Why Is This Woman Smiling?
Call it the European paradox: The economy may be lukewarm, but the STOCK MARKETS ARE HOT. Here are six companies to bet on.

(FORTUNE Magazine) – Even for adventurous investors, Europe often seems like a better place to vacation than to put money. Indeed, the very things that draw travelers to Paris, London, or Geneva--languorous lunches, quaint neighborhoods where no one appears to be working, museums and high-speed trains subsidized by sky-high taxes--would all seem to confirm the conventional wisdom that U.S., Asian, and Latin American markets offer better prospects.

In this case, though, the conventional wisdom would be wrong. Although Europe has slower economic growth than the U.S. and Asia, its stock markets have left the Dow and the S&P 500 in the dust this year. And companies across Europe are seeing profit growth that would make their U.S. rivals envious. After double-digit returns in 2003 and 2004, European bourses took off again in 2005: Britain's FTSE 100 is up 15%; France's CAC 40 is up 22%; and Switzerland's SMI is up 33%. (The S&P 500, by contrast, is up a measly 4.3%, not including dividends.)

"This has been the great paradox--very successful European equity markets surrounded by a lukewarm economic environment," says Philippe Brugere, manager of the Franklin Mutual European fund, which has scored a 21.5% annual average return over the past three years. "It's the opposite of the U.S."

So why are European stocks so hot? For starters, CEOs have been aggressively restructuring their companies and cutting jobs, despite a hostile political climate and fierce opposition from unions. "The strength in European earnings is the result of a tremendous rise in productivity," says Brugere. "That explains why even though profits are up and stock markets are rising, unemployment is still high. European companies are not hiring, but they're growing."

There are other reasons as well. Knowledge-based industries such as pharma and biotech have invested heavily in R&D and snapped up profitable U.S. assets. Demand from Asia and the U.S. has stimulated export-driven manufacturers like Siemens in Germany and Philips in the Netherlands. Low interest rates and a strong housing sector have enabled banks in Britain and across the Continent to rack up handsome profits. (The benchmark rate in the eurozone is 2.25%, compared with 4% in the U.S., which makes stocks more attractive than competing investments such as bonds or savings accounts.) Finally, valuations remain compelling: European indexes typically trade at 12 to 13 times next year's earnings, compared with 15 times for the S&P 500.

Despite these bullish signs, given the run of the past few years it's unlikely European bourses will see double-digit gains again in 2006, says Clas Olsson, who manages the AIM European Growth fund. Instead, select companies will keep surging, while the broader markets move ahead in a more muted way. To find the crème de la crème of the Paris bourse, as well as winners from the Frankfurt, Zurich, and London exchanges, we spoke to analysts and managers of the best-performing European funds. Our picks are all large caps--they have the wherewithal to take advantage of global growth, while being flexible enough to cope with challenges like the fluctuating dollar and volatile oil prices. Most of the companies trade as ADRs (American depositary receipts) in New York City, so buying them isn't any more foreign than scooping up shares of General Electric or IBM. One trades mainly in Switzerland, but most brokerages or online platforms shouldn't have any trouble accommodating orders.



•Switzerland is better known for its discreet private banks and exquisite watches than for its trailblazing pharmaceutical giants. But the tidy city of Basel is home to both Novartis and Roche, two drug companies showing double-digit earnings gains even as profits at U.S. giants like Merck decline. You may know Roche (ROG.VX, $204) because it's the maker of Tamiflu, one of only a handful of drugs that can treat avian flu. While demand for Tamiflu has, well, goosed Roche's stock (up 63% over the past 12 months), the bigger story going forward is the company's success developing a suite of anticancer drugs, especially Herceptin and Avastin. Herceptin is one of the best therapies available for treating aggressive forms of breast cancer; recent studies also show it reduces the recurrence of tumors in early-stage patients by 50%. Avastin has been shown to both shrink tumor size and extend the lives of patients with colon cancer, and is now being tested on patients with other forms of cancer as well.

These drugs should help Roche's earnings jump by 20% annually over the next four years, says Citigroup analyst Kevin Wilson, compared with 12% earnings growth for other companies in the sector. In addition, Roche owns nearly 60% of Genentech, the U.S. biotech powerhouse, which ought to keep new drugs flowing through its pipeline. "Roche is in the sweet spot in terms of product development," says Andrew Arbuthnott, who manages the Pioneer Top European Players fund in Dublin. Citigroup's Wilson says the stock, which trades mainly in Switzerland, could go as high as $260 next year, a potential gain of 27%.

Roche's neighbor Novartis (NVS, $53) isn't growing as fast, but it has another appealing attribute--valuation. While Roche is trading at 24 times 2006 earnings, Novartis sells for a more reasonable multiple of 17. Yet its growth is certainly respectable. Wilson sees profits rising 16% in 2006 and 13% in 2007. What's more, just as Roche has benefited from its majority stake in Genentech, Novartis is profiting from its relationship with Chiron, another California biotech and a major producer of vaccines. It already owns 42% of Chiron, and this fall it announced it would buy the remaining shares, which should add to Novartis's pipeline. Novartis shares are less volatile than Roche's, and Citigroup's Wilson has set a 2006 target price of $60. That makes it a smart pick for cautious investors who might otherwise reach for the Maalox, another Novartis product.



•When it comes to growth stories, German industrials will never get the heart racing like the Googles of the world. But despite years of recession and slow growth, old-line German companies have done a remarkable job of restructuring. That's why Germany's Xetra DAX is up 25% this year but is still trading at 12 times 2006 earnings.

Our first German pick, E.On (EON, $32), isn't a name most U.S. readers would recognize. But as one of the four major utilities that dominate Germany, it controls about 25% of the domestic power market. And thanks to soaring power prices in Germany, E.On should see profit margins surge. In part, that's because about half the electricity E.On supplies comes from its own nuclear plants, so it can charge more even as its own costs remain flat. What's more, says Dresdner Kleinwort Wasserstein analyst Lüder Schumacher, since German utilities lock in future power sales through forward contracts, E.On's bottom line hasn't yet felt the full impact of the run-up in prices. That should change beginning in 2006. "The stock is extremely cheap, selling at 11 times next year's earnings," says Schumacher, "while the sector is trading at a multiple of 13.9."

Earnings are expected to grow by about 12% annually over the next few years, but the other part of the story is E.On's yield, currently just under 4%. Schumacher predicts that E.On's shareholder-oriented management team will raise the dividend by 25% annually through 2007. "The dividend is on course to double, and I expect E.On's yield to hit 5.9% based on the current share price," he says. Plus, E.On is in the process of selling its multibillion-dollar stake in German specialty-chemicals company Degussa, which will create another payout for shareholders. E.On also owns a 6.5% stake in Russian energy giant Gazprom, which is booming due to high natural gas prices and support from the Kremlin. With Gazprom shares gaining fans in the West, E.On's stake is likely to jump in value. Schumacher thinks E.On's U.S. ADRs could hit $35.40 by mid-2006.

Our second German pick, Siemens (SI, $77), has long been regarded as the General Electric of Europe, making everything from power turbines and rail stock to medical systems and washing machines. But unlike its U.S. rival the German giant also happens to be bloated, with roughly 460,000 employees--50% more than GE, even though Siemens has one-third less revenue and earned only a quarter of the profits GE reported last year. But Siemens has a new CEO, Klaus Kleinfeld, who is determined to restructure the conglomerate. He has already sold off its mobile-phone division, and Siemens's underperforming IT services division may be the next to go. Kleinfeld has also accelerated cuts in headcount and is pressing German unions for efficiency gains from blue-collar workers. That should allow more profitable businesses like power generation and medical equipment to deliver more to the bottom line. "It's a complicated business with a very simple story--restructuring and turning around a very large company," says Franklin's Brugere.

Kleinfeld previously transformed Siemens's U.S. operation from a money-loser to a division earning half a billion dollars a year. But analysts remain skeptical, and the company's shares have barely budged. That means that, like the dogs of the Dow (think of Siemens as a dog of the DAX), there's plenty of upside if Kleinfeld can work his magic. One Siemens optimist, J.P. Morgan analyst Andreas Willi, predicts that earnings will rise 12% in 2006, followed by a 24% gain in 2007. Throw in a 2% dividend, a P/E of 14, and a Morgan Stanley 2006 target price of $88, and you have a tempting turnaround play.



•HSBC (HBC, $81) is truly a globally diversified bank--28% of profits come from Europe, 32% from North America, and 38% from Asia. That keeps earnings steady even if one particular region slows. And the British financial powerhouse, which posted earnings gains of nearly 10% in the first half of this year, is trading at only 11.7 times 2006 profits.

Over the past two years, says J.P. Morgan analyst Roger Doig, shares of HSBC have underperformed the broader market because of fears about the credit quality of the bank's U.S. loan portfolio. Those worries have eased recently thanks to steps taken to manage credit risk, including greater selectivity and charging higher rates to subprime borrowers, says Doig. HSBC is also benefiting from strong growth in Asia and from scooping up a bigger share of the wealth-management business in the Middle East, where petrodollars are filling the coffers of local banks. Plus, HSBC has been a leader in offshoring and taking other steps to control costs. That helps profits grow even if business cools. The imminent retirement of HSBC chairman John Bond, who led the company's global expansion, isn't expected to alter the bank's long-term strategy. Because of its size and diversity, HSBC is a conservative pick, but it's also a dividend champ, with a 4.4% annual payout. Doig says the stock could go as high as $92 next year. Throw in the dividend, and you have the potential for a 17% gain.



•Making money in the oil business these days isn't difficult. With crude at nearly $60 a barrel, you don't need much more than a well and a pump. What's tricky is boosting production--there's not a lot of easy-to-find oil out there--and satisfying Wall Street even if prices decline. Those are among the reasons U.S. giants like Chevron and Exxon are down about 10% from their highs earlier this year. Given the run-up in energy shares, not to mention the recent volatility in crude prices, a better way to find gushers in this sector is to look for defensive plays that will thrive if oil prices remain buoyant but won't suffer as much if they plunge.

France's Total (TOT, $129) is the world's fifth-largest oil company and probably the least known of the supermajors. But its performance speaks for itself: Its share price is up 32% this year, compared with 23.6% for BP and 16% for Chevron. And it has fared better than its American peers in the recent selloff, dropping only 6.5%. What's more, with a P/E of 10.3 based on expected 2006 earnings, Total trades at a slight discount to BP and Chevron, despite comparable earnings growth. Aymeric de Villaret, an analyst at Société Générale in Paris, rates Total as the top stock in the sector, noting that it has "one of the best risk-reward profiles, the highest level of transparency, an attractive valuation, and considerable exposure to refining."

There's more than Gallic pride behind de Villaret's buy rating: In 2006 he expects Total to increase oil and gas production by 3%, followed by an 8% rise in 2007. That should provide a buffer if prices moderate, as will Total's high-margin refining business in Europe. De Villaret believes that its U.S. ADRs could hit $140 by the end of 2006.

That ought to be enough to keep investors smiling.

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