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An Attractive European ETF for Intrepid Investors

Although many risks remain, this European equity ETF offers investors a good way to profit if a recovery gains traction.  

Alex Bryan, 10/29/2013

ETF VGK is one of the best options for investors who believe that this nascent recovery will gain traction. While not for the faint of heart, its holdings are trading at reasonable valuations and may grow faster than their U.S. counterparts as conditions in Europe improve.

The fund invests in large- and mid-cap stocks based in 16 developed European markets, representing most of the investable market. However, British and Swiss stocks account for nearly half the portfolio. While the fund has limited direct exposure to the weakest members of the eurozone, the health of these markets may have a disproportionate influence on its performance. This is the cheapest broad European stock fund with one of the most comprehensive portfolios available. Consequently, it is our pick for passive exposure to European equities and is a suitable core holding. The fund's largest holdings are quality multinational names, such as Novartis NVSdafone VODTotal TOT, and Nestle NSRGY.

European stocks can offer meaningful diversification benefits to U.S. investors. The FTSE Developed Europe and Russell 1000 Indexes were 0.90 correlated over the past decade. The fund offers greater exposure to basic-materials stocks than most broad U.S. funds, which tend to underrepresent them. It also owns more financial-services stocks. While European banks still face significant risks, these stocks may enhance the fund's diversification benefits. Like most international funds, VGK does not hedge its currency exposure. Consequently, it may help hedge against a decline in the value of the U.S. dollar relative to the euro and pound sterling.  

Fundamental View 
Europe has a long way to go to resolve structural imbalances and establish a sustainable growth trajectory. Deleveraging in the public and financial sectors has created a significant drag on the region's growth. Weakening demand for European goods and services has intensified price competition. In order to control costs, firms have laid off workers and cut back on hiring, resulting in an unemployment rate of 11% across the European Union. This high unemployment rate contributes to the vicious cycle of weak demand as consumers cut discretionary spending.

The risk of a prolonged recession, coupled with high and growing levels of government debt, has led to a series of sovereign credit downgrades across the region. Moody's downgrade of U.K. sovereign debt in February demonstrates that even the strongest European countries are not immune. But the possibility of an outright default looks increasingly remote, particularly in light of the European Central Bank's commitment to make unlimited purchases from troubled euro countries that apply for aid.

There are also some signs of improvement. Business activity across the eurozone has expanded for three consecutive months through September, according to Markit Purchasing Manager Index (PMI) Survey data. New business helped drive this growth. Business confidence is also starting to come back. This improvement in demand has helped reduce the number of job losses, though the labor market remains weak. Preliminary PMI survey data for October suggests that the expansion continued this month. Germany has generally held up the best of the major markets, while France, Italy, and Spain remain on precarious footing.

The U.K. has especially shined. According to PMI survey data, the British services sector expanded at the fastest clip in over 15 years during the third quarter of 2013 and posted its ninth month of consecutive growth in September. Sales grew as confidence picked up. Work backlogs increased, and service businesses expanded their payrolls to adjust. The manufacturing and construction sectors are also recovering. September marked the sixth and fifth consecutive month of growth for manufacturing and construction, respectively. Renewed strength in residential construction bodes well for British banks. 

European companies are less likely to enjoy durable competitive advantages than their U.S. counterparts. Of the fund’s holdings that Morningstar equity analysts cover, only 23% by market value carry wide economic moats, Morningstar’s assessment that a firm enjoys a sustainable competitive advantage. The corresponding figure for the Russell 1000 Index is 43%. Perhaps not surprisingly, European companies are also slightly less profitable. Over the trailing 12 months through September, the constituents in the FTSE Developed Europe Index generated a 10.9% return on invested capital, while those in the Russell 1000 Index posted 12%. But the fund's holdings may generate faster earnings growth if demand continues to strengthen over the next few years.

Alex Bryan is an ETF analyst with Morningstar.

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