beginning to recover from several sluggish years - company valuations are now starting to look stretched.

The most common way of analysing the price of companies is to look at their market value, and to divide it by its annual profits - this is called its price/earnings or p/e ratio. While p/e ratios in Europe still look reasonable on an absolute basis, when compared with other markets around the world, they are now beginning to look close to historic highs if they are adjusted to take account of the ups and downs of the business cycle.

Mark Hargraves, the head of European equities at Axa Framlington, says trend-adjusted valuations are now at similar levels to the market peaks in 1987 and in the early 1990s. But he also points out that they have not yet reached the heights of 1999.

"We've seen double-digit returns for the past four years, so you have to be a little more cautious now," Hargraves says. "Earnings growth has been the driver of the markets, and they still look like they can improve. However, over the past few years, people have been predicting high single-digit earnings growth and then seeing much higher returns. I think this year, you'll see earnings growth of 8 per cent, but there won't be any big upgrades after that."

The main risk to such continued progress in 2007 is that the European Central Bank (ECB) continues to raise interest rates and inadvertently stifles recovery in the Eurozone's (countries which have the euro as their currency) largest economies - France and Germany. The ECB has hiked rates five times in the past 15 months, most recently in December, and it is unclear whether there is an appetite for further rises.

Andy Lynch, a European fund manager at Schroders, concedes that fears over rising rates and continued uncertainty about prospects for the US economy, which is the second biggest customer of Europe's exports, may cause some short-term volatility in the markets. However, he remains confident that European equity markets will see another positive gain for the year as a whole.

"While we do expect profits growth to slow, companies continue to benefit from strong balance sheets and good cash flows," he adds. "This means they can continue to invest for future growth and are also more attractive to private equity companies."

The anticipated continued economic recovery in France and Germany is one of the most common themes driving fund manager's stock selection this year. Bertie Thomson, a European fund manager for Aberdeen Asset Management, says he believes one of the easiest ways to get exposure to the recovery story is by investing in the banking sector.

"Some of the banks in Germany are now at historically cheap levels, and we like the Nordic banks as well," he says. "You might also see some of the engineering and construction companies, and general retailers, doing quite well."

Thomson highlights French bank BNP Paribas as one of his favourite stocks, which has a good exposure to both the corporate and consumer banking sectors, and is relatively, conservatively managed. Thomson believes it is well capitalised and has good growth prospects.

In Germany, he says he is keen on retail chain, Metro, which has a good portfolio of properties backing up the company's valuation, and a good spread of formats - such as cash and carry outlets and hypermarkets through to consumer electrical stores.

James Macmillan, manager of BlackRock's Greater Europe Investment Trust, also believes Germany will do well over the coming year, pointing out that companies have been doing a considerable amount of restructuring in the recent past, which should now begin to show some dividends.

Axa Framlington's Hargraves says his fund has been keen on companies that have been capital-starved during the past decade, such as those in the oil services industry, which are now beginning to see some increased levels of investment. He points to Aker Kvaerner as one of his favoured stocks in this arena.

Elsewhere, Hargraves says he likes German energy company ABB, which is the leading provider of electricity in China. "Around 400 million Chinese are due to move from the countryside into the cities during the next 15 years, and they will use a lot more energy when they get there," he says.

Unless you're a sophisticated investor, the best way to get exposure to European equities is to buy one of the many mutual funds that invest in the region. However, with more than 100 funds to choose from, it's worth paying careful attention to exactly what your fund invests in.

Although most mainstream European funds stick to investing in the Eurozone and Europe's other developed economies, an increasing number are now beginning to invest small parts of their portfolios in the newer economies, such as Poland and Hungary. These markets tend to have slightly higher volatility, and hence provide the potential of greater returns, but in exchange for greater levels of risk.

Artemis' European Growth fund, for example, which is one of the best performing funds in the sector during the past few years, has had as much as 7 per cent of its portfolio in emerging European markets at certain times in the past few years. It caps its portfolio's exposure to the region at 10 per cent. Other funds have no exposure.

"Some of the managers are starting to dabble in emerging Europe now, but I think we're likely to see more of that as the markets become more developed," says Justin Modray of Bestinvest, the London-based financial advisers, says.

He believes that Artemis' European Growth fund, managed by Philip Wolstencroft is one of the best funds in the sector, precisely because it has such as flexible remit, which allows it to invest wherever it likes in Europe. Most funds are forced to stick closely to an index, taking only small bets aside from their benchmark.

For those in search of a lower-risk fund, Modray recommends Cazenove Europe, managed by Chris Rice. This is more conservatively run, and tends to invest in larger companies, picking stocks that are likely to do well given the current stage of the business cycle. Modray says that if you're thinking of investing in a European fund, it's worth checking what other exposure you have to the region in any other funds you own. "Regardless of whether you think Europe's going to perform brilliantly next year or not, it's still an important sector to hold within your portfolio," he says. "We would suggest you have between 25 and 30 per cent in Europe, around 50 per cent in the UK and the balance in Asia and elsewhere."

To find an independent financial adviser in your area, visit www.unbiased.co.uk, or call 0800 085 3250.