Slow growth in Europe, says Iain Morse has masked some good opportunities
Whatever happened to Europe? In the late Nineties, European unit trusts were top performers but have since lagged behind UK ones. And the economic news from France and Germany is lacklustre. Last week, German unemployment topped five million, out of the 38 million eligible to work, the highest total since 1933, and French unemployment is running at 10 per cent. Growth in the big European economies is low, and labour market reform slow.

"This may be true, but the valuations put on many European equities currently make them look cheap by comparison with UK or US equivalents," opines Dino Fuschillo, a European fund manager at Martin Currie Investment Management. Large-cap European shares, including multi- nationals, are valued at an average of 12 times estimated earnings for 2005. And there is room for further rationalisation in the single-currency zone.

"Merger and acquisition, the formation of new Europe-wide companies will continue," he adds, "and this creates opportunities for investors."

Despite low economic growth in the main euro-zone economies, many companies are enjoying high free cash flows. Why are these important? "They allow companies to reward their shareholders," says Stewart Fraser, director of European equities at Standard Life, "to buy back stocks and strengthen balance sheets." Free cash flows are calculated by deducting a company's capital expenditure from its operating cash flow, much of which should be made up from the company's sales. All that free cash has resulted in an average dividend yield of 2.8 per cent from the 500 largest companies in the FTSE Europe (ex UK) Index. This dividend level is higher than the interest rate set by the European Central Bank, which remains at just 2 per cent. "In other words," Fraser adds, "investors can get a high yield and the prospect of capital growth by buying equities." But both Fuschillo and Fraser agree on the need for careful stock picking in these markets.

There are also broader, longer-term arguments for Europe. They spring from the dramatic process of equitisation of the last 10 years. Equitisation is the process by which privately owned companies come to be listed in stock exchanges accounting for a larger and larger share of a country's real economy. Measured over 10 years, to the end of 2004, the market value of UK equities grew from 87 per cent of GDP, to 125 per cent, with the excess 25 per cent accounted for in part by the value of non-UK assets owned by British companies. Meanwhile, in Germany, Europe's largest economy, the same figure for 1994 was 18.3 per cent, increasing to just 38 per cent by the end of 2004. But change elsewhere has been more dramatic. In France, the same ratio increased from 23.9 per cent to 66 per cent; in Italy, from 14 per cent to 42.8 per cent; and in Spain from 21.9 per cent to 60.3 per cent.

"After allowing for share- price bubbles and the like, these figures tell a very persuasive story," says Tony Dolphin, chief economist at Henderson Global Investors. "Europe still has some way to go in equitising assets, and this should provide many investment opportunities." The theory behind this is that undervalued private companies will be sold off to public shareholders, releasing huge value in European mid- and large-cap companies. "The prospect to cheer investors is that of being able to buy shares at less than their long-term value," he adds.

But, as always, there's a catch. Economists are revising their euro-zone growth forecasts down. The consensus for 2005 is 1.7 per cent, much the same as for 2004. Stronger figures were expected but the strong euro, at its highest level against the US dollar for years, is choking off exports. If, however, you are convinced about Europe's prospects, the easy way to invest in it is through a retail fund. As usual, investors face the headache of choosing an out- performing fund. There are 104 in the sector. The best-performing, Schroders' Europe Income, grew by 20 per cent in a year. The worst, F&C's European Prime, grew a paltry 4.8 per cent. European Smaller Company funds fared much better. There are only 14 in this sector, but average growth was 24.7 per cent. The best, Schroders' European Smaller Companies, grew 31.6 per cent.

There are fewer investment trusts investing in European mid- and large- cap stocks, nine in all, but their performance has been strong, with the poorest, Charter Pan-European growing its share price by 20 per cent. The best, Fidelity's European Values trust, has returned a one-year 38 per cent share-price rise, and a 370 per cent rise over 10 years. This trust used to be managed by Anthony Bolton, who still runs Fidelity's successful Special Situations trust, and Bolton-trained current manager Tim McCarron.

Next come five trusts that make up the European Smaller Companies investment- trusts sector. In 2004, these returned an average 39 per cent, with the poorest performer, Henderson European Micro, increasing its share price by 31 per cent. The top performer, TR European Growth, was up 44 per cent. And investors seeking exposure to European private equity might consider Standard Life's Private Equity trust, up by 15 per cent for the year.

So, slow growth or not, there are certainly investment opportunities in Europe.