Five reasons to consider European stocks now

European stocks haven’t exactly lit the place on fire in recent years. If anything, they’ve been more of a long-standing dud. But things around the world are starting to tilt in their direction, and they’re starting to build some heat.

European stocks haven’t exactly lit the place on fire in recent years. If anything, they’ve been more of a long-standing dud. But things around the world are starting to tilt in their direction, and they’re starting to build some heat. Here are five reasons why you might seriously consider adding Europe’s shares into your portfolio now…

Their valuations are cheaper.

No matter how you look at them, European stocks look cheap. Their valuations aren’t simply at the lower end of their historical range, they’re also trading at a steep discount to their US counterparts – and that’s even after adjusting for the different sector mix. In fact, sector by sector, European shares are trading at a discount to their US peers. That gives them a thick cushion (i.e. margin of safety) in the short term and room for repricing in the long term.

European stocks are cheap. Source: Goldman Sachs.

They’re well-positioned to benefit from a pickup in global growth.

European stocks tend to do particularly well when the global economy is growing. That’s partly because they generate about 60% of their sales outside Europe, and partly because their relatively high fixed cost base gives them a lot of operational leverage – meaning that after sales reach a certain threshold, their earnings benefit more than proportionally. With China’s reopening, with global growth appearing more robust than feared, and with Europe having avoided the worst consequences of its recent energy crisis, the continent’s stocks are sitting pretty.

They’re poised to benefit from inflows.

While stocks in other places have benefited from inflows over the past few years, European stocks have mostly seen outflows. In short, they’ve been dumped and shunned by investors. But nothing changes people’s minds faster than a good price rally. So if European stock prices continue to rise, folks might be drawn back to the region and the higher demand might support their prices.

European stocks could benefit from future inflows. Source: Goldman Sachs.

They’ve got GRANOLAS.

While the S&P 500 is dominated by tech-heavy FAAMG firms (Facebook’s Meta Platforms Inc Class A (NASDAQ:META), Amazon.com Inc (NASDAQ:AMZN), Apple Inc (NASDAQ:AAPL), Microsoft Corp (NASDAQ:MSFT), and Google’s Alphabet Inc Class A (NASDAQ:GOOGL) represent 18% of the index), the Stoxx 600 is dominated by GRANOLAS (GSK (LSE:GSK), Roche Holding AG (SIX:ROG), ASML Holding NV (EURONEXT:ASML), Nestle SA (SIX:NESN), Novartis AG (SIX:NOVN), Novo Nordisk A/S Class B (XETRA:NOVC), L'Oréal, LVMH Moet Hennessy Louis Vuitton SE (EURONEXT:MC), AstraZeneca (LSE:AZN), SAP SE (XETRA:SAP), and Sanofi SA (EURONEXT:SAN) represent 23% of the index). These stocks are well-diversified, have relatively strong balance sheets and attractive dividend yields, and have been growing steadily. They’ve also all built wide competitive “moats” around themselves, which make it tough for rivals to puncture their market advantages and allow them to preserve their high margins even in difficult times.

The structural trends may be going their way.

Compared to US stocks, European stocks have a lower exposure to tech and a higher exposure to “old economy” sectors like industrials, materials, and financials. That could play in their favor if key trends like heavy central bank stimulus, deregulation, and stable growth and inflation make way for big government spending, higher regulation, higher interest rates, and higher inflation. In any case, European stocks could bring something more to your portfolio besides US stocks, and help diversify where you’re invested.

Sounds good so far. But what are the risks?

While European stocks may do well even if US stocks stagnate, they’re unlikely to perform well if US stocks are falling. Put differently, expect European stocks to provide diversification when things are going well, but not when things have soured.

The risk of the global economy falling into a recession is also a major risk for European companies, because of their close association with global growth. I personally see this risk as being pretty significant. Over the longer term, a lack of competitiveness and productivity may also limit the upside for companies’ profits in the region.

An escalation in the conflict between Ukraine and Russia, increased political fragmentation, and the risk of stringent regulation are other significant downside risks worth mentioning.

What’s the opportunity then?

If you’ve got a long-term investment horizon, European stocks look attractive: their valuations are low, and they’ve got room for margins to expand and sales to grow – which, as we explained here, is what matters most in the long run. And if the global economy manages to avoid a crushing recession, these stocks might perform strongly over the medium term too. But even more importantly, rotating at least some of your US exposure to European stocks may improve the risk-adjusted profile of your portfolio over time, and make you less dependent on the idea that US stocks will continue performing as well as they have over the past decade.

US investors could consider the Vanguard FTSE Europe ETF, which offers a broad-based exposure to the developed economies of Europe, with a particular focus on the UK, France, Switzerland, and Germany. It’s well-diversified, low-cost, and boasts an attractive dividend yield of 3.12%. European investors could consider the Lyxor Core STOXX Europe 600 UCITS ETF Acc.

Stéphane Renevier is a global markets analyst at finimize.

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