Our Five Favorite European Stocks

As one of Morningstar's equity strategists and the editor of the Morningstar InternationalInvestor newsletter, I currently manage a live portfolio. This portfolio contains five European stocks that are at or near our 5-star rating. In this article, I'll walk you through the an explanation of the business and our thoughts on the growth opportunities for each of these very different firms.

But before I get to the stocks, I would like to say a few things about Europe in general these days. Despite the strong euro and other currencies, most of the economies continue to do well. Although there has certainly been a slowdown in Ireland, Spain, and, to a lesser extent, the United Kingdom, most of the countries are doing well as exports remain surprisingly strong. Many of the companies I'll discuss are benefiting from continued growth in emerging markets, providing products or services without the direct risk of establishing headquarters in these areas.

 BT Group 
Moat: Narrow | Fair Value Uncertainty: Medium | Price/Fair Value Estimate Ratio*: 0.60
BT, formerly known as British Telecom, is the incumbent fixed-line telephone operator in the U.K. This is not a fast-growing stock, but it generates a ton of cash and yields about 7%. The U.K. is perhaps the most competitive telecom market in the world, and BT has lost significant market share since the telecom market was deregulated. It now only supplies telephone service to about 60% of the country, one of the lowest percentages for an incumbent operator in the world. However, this means it has already gone through the worst of the competitive threats of wireless substitution, as well as telephone service offered by cable television firms or broadband providers.  Virgin Media , which has about 99% of the U.K. cable market, has been offering phone service for more than 10 years and only covers a little more than half of the population; new subscriber additions have been limited. Broadband providers have been more successful at attracting phone customers, but they still need to use BT for at least part of their service--therefore, these customers continue to generate some revenue for BT. The costs to service these users falls to the broadband provider, which means the profitability to BT isn't significantly lower. BT itself is the largest provider of broadband services. Growth in this product is offsetting the losses in the fixed-line business.

However, the main growth for the firm is on its enterprise side. BT has one of the most extensive global networks in the world, covering 172 countries. It has been expanding its offerings from just voice services to controlling enterprise customers' entire communications networks. These are often five- to 10-year contracts for hundreds of millions or even billions of dollars during the life of the contract. These contracts initially lose money as additional networks are built out, but they become progressively more profitable over time. Many of these contracts are now in the second half of their lives, which has enabled margins to increase significantly.

 Veolia Environnement (VE)
Moat: Narrow | Fair Value Uncertainty: Medium | Price/Fair Value Estimate Ratio*: 0.67
Veolia, based in France, is the second-largest water treatment and waste treatment company in the world. On the water treatment side, the main business is running water systems for governments in many parts of the world, including joint projects with municipal water systems in the United States. As emerging countries develop, they have an increased desire for clean drinking water, which provides long-term growth for this business. There is an ongoing $1.5 trillion clean water project under way worldwide. The firm also benefits from governments' movements from managing their own water systems to privatizing them. Due to Veolia's excellent reputation, it's often able to secure these contracts as they become available. Veolia also helps businesses by either providing them with specialized water or treating the water the companies use before releasing it back into the public domain.

On the waste management side, again the firm has benefited from the decision of many governments to outsource waste disposal. It is also involved with all aspects of waste management, including urban cleaning services, soil and site remediation, collection, sorting, transfer, treatment, and recycling. As people worldwide become more concerned with the environment, I think this business has lots of growth opportunities.

 Siemens (SI)
Moat: Narrow | Fair Value Uncertainty: Medium | Price/Fair Value Estimate Ratio*: Under Review
Siemens is a large German conglomerate that is one of the largest players in the global infrastructure market. It produces turbines to power the rapidly increasing electrical needs in emerging markets and is involved in the building of plants and the transportation of energy from production to use. It also builds automation and drives that run factories in emerging markets, which turn out products being purchased in both emerging and developed markets. I think Siemens is very well-positioned to continue to benefit from the faster growth in emerging markets for many years.

Besides growth opportunities, Siemens is also in the process of reorganizing itself. It has shed its low-margin handset production business, formed a joint venture with  Nokia (NOK) for its telecom equipment business, and moved into higher-margin businesses, such as health-care machinery. Between the changing mix of businesses and cost-cutting, I expect that the firm will become significantly more profitable over time.

 Novartis (NVS)
Moat: Wide | Fair Value Uncertainty: Low | Price/Fair Value Estimate Ratio*: 0.69
Novartis is a large Swiss pharmaceutical company. The beauty of Novartis is its diversification. Like most of the world's large pharma firms, it has been affected by drugs losing patent protection. However, its other divisions are picking up the slack. Novartis owns the second-largest generic pharmaceutical company in the world, and as branded drugs from Novartis and other firms lose patent protection, this division benefits as it picks up production of many of them. Novartis also has a large vaccine business, an area that many firms have exited. This creates an opportunity for increased profitability for those left, especially as new vaccines are developed. Its eye-care division will expand significantly with the acquisition of  Alcon  from  Nestle (NSRGY) during the next couple of years, and though the price paid was high, the purchase greatly increases the prospects of this division. On the pharmaceutical side, Novartis has recently demonstrated the effectiveness of several new cancer drugs that have exciting long-term potential. This indicates that the pipeline isn't dead, and this big pharma firm still has the know-how to develop blockbuster drugs.

 Thomson 
Moat: Narrow | Fair Value Uncertainty: Medium | Price/Fair Value Estimate Ratio*: 0.28
Thomson, a French company that has undergone a complete transformation, is the most controversial of these stocks. It has exited the consumer products business and turned itself into a software and services provider to the media world. It bought Technicolor in 2001 and has since surrounded it with 20 smaller acquisitions, positioning it to help produce movies. It is also the largest replicator of CDs and DVDs in the world. Although the market has priced this business as if it will disappear tomorrow, the DVD wars are over, and I think the settlement on Blu-ray technology will provide several more years of a profitable, though declining, business.

Thomson also produces set-top boxes. Although its main customer is  France Telecom (FTE) for its broadband and IPTV (Internet protocol television) services, it also sells some to  Direct TV  in the U.S. Its main troubled unit is its broadcast equipment business, which is losing money and will hopefully be sold when markets improve. The big question mark surrounding Thomson is its recent decision to cancel its dividend to save money. In my analysis, it had the money and the future cash flows to maintain the dividend, which may mean there is some need for cash of which I'm not aware.

In conclusion, these five companies have different reasons for their depressed stock prices, but I think this provides a margin of safety, enabling the purchase of some intriguing stocks. Most will benefit from growth in emerging markets, which I think will be faster than developed market growth. Further, by being based in Europe, they avoid a significant dose of political risk.

* Price to fair value estimate ratios calculated as of market close on June 11, 2008.