Europe: It's Japan, only worse

  @Money January 17, 2013: 12:37 PM ET
europe japan financial crisis 2

Europe's financial crisis could linger for years, making foreign investing tougher than ever.

(Money Magazine)

The plot line has an all-too-familiar ring to it: One of the biggest engines of global growth seizes up in the aftermath of a massive financial bubble, sending equities into a tailspin and the economy into a recession.

Policymakers seem incapable of pulling out of the dive, so fearful consumers cut back, troubled banks quit lending, and weakened companies stop hiring.

The result: more than a decade of slow or no growth.

Japan in the 1990s? No. Try today's Europe, where leaders are struggling to work their way out of a massive credit bubble, with no quick fix in sight. With the region's markets down more than 30% from recent highs, you're feeling the pain too.

You can't turn your back on international investing, though -- U.S. stocks account for only a third of world markets, and growth at home is tepid as well. But you need to adjust your approach.

When the same scenario played out in Japan, Americans barely batted an eye. As bad as the bursting of Japan's stock market and real estate bubbles was -- Japan has yet to fully recover -- it did little to impede earnings and economic growth around the world. In fact, during Japan's lost decade, U.S. investors earned stock returns of nearly 20% a year.

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Alas, there are significant differences between Japan then and Europe now that make ignoring today's crisis risky. The biggest is scale: Even though Japan's economy was the second largest in the world in 1990, it was only about a third the size of that of the U.S. By contrast, Europe is collectively the single largest engine in the world.

"Its sheer weight means it will have a bigger impact on the global economy," says Nariman Behravesh, chief economist at IHS Global Insight.

That doesn't mean you have to start handicapping the upcoming German elections or hanging on to European Central Bank president Mario Draghi's every word. You must, however, keep Europe's mess in mind as you position the overseas portion of your portfolio for what economists predict will be a prolonged period of subpar growth.

To dodge Europe's biggest problems and find the best opportunities across the pond, follow these strategies.

STRATEGY NO.1: Trim you stake in Europe, but don't flee this part of the world altogether

The challenge: Given the meltdown in European markets, the knee-jerk reaction is to rid yourself of any and all companies on the continent. But it was a whole lot easier to turn your back on Japan in 1990. Not only is Europe collectively more than $1 trillion larger than the U.S., but it also represents an entire region that's far more intertwined with our economy than Japan's market ever was.

Sales between the U.S. and the 27-member European Union, for instance, represent the biggest trade relationship in the world. What's more, 11% of all revenue generated by companies in the Standard & Poor 500 comes from Europe.

So even if you wanted to, you couldn't entirely eliminate this region from your portfolio, says John Stoltzfus, chief market strategist at Oppenheimer.

Downshifting your European exposure, even slightly, can be tricky, because the question that invariably arises is, Where else should I put that money? The next biggest developed market abroad would be Japan, which is on the brink of slipping into its third recession since 2008.

The opportunity: One option is to move modestly into the faster-growing emerging markets, says Pat Dorsey, president of Sanibel Captiva Investment Advisers.

In a typical international stock fund, about 85% of your assets will be invested in the developed world (roughly two-thirds of which would be held in Europe). That would leave your foreign portfolio with only a 15% stake in rapidly developing markets like China and Latin America.

Related: Why market timing is so hard

Dorsey recommends shifting that to a more growth-friendly mix: a split of 75% developed markets and 25% emerging markets for conservative investors; a two-thirds/one-third mix for more aggressive folks.

Worried about the added risk? A 75%/ 25% mix would have lost a mere one percentage point more than an 85%/15% portfolio in the worst 12-month stretch of the past decade. Yet it would have delivered nearly one percentage point more in gains annually. On a $100,000 investment, that's another $20,000 in your pocket over those 10 years.

If you invest abroad through a single index fund, such as Vanguard Total International (VGTSX), you will have to add a second fund to bolster your emerging-market weighting. You can still maintain a simple index strategy, though, through a fund such as Vanguard Emerging Markets Stock (VEIEX), a member of the MONEY 70, our recommended list of mutual and exchange-traded funds.

If, on the other hand, you already own a more focused developed-market fund, the simplest way to make the shift is to sell off a portion of your holdings. Many foreign funds that concentrate on Western Europe are sitting on capital losses from the past five years, so realizing the loss can help lower your tax bill.

Europe already over the fiscal cliff

Then use that money to buy a diversified fund that invests in emerging markets. To avoid taking undue risks, stick with ones specializing in blue-chip stocks based in developing countries.

Two good examples: Causeway Emerging Markets (CEMVX), which counts the South Korean conglomerate Samsung Electronics and Russian energy giant Lukoil among its top holdings, and T. Rowe Price Emerging Markets Stock (PRMSX), which invests nearly 90% of its assets in large- or mega-cap names. The latter is another MONEY 70 offering.

You may, however, already invest overseas through individual stocks or country-specific ETFs, or you may prefer that degree of control over your portfolio. In that case, you can employ one or more of the next three strategies. Just remember to make these moves within whatever mix of developed and emerging markets you favor, be it 75%/25% or two-thirds/one-third.

STRATEGY NO. 2: Shop for beaten-down global giants, but check the price carefully

The challenge: The global marketplace is far more interconnected than it was when Japan collapsed. "Despite its reputation back then, with companies like Honda and Toyota, the Japanese economy was actually less export-driven than you'd think," says Harry Hartford, president of Causeway Capital Management.

The same can't be said for European firms, which collectively generate more than half their revenue abroad. You can use that to your advantage by investing in multinationals that have headquarters in Europe but don't rely on a strong home economy. When doing so, though, keep a close eye on the price you're paying.

Unlike in Japan, where stock valuations remained uncomfortably high for more than a decade because of lousy corporate profits, price/earnings ratios in Europe have sunk 25% in recent years to historic lows.

Related: Where will the next big bull market come from?

The one exception: As more investors have glommed onto the globalization theme, high-quality companies that generate strong sales abroad are no longer that cheap, says Kimball Brooker, co-manager of the First Eagle Global Fund.

Some, in fact, are downright expensive. Take Inditex (IDEXY), the Spanish parent of the global retailer Zara, and U.K.-based spirits maker Diageo (DEO) which owns Johnnie Walker and Guinness. Both stocks have shot up some 50% over the past 18 months; Inditex is trading at a P/E ratio of 26, based on forecasted earnings, while Diageo sports a P/E of more than 40. By comparison, the average European consumer discretionary stock has a P/E of just 11.

The opportunity: Cherry-pick European multinationals that are globally minded and reasonably priced. Charles de Vaulx, chief investment officer for International Value Advisers, favors Teleperformance (TLPFF; Price/Earnings ratio:11.1), a global call-center operator that generates 70% of its sales outside its home base of France.

Related: Picking the best stocks for your portfolio

He also likes the French energy conglomerate Total (TOT) (P/E: 6.8), which makes 77% of its sales outside its home country, and Sodexo (SDXAY) (P/E: 14.9), one of the world's biggest food-service companies, which operates in 80 countries and generates more than half its profits and revenue outside Europe.

Another way to make sure you own a diversified mix of true bargains is to go with foreign stock funds that emphasize European multinationals and that are run by managers with a deep value bent.

This group includes Tweedy Browne Global Value (TBGVX) (Average P/E of portfolio:12.2), whose top holding is Total. Another solid choice is Harding Loevner International Equity (HLMNX) (Average P/E: 14.8). Both funds have gained about 1% a year for the past five years at a time European stocks have lost more than 5% annually.

STRATEGY NO. 3: Seek out companies that actually benefit from slow growth

The challenge: When Japan's economy tanked in the '90s, you could find abundant growth elsewhere in the world. In fact, throughout the 1990s the U.S. economy expanded at an above-average 3.4% annual clip. And even Great Britain was growing at nearly a 3% annual pace, fast by its standards.

Today you'd be lucky to find 2%-plus annual GDP growth anywhere outside of emerging markets.

"European nations will have pedestrian growth for many, many years, but so will other countries," says de Vaulx. Indeed, economists at IHS Global Insight predict sub-2% growth for the eurozone until at least 2026, with no better than 3% average growth for the rest of the developed world between now and then.

The opportunity: Look for companies that can profit in times of slow growth -- or that will actually benefit from the side effects of a sluggish economy.

For instance, because the euro has been steadily losing value throughout the region's debt crisis -- it has fallen 15% against the dollar since last spring -- industry-dominant manufacturers that sell outside the eurozone stand to benefit, says Edward Gray, co-manager of the Delaware International Value Equity Fund.

Related: How much to pay for stocks

A prime example is BMW (BMW). The weak euro has helped boost sales in fast-growing markets like China by making the company's products more affordable. And ultralow interest rates in its home country of Germany have reduced the luxury-vehicle maker's borrowing costs.

Few sectors are as defensive as utilities, since even in a lousy economy households have to keep the lights on. Tom Forester, head of Forester Capital Management, favors National Grid (NGG). Despite the fact that the United Kingdom was in a recession early in 2012, this electric and gas utility enjoyed a 7% jump in operating profits in the first half of last year.

Having no exposure to the worst markets in Continental Europe helped National Grid's performance. So too did the company's U.S. business: More than 56% of National Grid's revenue comes from the U.S., mostly in the Northeastern markets.

STRATEGY NO. 4: Venture into the countries that have stayed healthy despite the region's woes

The challenge: With 17 different nations, political systems, and cultures making up the eurozone, a quick fix to its debt crisis is unlikely.

The cracks in the union are already beginning to show. "Austerity fatigue is clearly setting in among countries in the south," notes Donald Quigley, co-manager of the Artio Total Return Bond Fund. Unemployment rates have reached Great Depression levels of around 25% in places like Spain and Greece.

Meanwhile, in the financially stronger North, "you have bailout fatigue" among citizens who are tired of throwing financial lifelines to their neighbors, adds Quigley.

The opportunity: You can use the region's diverse economic conditions to your advantage. "Applying a broad brush to Europe no longer works," says David Kotok, chief investment officer at Cumberland Advisors. "You have to be selective."

You'll find pockets of growth in the financially stable markets of Switzerland and the Nordic countries. True, the Nordic stock markets are more expensive than the euro zone's, but corporate profits there are growing nearly 20% faster a year than in the rest of the region. You can take a stake in these nations with a fund like Global X FTSE Nordic ETF (GXF).

Related: Investing - Where to make money in 2013

Also, think outside developed Europe. If you invest in a fund that specializes in European stocks, more than 90% of your money will be in the Western part of the Continent. Yet Eastern Europe, which you can invest in through a fund like SPDR S&P Emerging Europe (GUR) , offers some intriguing opportunities.

Over the next three to five years corporate earnings in this developing region are expected to grow more than 18% a year, thanks in part to productivity gains but also the burgeoning consumer economy in places like Poland and Turkey. Compare that with the 13% annual forecast for Latin America, Asia's 11% rise, and the 8.8% growth rate in Western Europe.

At the same time, Eastern European companies have less debt on their books than their counterparts elsewhere in the developing world. They're also trading at historically low valuations, both in absolute terms and relative to Western Europe. Eastern European shares typically trade at a 26% discount to the West. Today that figure has dropped to 52%.

Finally, John Derrick, director of research for U.S. Global Investors, points out that as good as Western European companies are when it comes to paying dividends, Eastern European firms are even more generous. The MSCI EM Eastern Europe index sports a dividend yield of 4.4%.

That's half a percentage point higher than the S&P 350 Europe index, its Western European counterpart. In essence, you're getting paid to wait. Given how long it may take for growth to return to this barren continent, that extra income sure will come in handy in the coming years. To top of page



The picks
You can make strategic moves in Europe with these stocks, funds and ETFs.
Stock (Ticker) P/E Dividend Yield
Teleperformance (TLPFF) 11.1 1.7%
Total (TOT) 6.9 5.0
Sodexo (SDXAY) 15.8 2.0
BMW (BMW) 8.5 2.5
National Grid (NGG) 13.1 4.1
Fund (Ticker) Total return: 1 year Total return: 3 year
Tweedy Browne Global Value (TBGVX) 18.9% 9.5%
Harding Loevner International (HLMNX) 14.3 7.5
Global X FTSE Nordic ETF (GXF) 20.3 6.8
SPDR S&P Emerging Europe ETF (GUR) 9.6 0.9
NOTES: Price/earnings ratios for stocks are based on projected corporate profit. Three-year-return figures for mutual funds and ETFs are annualized.
SOURCES: Bloomberg, Morningstar, Zacks.com
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