(FORTUNE Magazine) – For years now, Europe has been branded as a boring, low-yield place to park your hard-earned money. It's time to rethink that assessment. Despite their lackluster image, European shares have been keeping pace with American stocks, and some analysts think they may even pull ahead. Over the past four years the Morgan Stanley Capital International Europe index of 573 leading shares has even slightly outperformed the S&P 500, rising 92.8% compared with 92.4% for the S&P. Today many European stocks look relatively cheap, with an average price/earnings ratio of just 14 compared with a U.S. mean of 17.5, according to Goldman Sachs.

Europe provides some investment opportunities that the U.S. doesn't, in part because it is out of phase with American economic and market cycles. While the U.S. began to emerge from the last recession in early 1992, Britain's economy didn't begin to recover until late 1993, while France, Germany, and other countries in continental Europe didn't really show any signs of recovery until 1995. Those economies are at about the same point now that the U.S. was in late 1993, when the Dow stood at around 3700.

But investors need to be patient to realize big gains in Europe; it's a place where change is coming, but not at a red-hot pace. "We think there is value in Europe," says Alan Albert, senior managing director with Merrill Lynch Global Asset Management, "but the question is, will the value ever come out?" There are also a few dark clouds on the horizon. The biggest worry is how conversion to a single European currency, planned for 1999, will affect local economies and markets. Governments throughout Europe are adopting fiscal austerity in order to meet agreed-upon economic guidelines by the deadline, raising the danger of pushing the continent right back into recession. A major setback for the widely anticipated plan could also derail financial markets.

Despite those risks, money managers see a lot of potential at European companies. Even Merrill's Albert is bullish on the Old World. Some 10% of all Merrill Lynch's client assets are invested in international markets--up from less than 2% in 1989--and Albert is advising U.S. clients to increase their European exposure heavily, to around 20% of their portfolios. Why? "The U.S. markets are ripe for a correction," he predicts. "In that case the European markets will likely hold up better."

A key reason is that time lag with the U.S. Faced with growing competition, European companies are finally embarking on the course of major downsizings and management restructurings that their American cousins long ago traveled. "Europe is just moving into the second year of a decade-long cost-cutting phase that the U.S. entered around 1985," says Paul Horne, Paris-based international economist with Smith Barney. "This is the start of a profits revolution for Europe, while the U.S. market probably doesn't have much more room to grow."

Some macroeconomic conditions will also help European stocks: Interest rates are still headed down in much of continental Europe, for instance, making it cheaper for companies to retool and make acquisitions. That will lift profits. "We think that in 1997 earnings growth in Europe will be around twice what it is in the U.S.--about 20% compared with 10%," says Jeffrey Weingarten, global strategist for Goldman Sachs in London.

Europe is also becoming a friendlier place to invest. First, European companies have lost some of their reluctance to go public, as companies in need of capital increasingly float shares on stock exchanges. Last year there were nearly 200 IPOs, up from 81 in 1992. That, in turn, is making markets more liquid. Over the past four years, trading volume is up 88% in London and 81% in Paris. The old traditions of financial secrecy and family and state ownership are finally dying out, with more companies publishing detailed accounts and meeting with analysts and shareholders. "Just five years ago very big German companies like Volkswagen weren't even interested in talking to me. Today they have changed their tune," says Robert Sargent, European equity fund manager with Morgan Stanley Asset Management, whose $900 million Specialist European Program has averaged about 15% annual growth since its inception in 1987.

Now VW, for instance, talks publicly and often about the importance of delivering shareholder value. And because it's also walking that talk, Sargent and other analysts have been recommending the automaker's shares. After years of poor performance, VW announced a doubling of profits in 1995 and a further doubling in the first nine months of this year. Analysts expect this doubling act to continue for at least the next two years, thanks to newer, more attractive car models; a trimmed-down work force; and increased production in low-cost countries like Brazil, the Czech Republic, and Mexico. Volkswagen's sales in the U.S. have jumped from a paltry 62,000 in 1993 to almost 139,00 so far this year, making VW the No. 1 European car importer. Analysts expect the launch of a new version of the Beetle in the U.S., scheduled for the 1998 model year, to further boost the German automaker's U.S. presence.

VW's management isn't the only one trying to please investors. Enough companies have seen the light that some money managers have launched European value-focused mutual funds. One is Top 50 Europa, a Frankfurt-based $933 million fund started by DWS, the funds management arm of Deutsche Bank. The Europa portfolio is limited to 50 companies with proven track records of increasing shareholder value. Founded in October 1995, the fund generated a 37% return on investment during its first year. "There is a lot of enthusiasm out there now," says Elisabeth Weisenhorn, founder and a manager of the fund. "Companies were asking us what they should do to be considered an investor-focused company."

Key to selection for Weisenhorn's buy list is a history of setting, and meeting, performance targets. One company that fits that bill is Germany's Mannesmann, formerly a stodgy producer of machinery, car parts, and industrial piping but now recasting itself as a profitable telecommunications provider. Since winning government permission in 1990 to compete in Germany's deregulating telecoms sector, Mannesmann has captured 40% of the country's fast-growing mobile-phone market. Its recent acquisition of DBKom, the German national railway's former communications network, also leaves the company well positioned to compete in the far larger fixed-link telephone market in 1998 when the last competitive barriers are removed.

But even if you're riding a hot industry like telecoms, picking the right stocks in Europe can be especially tricky because regulation, tax codes, and accounting policies still vary widely from country to country. The devil's in the details, and unwary investors can get burned. "The lesson is, don't touch a company whose accounting procedures you can't understand," warns Gilbert de Botton, founder and chairman of Global Asset Management, a Bermuda-headquartered investment house with 11 European funds and $9.2 billion under management.

Beyond unnerving accounting vagaries, of course, lie whole categories of industry in Europe whose fundamentals investors should regard with suspicion, De Botton says. for example, banking, carmaking, steel, and consumer electronics all suffer from overcapacity.

You might also assume state-owned European companies, which remain overstaffed and barred by fearsome legal and union obstacles from making the kind of layoffs they need to compete, fall into the "avoid" category. You'd be right, but there's one notable exception: SGS-Thomson Microelectronics, the Franco-Italian microchip producer that's 70% controlled by those countries' governments. SGS actually leads the world in the development of specialist chips called MPEGs, critical enablers for a new generation of products like Internet computers, digital videodisk players, and digital television scheduled to hit the market in 1997. Though the MPEG market is currently only about $270 million annually, it is expected to explode to $3.6 billion a year by 2000. And SGS dominates, with a 44% market share. Analysts are predicting that SGS's earnings will grow 20% next year, followed by at least 12% in 1998. SGS-Thomson "is that rare European company able to deliver constant earnings growth," says Merrill Lynch technology analyst Neil Barton.

A few formerly state-controlled companies are also looking good these days. French oil giant Elf Aquitaine cut the government's stake to under 1% in November and bought back 4.5% of its stock to show shareholders it wants to improve returns. Elf has shed around 12% of its staff and trimmed production costs by 30% since 1992. Looking further out, ongoing restructuring is expected to reduce Elf's unit costs by another 10% by 1998, adding to profitability. Buoyed by newly discovered oil deposits in West Africa, the company's oil output may rise 25% by the year 2005.

Another solid bet: Putting money into cyclical stocks whose profit trajectory is heading sharply upward. "We've been taking profits from our growth stocks and are starting to fund value stocks," says John Bennett, investment director of European market activities for Global Asset Management. "Much of that is to be found in undervalued European cyclicals."

Britain's Daily Mail & General Trust, a newspaper and magazine publisher, is a prime example. With newsprint prices falling, ad revenues rising, and consumers spending more willingly, British publishing is enjoying an upswing. The Daily Mail's current circulation of 2.1 million is up 14% from last year and at its highest since 1968. The company has diversified recently into regional newspapers, cable television news, and the Euromoney investment publications group. Analysts expect earnings per share to rise by a whopping 32% next year.

Beyond such unusual opportunities, investment strategists offer a solid defensive reason for putting money into the Old World, whose latest bull runs are actually younger than Wall Street's. Historically, these markets have been somewhat less volatile. "Over the last 25 years, the European markets have held up better in major corrections ten out of 11 times," says Weingarten of Goldman Sachs. In the second half of 1987, for instance, U.S. markets plunged 33%, while Europe declined 24%. The simple message for investors in a U.S. stock market that may be near its peak: Invest in Europe and diversify your risks.

REPORTER ASSOCIATE Joe McGowan