Continental joy as Europe returns

Economies and stockmarkets have a remarkably low correlation: healthy GDP growth does not necessarily translate into good returns on equities, while a sluggish economy is not inevitably bad for the stockmarket.

The eurozone is a perfect example of that: its economy has had a dismal two years, falling by 0.64% in 2012 and 0.44% last year according to IMF figures - well behind the rapidly recovering US and even our own sluggish economy.

Commentary on Europe has been equally gloomy, full of dire predictions about the need for more bail-outs, the risk of a break-up of the euro, high unemployment and political extremism.

Eurofirst 300 surge

Yet Europe's stockmarket performance has been excellent: over the two years to last December, the FTSE Eurofirst 300 rose by more than 30%, well ahead of the 20% or so gain for the UK's FTSE 100 index (UKX), although it was behind the soaring S&P 500 index.

Investment interest in the region is also increasing: private investment into funds in the Europe ex-UK sector at the end of last year had risen to well over twice the level of the previous 12 months, according to statistics from the Investment Management Association.

European fund managers are clear on the reasons: austerity has worked; growth is resuming, albeit gradually; and corporate valuations are relatively attractive.

Stuart Mitchell, founding partner of European specialist SW Mitchell Capital, points out that despite the good performance of the past two years, European shares trade at a discount of around 40% to US shares, based on Shiller price/earnings ratios - although that is partly because the spectacular five-year rally in US stocks has left that market looking fully, if not even excessively, valued.

But he also points out that, contrary to the popular perception of Europe labouring under a burden of excessive debt, it is actually less of an issue for Europe than for other countries: total debt, including government, corporate and private debt, has risen around 20% in the eurozone since the start of the financial crisis, compared with 35% in the US and 45% in the UK.

What matters is asset price and I think Europe is still attractive at these levels, with both absolute and relative multiples looking attractive."Sam Cosh

The eurozone also has a trade surplus, in contrast to the deficits in the US and UK.

"We were always of the view that [the eurozone] would muddle through," says Mitchell. "But we have been surprised by how unequivocally successful austerity has been."

Sam Cosh, manager of F&C's European Assets investment trust, does not expect a rapid economic recovery, but thinks next year's environment will be "more supportive".

"What matters is the price you can buy assets at and I think Europe is still attractive at these levels, with both absolute and relative multiples looking attractive."

Many investors are excited by opportunities in the peripheral countries such as Greece, Spain and Italy, which have suffered most in the wake of the crash. Barry Norris, chief investment officer of Argonaut Capital Partners and manager of its European Alpha fund, thinks Grecovery - a play on the old Grexit acronym for the expectation that Greece would have to leave the euro - will be the key event in Europe next year.

While its economy has been ravaged, with GDP down by a quarter in the past five years and unemployment rising to 27%, it has been expanding on a quarterly basis since the second quarter of last year and the IMF is predicting a small increase for the current year. That has helped Greece recover its competitiveness, with labour costs down by a quarter since the start of the crisis.

Other southern European countries are also coming out of recession, making their stockmarkets more attractive too.

Southern comfort

"In Europe, there are a lot of high-quality companies that have performed well, and their margins have reached new highs. The good news is priced in and these stocks could struggle to perform," says Norris.

In southern Europe, companies - and cyclical ones in particular - have had a grim time and have had to cut costs to survive.

Already, he adds, there are signs that companies exposed to domestic, rather than global, demand have started to produce better earnings growth. Investors are not just returning to bombed-out countries; they are also starting to consider the most bombed-out industries: banks, property and building companies.

In Europe there are a lot of high-quality companies that have performed well, and their margins have reached new highs. The good news is priced in and these stocks could struggle to perform."Barry Norris

As with the peripheral economies, these companies have had to pay the price of their over-exuberance in the run up to the financial crisis, with asset and debt write-offs, retrenchment and increased capital buffers. Some of those that have survived that process are now looking much healthier.

Norris says he is now significantly overweight European banks, having owned none of them since 2008 - seeing them as a good way of playing the domestic recovery. He points out that in 2012, about two-thirds of the operating profits of eurozone banks was consumed by loan provisions, but if provisions halve, banks' profits could double.

He and Mitchell both like Italy's Intessa Sanpaolo. Mitchell is also enthusiastic about some property companies - including Spanish property company Sacyr Vallehermoso, despite the general pessimism about the Spanish property market.

But the recent good performance of Europe was not a flash in the pan: Fidelity calculates that, over the decade to the end of November last year, the total return on the FTSE Eurofirst 300 index beat the developed markets of the US, UK and Japan, with a gain of 108%.

Indeed, Stephen Maclow-Smith, manager of JPMorgan's European Investment Trust, thinks the past 30 years have been excellent ones for investors in European equities. He calculates that the MSCI Europe ex UK index has outperformed the rest of the world by an average of 2.5% a year over that period.

He cites two reasons for this: first, European companies have been taking advantage of the ease of doing business across regional borders to build "national champions" with the scale to compete globally. Secondly, European companies have had to get used to operating with a strong euro and have streamlined their operations to suit.

European fund investors: UK or not UK?

Should British investors accept that, like it or not, the UK is part of Europe and choose a fund which reflects that, or should they just confine themselves to the Continent?

There is no clear winner between the two IMA sectors - including and excluding UK (see table above). Both have had spells in the lead (though Europe including UK funds have had the edge over the past year).

We are surprised how unequivocally successful austerity has been."Stuart Mitchell

There is, however, likely to be a dramatic difference between the investments they hold, as a cursory glance at some of the funds in the two sectors shows.

The largest holdings of Invesco Perpetual European Equity Income and F&C European Growth & Income - two of the top-performing funds in the ex-UK sector - include drug companies Roche and Novartis, Deutsche Telekom, software group SAP and the RTL entertainment business.

In contrast, the largest holding of JPMorgan European Equity (in the including UK camp) is HSBC and it has almost a quarter of its assets in the UK, while Threadneedle Pan European's biggest holding is Vodafone with almost a third of its assets in the UK.

The decision on which sector to choose will, therefore, depend on the funds in the rest of your portfolio. Many UK investors will start their portfolios with a domestic fund, diversifying gradually to include foreign funds - with Europe one of the more likely destinations for the first global foray.

If that is the case, it would be wise to choose a fund from the ex-UK sector, as buying a fund which includes the UK could actually end up increasing UK exposure. Indeed, many pan-European (including UK) funds are aimed more at investors based outside the UK rather than domestic retail buyers.

If, however, you view a European fund as part of a global portfolio and are simply picking among the best-performing managers, then you should consider both sectors, as both have some highly rated and well-managed funds.

Among the ex-UK funds on Money Observer's Rated Funds list are Baillie Gifford European and Jupiter European, while Threadneedle Pan-European is an option for those wishing to include the UK.