European stocks: Are they worth the investment risk?

By John Waggoner

July 29, 2012

Bargains abound in this world for the brave. You can probably get Syrian beachfront property and Afghan ski resorts for a song.

But bargains aren't worth much if they don't actually appreciate. Currently, you can find plenty of cheap stocks in Europe. Are they worth it? Possibly.

Before anyone gets too excited about cheap European stocks, bear in mind that European stocks are almost always cheap, at least compared with U.S. stocks. Europe has been the Next Big Thing since the Berlin Wall fell.

Right now, however, Europe is the Current Big Mess. Massive government debt in Spain and Italy raises the specter of gargantuan defaults, which could threaten the European banking system and spell the demise of the euro.

The stock market dislikes many things, but it hates the possibility of government default and currency failure. Spain's stock market has plunged 67% the past 12 months, according to MSCI, which tracks international markets. Greek stocks have tumbled 39%, and Portugal's stock market has fallen 38%.

You'd probably be delighted to buy kitchen appliances at 38% to 67% off. But some things deserve to be cheap, and that's where investing in Europe becomes problematic. A $12 oven isn't necessarily a bargain.

One way to measure cheapness, in stock terms, is by looking at a stock's price, relative to earnings. The P-E ratio — price divided by earnings — is one way: Lower is cheaper.

Currently, the Standard and Poor's Europe 350 Index, which measures the stock performance of large European companies, sells for 11 times expected 2012 earnings and nine times estimated 2013 earnings.

Some of the cheapest European stocks are bank stocks, which investors are treating like an irritated cobra. Because the banks are at the heart of the euro crisis, you should avoid them, too. But many consumer and pharmaceutical companies are based in Europe, and they're cheap, too.

Jeff Auxier, bargain-hunting manager of the Auxier Focus fund, loves crises. "We come alive during a downturn," he says. Prices are lowest when investors are the most frightened. The Auxier Focus fund (ticker: AUXAX), beat 98% of its Morningstar category peers the past five years. It's a U.S. stock fund but can go abroad.

His favorite Europe play: Tesco, the third-largest grocery chain in the world (TSCDY). The U.K.-based company is, in part, a play on the rapid urbanization of China and other emerging markets. "Supermarkets can serve that growing mass market," he says.

How cheap? The company's market value is less than the value of the real estate it owns, Auxier says. Tesco pays a dividend, too, and its U.S.-traded shares yield 4.5%.

Tim Hartch is co-manager of Brown Bros. Harriman Core Select fund (BBTEX), another U.S. fund that can go abroad. He likes Diageo (DEO), a British spirits company with operations in the U.S., Latin America and Africa.

Big European pharmaceutical companies also look appealing, Hartch says. He likes Novartis (NVS), the Swiss pharmaceutical company. Novartis also owns Alcon, a leading eye care company.

European stocks have one other component, which can help or hinder U.S. investors: the currency effect. If you own an overseas company and the dollar falls in value, you get a boost from the currency conversion. If the dollar rises, it saps your return.

Suppose you bought 100 euros when a euro was worth $1. Then you dug a hole in the garden at Chateau de Gros Nez and buried your euros.