Our Top European Stock Picks

Jeremy Glaser: From Morningstar.com, I'm Jeremy Glaser. I'm joined today by Securities Analyst, Paul Swinand, to take a look at some European stock picks.

Paul, thanks for joining me.

Paul Swinand: Thanks for having me.

Glaser: So what's your first high conviction pick for people who are looking for European stock exposure?

Swinand: The first stock I'd like to talk about is VW, the automotive company. The ticker is VOW. We've recently raised the fair value from €110 to €160, and that's based on our forecast of them making better gross margins. To give you an idea of what's going on with the stock right now. They've recently reported that demand has picked up especially in emerging markets such as the BRIC countries.

For example, demand in Russia was up over 50%. In China, sales were up over 30%. At the same time, the stock has been a little bit depressed because first of all they've been investing more in factories and with the global economic crisis sales and margins have been pressured. So in the last quarter, they actually had 500 basis points better gross margins. We think there's still room for gross margins to improve from here, and so we increased their fair value.

The reason the stock is still trading below their fair value is because there is also some additional headwind priced into the stock for the spring. The European countries have incentive programs for the consumers similar to the U.S. Cash for Clunkers program. Those are going to roll off in 2011. So most analysts are thinking that sales will be down 5% or so in the spring, and so the stocks are still under some pressure based on that expectation. We think even if the stocks are down that much, we think that the extra demand from emerging markets will cover up for that and the improved gross margins will help us well, so we think that VW is fairly undervalued at this point.

Glaser: Another pick that you mentioned was Roche, the pharmaceutical giant. Can you tell us why that stock looks attractively priced right now?

Swinand: Right now, Roche is – we believe that it's a wide-moat stock, and that it is trading like a big pharma that has a big exposure to its patent – its pipeline and its patents. So a lot of big pharmas, if they're out of patents, they don't have any more new drugs and then they lose some of their profitability.

Roche is really focused on their biotech business and a lot of their business lines are much more like a biotech company than a traditional pharma company. So for example, they've got a big oncology division. We think that those are better businesses long term. They'll have more growth and better margins. However, there is again some bad news in the stock in the short-term.

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One of their biggest oncology drugs had a review by the FDA. It's likely to lose its indication for breast cancer. That has hit the stock pretty hard. There is also a diabetes drug, which had a lot of promise, which will likely be abandoned. So it won't come through the pipeline as expected. So those are two big pieces of bad news that are weighing on the stock, right now.

Glaser: Sounds like investing in Europe is like investing in United States, you got to look past the short-term and find the long-term value. Are there any companies that we think just at today's prices, it's just going to be hard for investors to really come out ahead?

Swinand: Yeah. One of the things we're also looking at in Europe is the luxury goods makers, there are three different names which we cover. One is Hermès, we also cover LVMH, and Richemont. All three stocks have been up a lot in the last year due to high sales growth, particularly that in emerging markets such as China, and also just growth from actually Asian luxury tourists.

Now, while the growth looks good and the margins are great, we view them all as narrow-moat stocks, so fairly defendable economic businesses. The stocks have way overrun their long-term growth projections. Particularly for example, Hermès has the highest margins and the highest growth, but right now, it's trading at two times our fair value. So next year as they lap those high growth rates. We'd urge investors to be very, very carefully especially if you are getting in now at very high prices.

At the same time, we would say, take a look at some stocks that maybe have exposure to emerging markets, but haven't had all that growth priced into their stock prices today. One example, I would say would be Adidas. It's trading right around its price to fair value right now, but if they do better than expected in China, if some of their brand like Reebok take off in Russia, perhaps our growth expectations are even a little too low.

Glaser: Paul, thanks for your picks today.

Swinand: Thank you very much.

Glaser: For Morningstar.com, I'm Jeremy Glaser.