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Market Update

Buy Europe?

Investors need to ask themselves if attractive valuations in the region trump the negative news.

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After several years of recessions, default threats, austerity measures, and more, Europe remains as fragile as ever. In 2016 alone, we've seen the U.K. vote to leave the European Union, a prolonged Spanish election that saw a rise in anti-austerity sentiment, and an Italian prime minister who said he'd resign if a December referendum on constitutional reform doesn't go his way. Throw in continued sovereign debt issues, banking sector worries, and negative interest rates, and you can't help but wonder why anyone would want to invest in the region.

Many investors are staying away from Europe. According to Alina Lamy, a senior market research analyst with Morningstar, international funds, of which Europe accounts for a substantial portion of assets, have seen just $2.6 billion in net inflows between January and the end of September, compared with $191 billion in inflows over the same time period in 2015. Since April, though, these funds have experienced $17 billion in net outflows.

"Undoubtedly, the sentiment toward European equities is pretty negative," says Andrew Clifton, a portfolio specialist at T. Rowe Price, which runs  T. Rowe Price European Stock (PRESX), which earns a Morningstar analyst rating of Bronze.

As Clifton sees it, Brexit sent many investors rushing for the exists, while the Italian referendum is keeping them away. It doesn't help that Europe is made up of a number of countries, each with its own issues and elections. Any negative headline in any one nation tends to make investors worried about Europe as a whole. "Investing in Europe always leaves you open to these kinds of headlines because these are democracies and they all have political cycles," Clifton says.

When it comes to investing, though, negative headlines often translate into buying opportunities. But is that really the case in Europe? There are a number of attractively priced stocks to choose from, but short-term sentiment changes and ongoing political risks may make for a rocky ride.  

More Growth Than It Seems
Overall, the European market is cheaper than it has been in a while. The MSCI Europe is trading at a forward price/earnings ratio of 17.5, which is lower than its historical average of 19.5 times earnings and below where many U.S. stocks are trading. Part of the reason for the lower valuation, though, is that corporate earnings have been depressed for some time--they're about 35% below the level they were a decade ago--in large part because of the oil price collapse and the slowdown in emerging markets, says Clifton.

Since earnings typically drive stock performance over time, stock prices should rise if earnings growth picks up. But will these companies grow again? Clifton thinks so. He says that the energy sector and emerging-markets growth headwinds have neutralized, and that while Europe may seem like it's in the midst of a giant mess, economic growth has been resilient, while overseas markets for many of these companies has continued to fare well.

In fact, a number of positive economic indicators in the region are getting lost among the negative headlines, says Bob Johnson, Morningstar's director of economic analysis. The International Monetary Fund estimates that Europe will grow by 1.7% in 2016--higher than the U.S.'s 1.6% growth--and, in October, it upgraded U.K. GDP growth from 1.7% to 1.8%. Europe's industrial production numbers were also up 1.8% year over year in August; home prices climbed by 2.9% year over year in the third quarter; and PMI data rose to 53.3, from 52.6 in September. 

All of this is good news for Europe. "My take is that it continues to do better than expected in terms of economic growth," says Johnson. "But the Europeans have been trying to talk themselves into a recession all year. It seems they are a lot more focused on sentiment indicators and brush off hard data that looks better to us."

An Undervalued Market
It's that negative sentiment that's keeping prices low and allowing investors to find undervalued opportunities, says Steve Caruthers,  an equity investment specialist at Capital Group, which runs  American Funds International Growth and Income (IGAAX), a Gold-rated fund. Despite some positive economic news, the market is discounting a slow or non-growth economy, "and they have discounted that for the foreseeable future," he says.

Over the last year, the managers of the International Growth and Income fund have been investing more in Europe, says Caruthers. Right now 44.8% of the portfolio's assets are in European stocks, which is below its historical norm of around 50%, but about 2% higher than where it was at this time last year.

While its managers have been mostly buying depressed oil and gas stocks, they do see opportunities in a number of more cyclical industries, like energy and industrials, says Caruthers. "The cyclical side will benefit if we do in fact see a stabilizing Europe and increasing demand from China and the U.S.," he says. The fund's managers are also seeing value in companies that derive revenues from outside Europe--"it's a region full of multinationals," he says--while a number of dividend-paying domestic operations are also on their radar.

Clifton is finding attractively valued companies in the consumer discretionary space, including in media and car-part industries. He's also finding buys in technology and in more value-oriented regulated utilities. He's less keen on consumer-staples stocks, which, he says, have been bid up by dividend-hungry investors.

Investing Ideas
For the investor who's willing to endure some short-term volatility, there are a number of quality stocks in Europe trading at attractive prices.

Several large pharmaceutical companies-- AstraZeneca (AZN),  GlaxoSmithKline (GSK), Novartis (NVS) ,  Sanofi (SNY), and  Allergan (AGN)--are all trading in 4-star range as of this writing, meaning that they are selling below Morningstar's estimate of their fair values. They all also earn wide economic moat ratings, which suggests that they have significant competitive advantages versus their peers.

Other wide-moat European stocks trading in 4- and 5-star range as of this writing include food giant  Nestle (NSRGY) and oil and gas services company Core Laboratories (CLB).

For those would rather buy a Europe-focused ETF than choose individual names,  iShares Core MSCI Europe (IEUR) and Vanguard FTSE Europe ETF (VGK) both earn Morningstar Analyst Ratings of Gold. Each has about 72% of its assets located in four countries--the U.K., France, Germany, and Switzerland. Among mutual funds,  Vanguard European Stock Index (VEUSX) is rated Gold.

Look Long Term
Because of Europe's continued ups and downs, investors are going to have to be patient. In some ways, it does look as though risks are diminishing, though in other ways it looks like they're increasing, says Johnson. It will take at least a year or two to see how Brexit plays out, and a number of presidential, parliamentary, and referendum-related votes over the next year could impact the region in one way or another.

However, high-quality stocks trading at undervalued prices do tend to approach fair value at some point, says Johnson, and there are still good-quality operations in the region.

Clifton does say that the mood could shift at any time--it could suddenly become better or worse. But if you want to be in Europe, and most diversified investors usually do want to put some of their assets in the region, then, based on valuations alone, now could be a good time to get in. "When we look back at this time," says Clifton, "we (may) see that it was a good time to pick up some good-quality franchises at attractive valuations."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.