Good news amid the euro-gloom

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  • 09/04/2014
Aim for companies with international ambition 3 of 3 Introduction 1 of 3

Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Despite all the potential pitfalls, however, there is still plenty in Europe for investors to find encouraging. “Even after rallying, continental European stocks generally still look to be pricing-in levels of profitability that are too low, in our view,” says Kevin Gardiner, head of investment strategy for Barclays Wealth & Investment Management. “Sluggish growth – and, eventually, a weaker euro – is unlikely to prevent euro-area stocks from performing strongly again in 2013.”

Moreover, European shares are cheap by historical standards. We know this because of one indicator in particular: CAPE (the cyclically adjusted price to earnings ratio).

To calculate a share’s CAPE, one divides its total market capitalisation by its average annual earnings over the past 10 years. The point of using a ten-year average – as opposed to the one-year figure used to calculate a conventional price-to-earnings (P/E) ratio – is that it irons out anomalies in the business cycle.

In early May, the MSCI Europe Index, which tracks Europe’s developed equity markets, had a combined CAPE of 14 – well below its long-term average of 21. This is pretty close to all-time lows, and also looks cheap compared with the equivalent figures for Japan (16), China (18) and the US (22).

Please bear in mind that all the investments mentioned in this article can fall in value as well as rise.

14 Europe’s “cyclically adjusted price to earnings ratio” is well below its long-term average of 21

Which funds make sense for europhile investors?

Most financial assets tend to revert to mean over the long-run. So if you think European equities will do the same, you might consider investing in a broad selection of them via a tracker fund (see Tracker Funds, below). Alternatively, you could take on more risk in the hope of bigger rewards by choosing a fund that focuses on companies in one of the PIIGS countries, on the basis that today’s most depressed markets could offer tomorrow’s biggest gains.

The PIIGS stock markets all have CAPEs of 10 or less, and Gardiner says he likes the look of them as high-risk plays. “Risk appetite globally will improve over the year as a whole,” he says, “favouring the higher-risk continental European indices.” However, it should be remembered that these countries also have terrible fiscal constraints, and may therefore be risky places to invest.

Trackers are useful because they provide a cheap way to gain exposure to a market, but that doesn’t mean you should ignore actively managed funds. Indeed the complex situation in Europe today is particularly suited to funds that pick stocks to exploit certain themes. For example, you could consider a fund that focuses on high-quality European companies that derive much of their earnings from outside the Eurozone. “The European corporate sector will be supported by overseas earnings in faster-growing Asia, Latin America and the US,” Gardiner says.