S&P on Europe: Better to Be in Than Out

Yes, the region has problems, but S&P Capital IQ says it’s turned more positive on the area, citing the ECB’s move to ease pressure on banks

There’s nothing like the threat of multiple sovereign defaults and near-zero economic growth to dim a region’s investment attraction, so it’s no wonder that Europe has been about the last place anyone wants to put their money lately.

While still a great place for vacations, just about everything that could go wrong economically for Europe has gone wrong: multiple sovereign bailouts, a recessionary economy, inflexible labor markets, large government bureaucracies, and a persistently strong common currency that has prevented ailing nations from devaluing their way out of trouble to name but a few.

With all of that to contend with, it comes as something of a surprise that European equity have posted strong gains for the year to date, even as the region’s economic activity slows.

The European Central Bank’s move in December to provide low interest loans to banks has had the dual affect of easing concerns about a credit crunch caused by the banks hoarding cash to stay solvent, and lowering short term interest rates that will hopefully help stimulate borrowing and presumably growth. Also, government officials and private investors have reportedly reached an agreement to avoid a default on Greece’s sovereign debt, which could have forced Greece out of the euro and undermined the solvency of the region’s banks.

While still well aware of the region’s problems, S&P Capital IQ has turned more positive on Europe recently, citing the overwhelmingly negative sentiment among investors and the ECB’s move to ease pressure on banks.

“We have become incrementally more positive,” says Robert Quinn, S&P Capital IQ’s chief European equity strategist. “Our core message is: don't chase the market, but don't not be in it.” In view of his outlook, he recently upgraded his recommendation for European information technology stocks to overweight, and cut the defensively-postured telecom sector to marketweight.

Euro-ETF Plays

If you want to “be in it,” there are of course many different ways to go. There are currently more than 20 exchange traded funds focused on Europe, though most of them are individual country funds. For a broad exposure to Europe from an ETF, it would be hard to beat the Vanguard MSCI Europe ETF (VGK), which tracks the MSCI Europe Index of about 460 stocks. The fund has $6.1 billion in assets (across multiple share classes including a traditional mutual fund) and has average daily trading volume of more than 2 million shares. U.K.-based companies have the largest geographical allocation, with about 36% of assets as of year end 2011, followed by France at 14% and Switzerland at 13%.

With so much turmoil in the region, however, the benefit of an active manager makes sense.

There are about 20 different mutual funds targeting the European region that are currently open to new investors and not designed for institutional clients. Over the past three years, their performance ranges from an average annual total return of more than 30% to less than 10%. Net expense ratios vary from about 1% to 1.8% for Class A shares.

Among these funds, three stand out for their combination of strong historical performance, low costs, and four or five star ranking from S&P Capital IQ’s fund ranking methodology.

Over the past three years, the Invesco European Small Company Fund (ESMAX) has delivered the second best performance (for Class A shares) among all Europe region funds, with an average annual return of 22.6% as of February 8.  

Launched in August, 2000, the $113 million fund has delivered a 5.96% average annual return since then. As of January 31, its holdings were mostly industrial (36.3% of assets), consumer discretionary (15.9%) and information technology (13.2%) companies. Geographically, the U.K. was the largest allocation at 33%, followed by Ireland (16%) and Germany (10.2%). Its largest holding (3.8% of assets) at the time was Kier Group, a U.K.-based construction and civil engineering firm.

For those looking to own larger, better known companies, the T. Rowe Price European Growth Fund (PRESX) has a top 10-holdings list stocked with household names. The largest of its 65 holding as of January 31 was British energy company BG Group. Its 17% average annual return over the past three years is in line with other top performing funds, and its costs are below average.

The fund has about $640 million in assets, and has delivered an annual total return of 6.7% since it opened in October, 2005. The U.K. was its largest country exposure, with about 36% as of year end 2011, followed by Germany and France each at about 14%.

A third alternative is the Invesco European Growth Fund (AEDAX), which was the third best performing European region equity mutual fund over the past three years with an average annual return of 18.6%.

The weighted median market capitalization for its holdings was $7.8 billion, compared with about $900 million for its sister small cap fund. It has delivered an average annual total return of about 11.2% since it opened in November, 1997. As of year end, its largest holding was UK bookmaker Paddy Power.

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S&P Capital IQ Senior Editorial Manager Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for mutual fund and ETF stories.

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