Stocks And ETFs For An Undervalued Europe

By Matthew McCall | January 25, 2012 AAA

Most investors realize that shares of European stocks and exchange-traded funds (ETFs) have underperformed their counterparts in the United States over the last year. This is due in large part to the sovereign debt issues the region is having that have spread from Greece to Italy. The black clouds that hang over Europe and its stock market remain, but there could be some sun beginning to shine through. (For related reading, see How Countries Deal With Debt.)

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Data compiled by Bloomberg shows that European stocks are the cheapest when compared to the U.S. since 2004. The Stoxx Europe 600 Index trades with a book value of roughly 1.43 versus a book value of about 2.14 for the S&P 500. The reading on the Stoxx has been at least 30% cheaper than the S&P 500 for 69 straight days - the longest such streak since 2004.

Not all Good News
Even though the numbers suggest that European stocks will close the gap with U.S. stocks, there is more to the story. The U.S. gross domestic product (GDP) is expected to grow by 2.3% in 2012 versus a contraction of 0.2% in Europe. This is one reason the U.S. deserves a higher book value.

The stock market bulls, in particular European advocates, will make the argument that European shares are cheap regardless of the GDP number. The counterargument is that growth is a key component in evaluating a regions stock market.

For investors that are willing to put some risky money to work in Europe or fully believe in the numbers, here are a few options. (For additional reading, see The Contrarian Play In Europe.)

European ETFs
The largest European ETF is the Vanguard European ETF (ARCA:VGK) with over $6 billion in assets and an expense ratio of only 0.14%. The ETF is made up of 458 stocks with the top 10 accounting for nearly 23% of the allocation.

The ETF is heavily invested in the U.K. (36.2%), followed by France (14%), Switzerland (13.3%) and Germany (12.2%). It has a price-to-book ratio (P/B) of 1.4 and trades with a price-earnings ratio (P/E) ratio of 11.1. Last year, it was down around 11.5%, but year to date (YTD) in 2012 it is already up nearly 6% and at a new one-month high.

Another option is the iShares S&P Europe 350 Index (ARCA:IEV) that has around $964 million in assets under management and a higher expense ratio of 0.60%. The ETF is also highly concentrated in the U.K. (35.78%) and is followed by France (13.92%), Switzerland (13.26%) and Germany (12.08%). There are a total of 357 stocks that currently make up the allocation.

When comparing the valuations of the two ETFs, it is clear there is on winner. IEV has a P/B ratio of 2.53 and a P/E ratio of 13.9, both much higher than VGK. Performance was nearly identical for IEV, losing around 11.1%, slightly edging out VGK and YTD gained a similar percentage. The lower fees and more attractive valuations have me leaning towards VGK over IEV as the ETF of choice. (To learn more, check out The Benefits Of ETF Investing.)

Stocks
The U.K.-based bank, HSBC Holdings (NYSE:HBC) has been hit hard by the European financial situation, and is currently attempting to rebound as it recently hit a new two-month high. The large financial firm trades with a price/earnings growth ratio (PEG) of only 0.63 and also pays a hefty 4.2% dividend. Technically if it can hold above $40 in the next two weeks it looks as if the bottom was put in during last November.

Siemens AG (NYSE:SI) has nearly doubled since the low of the recession, but recently it has had trouble putting together a move higher. The drop in the past year has brought the PEG ratio down to 0.27 and it pays an attractive 3% dividend. The electronics and electrical engineering company is dependent on the economy and with Europe not seeing much, in any growth it has weighed on the share price. But if the region turns around the stock must be watched.

The Bottom Line
Even though I believe the European shares have a very high probability of outperforming the U.S. market in the next few months to a year, it does not suggest going overboard with the region. There are still many black clouds that hang over Europe that could send the valuations even lower. Remember that stocks that are cheap are attractive, but they can always get cheaper. (Check out, The Importance Of Diversification.)

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At the time of writing, Matthew McCall did not own shares in any of the companies mentioned in this article.

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