TAKE NOTE COVER STORY - continued
INVESTING IN EUROPEAN COMPANIES
Europe's economic challenges are just one factor portfolio managers and their teams consider when building a diversified portfolio. They continue to focus on stocks that have the best long-term potential. In the current environment, that means avoiding banks in southern Europe, while selectively choosing banks with strong balance sheets and low loan default rates in northern Europe. The current slowdown has also prompted the managers to shift sector allocations. Last summer, for example, Tenerelli says he reduced some consumer staples and industrials and business services stocks.
"As long as the rest of the world maintains its growth, we think there will be opportunities in northern Europe, and indeed, that's the way my portfolio is skewed," says Raymond Mills, portfolio manager of the T. Rowe Price Overseas Stock Fund (TROSX), which invests about 36% of its assets in Europe, excluding the United Kingdom. At the end of September, the portfolio had little exposure to Italy and Spain. Its top European country holding was Germany, at 10.2%.
Metrics. Tenerelli and Mills note that geographic distribution isn't the only quality they seek. Other key factors include a company's valuation, export markets, management team, and corporate governance. One advantage resulting from the debt crisis is the devaluation of the euro, which makes European exports cheaper on a relative basis to other countries with stronger currencies. Eurozone exports grew in 2011 to some of its highest levels since the formation of the euro area in 1999.3 What's more, an EU study reveals that, since the eurozone's creation, European imports have grown at a far slower pace than imports have in other regions, including the U.S., Asia, and Latin America.
Sectors. Tenerelli and Mills say their portfolios include European companies in sectors—such as business services, consumer discretionary, industrials, and information technology—that export heavily to the U.S., China, Latin America, and Eastern Europe. One of the key engines stoking growth rates is the rapid increase in consumer demand from burgeoning middle classes in Brazil, China, and other Asian countries, including Indonesia and Singapore.
While slower economic growth can dampen the prospects of many companies, the seemingly obvious connection between economic growth in a region and stock market performance is often inaccurate or misleading, according to Mills. He points to several studies showing that there is often no strong correlation between the two, particularly in the short term. "For over 100 years, Japan was the fastest growing economy," Mills says. "It also was one of the worst equity markets. So economic growth and market returns don't always go in lock step." One explanation for the discrepancy, he notes, is that investors often pay a premium for stocks in fast-growing economies, while benefiting from hidden value in slower-growth countries. That, adds Tenerelli, may explain why the valuations of European companies are at a 25-year low.
THE HIGH YIELD MARKET
The search for solid returns does not end with stocks. Investors have sought out fixed income securities that offer higher interest than sovereign bonds.
The market's appetite for corporate bonds is not only a reaction against government debt but a growing recognition of the opportunities in well-run companies with solid balance sheets and a high probability of repaying debt.
The search for higher yield—and potentially higher returns—has led many investors to the European high yield market, says Michael Della Vedova, manager of the T. Rowe Price European high yield strategy. These bonds typically represent a small allocation in several T. Rowe Price funds, including the Strategic Income Fund and the International Bond Fund. High yield bonds can be a volatile asset class, and investors should consider incorporating them as part of a diversified portfolio that meets their long-term investment goals.
The European high yield market has grown by 140% since 2008, as many European companies have been unable to refinance existing loans amid the continued process of bank deleveraging. In fact, Della Vedova says high yield issuance in Europe is accelerating faster than in the U.S. "You're seeing an increasing number of multinational companies participate in the European high yield market," he says.
Della Vedova and T. Rowe Price's global credit analysts believe the European high yield market has also become more diversified. "While European high yield 10 years ago was dominated by lower-rated bonds, the market today has a higher-quality profile," he says. Default rates have also decreased, to just 1.1% in 2011, compared with 2.3% in the U.S. This is clearly reflected, he says, in a broader set of industries in the high yield market that produce tangible goods, which are easier to assess than service-oriented companies.
The European debt crisis likely will create more challenges, even as the region makes significant progress in addressing its complex set of fiscal problems. Just what form the eurozone takes in the future is not certain, but the risk-aware and long-term approach of investment professionals—one based on fundamental research and careful security selection—will continue to provide solid long-term investment opportunities for investors.
Investing overseas holds special risks—political uncertainty, unfavorable currency exchange rates, and to a lesser degree, market illiquidity. Diversification cannot assure a profit or protect against loss in a down market.
1, 2 The World Bank.