The search for the next great eurostars

Europe's economies may be growing slowly, but its markets are heading for a fourth year of double-digit increases. We found six promising stocks.

By Nelson D. Schwartz, Fortune

(Fortune Magazine) -- Americans may drink French wines, drive German cars, and wear Italian suits, but when it comes to buying shares, they prefer to stay close to home. Which is too bad for those who want to keep buying BMWs and bottles of Bordeaux. Because while the recent run of the Dow and the S&P 500 may be generating headlines and cocktail party chatter, the performance of European stocks over the past year has been as good as or better than U.S. equities.

We're not talking about obscure or risky bourses in Montenegro or Moscow. Spain's benchmark IBEX-35 index has returned 32% (as of Dec. 1), while Germany's DAX is up 15%. The S&P, by contrast, has returned 14%, and the Nasdaq only 10%. Indeed, as FORTUNE went to press, it looked as if European stocks would finish 2006 with double-digit gains for the fourth year in a row. What's more, even after such outsized returns, those stocks remain cheaper than their U.S. counterparts--trading at 13 times projected 2007 earnings, compared with a multiple of 15 for the typical American stock.

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"We're still seeing more value in Europe than in the U.S.," says Scott Snyder, who manages international funds at Icon Advisers in Denver. "We see a good 20% discount to fair value in Europe, so there's plenty of upside." Another argument for investing in European stocks: Profit margins have room to grow. "American margins are at all-time highs, but European companies are still catching up," says Josh Byrne, lead manager of Putnam's European equity funds.

That doesn't mean investing in Europe offers guaranteed winnings over the next 12 months. Increasingly, says Philippe Brugere, manager of the Franklin Mutual European fund, careful stock picking will be required. "There are some headwinds now, like rising rates and currency risk from the falling dollar," says Brugere. "German exporters are dependent on global markets, so the dollar is a worry." Adds Clas Olsson, manager of the AIM European Growth fund: "While the fundamentals are good, things aren't accelerating as fast as they were earlier in the year. We could be in for a slowdown on the back of a slowing U.S. economy."

To find companies that can thrive even if the broader market falters, we turned to Brugere and Olsson, as well as other managers who have a history of outperformance. That's how we arrived at last year's European picks, up an average of 17%. Our selections this year are drawn from a variety of sectors--from financials and energy to metals and consumer electronics--in order to capture today's most appealing growth opportunities. They encompass the best-performing markets within Europe, such as Spain and Switzerland. They aren't overly dependent on sales to the U.S., so a falling dollar shouldn't have too much impact on earnings. And you don't need a passport or a Swiss bank account to buy them--all six trade as American depositary receipts (ADRs) on the New York Stock Exchange. That means acquiring shares is no different from buying American blue chips like Microsoft or GE. Indeed, because they're traded in dollars, they should provide an additional hedge if the pound and the euro strengthen further against the greenback.

British Petroleum (BP) $68

For Britain's BP, 2006 has been what Queen Elizabeth II once called an annus horribilis. From a pipeline leak that forced the company to close its Prudhoe Bay oilfield in Alaska in the summer to billions in legal claims stemming from a disaster at a Texas refinery, the past 12 months have been an exercise in what analysts call "headline risk." But while those problems have been a major headache for CEO John Browne and have revealed deep management failures at BP's North American unit, the long-term outlook remains solid. The company is still the second largest of Big Oil's super-majors in terms of production (only Exxon Mobil is bigger), with huge untapped reserves stretching from Russia to West Africa to the Gulf of Mexico.

For investors there's a silver lining to BP's stormy year. Despite bumper profits from record oil prices, BP shares have underperformed rivals such as Exxon, Chevron, and Royal Dutch Shell, making the British giant an appealing value proposition. While Exxon is trading at 11.8 times next year's earnings, BP carries a multiple of only 9.8. "At the end of the day, BP has reasonable growth prospects and no longer trades at a premium," says Putnam's Byrne. Meanwhile, BP's multibillion-dollar stock-buyback plan and its 3.5% dividend offer further downside protection. Even if oil prices moderate, says Bear Stearns analyst Nicole Decker, "BP is among the rare few companies that will continue to grow organically at a reasonable cost." Plus, says Decker, 2007 should see a recovery in both the company's image and its financial performance as it puts Alaska, Texas, and other trouble spots behind it. She thinks BP shares could hit $82 by the end of 2007, a 21% gain over the current $68.

Rio Tinto (RTP) $215

Rising oil prices may have grabbed the spotlight in recent years, but they're only a small part of the global commodities boom. Metals have appreciated even faster. Copper has nearly tripled over the past year, as demand from China and other emerging markets has soared. Mining stocks have jumped as well, but few companies are better positioned to benefit than Britain's Rio Tinto. With huge operations in Australia (shares are listed in both London and Sydney), Africa, and the Americas, Rio Tinto expects revenues this year to grow 25% compared with last year's, while profits should finish up more than 50%.

Copper and iron ore account for 75% of earnings, but the company also has valuable exposure to other hot metals, such as uranium. Even better, it has deep reserves, including an interest in four of the world's top ten undeveloped copper projects. Iron ore production is also growing rapidly, says J.P. Morgan analyst David George, which should help earnings even if copper prices cool off. And with a P/E ratio of ten and minimal debt, Rio Tinto is cheaper than such rivals as BHP Biliton, which trades at more than 12 times earnings. George sees a 30% upside in Rio Tinto shares, which have pulled back recently to $215 amid global fears of an economic slowdown.

Credit Suisse (CS) $67

Our next pick, Credit Suisse, is well known in the U.S. as a major player in investment banking, but back home in Switzerland, says Putnam's Byrne, it has long played second fiddle to UBS because of the latter's dominance in wealth management. Now that's changing: Credit Suisse sold its slow-growth insurance business, Winterthur, to AXA for $10 billion this summer and is focusing on its own wealth-management business while boosting margins at its U.S. investment bank. The Zurich giant has also launched an aggressive stock-buyback program, with the goal of snapping up nearly $2 billion of its stock, or 3% of outstanding shares, by next April.

Like our energy-sector recommendations, Credit Suisse is also reasonably priced, trading at 10.9 times forward earnings, compared with P/E multiples of 12.6 for UBS and 11 to 12 times earnings for U.S. investment banks, according to Citigroup analyst Jeremy Sigee. In November, Sigee upped his rating on Credit Suisse from hold to buy, while increasing his target price to $75. With Credit Suisse currently trading at $67--and boasting a 2.8% dividend--you're looking at a potential gain of nearly 15%. Not bad for a typically conservative Swiss bank.

Banco Santander (STD) $18

While Credit Suisse has been refocusing on its core business, Spain's Banco Santander has been riding an expansion wave that has made it the biggest bank in the eurozone. Earlier this year it acquired Britain's Abbey National, boosting an international profile that also includes such rapidly growing Latin American markets as Brazil, Mexico, and Chile. In addition, Santander is thriving because of the boom in its home market, where economic growth over the past ten years has averaged 3.6% annually, nearly twice the rate of other European countries. Morgan Stanley analyst Pablo Beldarrain Santos, who rates Santander his top pick among Spain's banks, expects earnings to jump 25% this year and 20% in 2007.

Despite that kind of earnings growth, Santander remains reasonably priced, trading at ten times projected 2007 earnings, a 10% discount to other banks in Europe. If all that weren't enough, Santander pays a 3% dividend, which analysts expect to rise as profits grow in the next few years. Santos sees an upside of 20% in the shares of this fast-growing bank, which are now trading at $18 for its U.S.-listed ADRs.

Veolia (VE) $66

Although Veolia has been in business in France for more than 150 years, its name may be unfamiliar even to investors who follow European business. Formerly the water-supply and environmental-services division of Vivendi, Veolia was split off and renamed in 2003. Since the split from the entertainment side of the business (which retains the Vivendi name), Veolia has thrived, nearly doubling over the past two years on strong growth in its utility business in France and around the world. In the U.S., for example, Veolia supplies drinking water in Indianapolis and wastewater treatment at Kentucky's Fort Knox. Earnings growth for 2006 is expected to top 30%, while revenues are rising at a 20% rate.

For long-term investors, the appeal of Veolia is that it's a great way to play the growing demand for a commodity that in many parts of the world is scarcer than oil--fresh drinking water. In India, China, and other emerging markets, population growth and environmental pressures offer Veolia tremendous opportunities in areas like water treatment and desalinization. The company already provides water to nearly 19 million people in China and has also won new contracts recently in the Persian Gulf and in Yerevan, the capital of Armenia. Shares of Veolia have rallied since the summer, when management abandoned plans to merge with French construction company Vinci, but HSBC analyst Verity Mitchell still sees 20% upside in the stock, which currently trades at $66.

Royal Philips Electronics (PHG) $37

Our last pick, Royal Philips Electronics, is well known as a maker of consumer products like Norelco shavers, light bulbs (the British royal family recently asked Philips to light Buckingham Palace with its low-energy bulbs), and medical devices such as CT scanners. But on Wall Street, says Franklin's Brugere, analysts have tended to focus on the company's huge but low-margin semiconductor business.

Now in the midst of a turnaround, Philips agreed in August to sell 80% of the chip business to private-equity buyers for more than $10 billion, freeing up cash for higher-margin divisions such as medical devices, as well as an aggressive stock-buyback program. With this transaction, says Brugere, "volatility has been reduced, multiple expansion is taking place, and management is doing what it has promised in terms of restructuring." Wall Street has taken notice: Philips shares have rallied since the August deal, rising from $30 to more than $37, and the company has boosted its multiple to roughly 22 times 2007 earnings. Even so, says Brugere, there's still an upside of 20% as this Dutch giant cuts costs, drives shareholder returns, reallocates capital, and earns new respect from the Street.

feedback nschwartz@fortunemail.com

Six stocks to bet on in Europe From Spain to Switzerland, from water treatment to consumer electronics, here are half-a-dozen European companies that represent the region's most appealing growth opportunities. All six trade as ADRs on the New York Stock Exchange.

Data as of Dec. 1, 2006. P/Es are based on next year's projected earnings. Fortune table / source: Bloomberg

Happy Returns Look Back, Enjoy

It was a good year for European stocks--but an even better one for the six picks from Europe we recommended in the Investor's Guide last year. While the benchmark MSCI Europe index is up 15% in 2006, our group of ADRs notched an average total return of 17%. Two German companies did especially well: E.ON gained 29% on a boom in the European utility sector and the growth in value of its stake in Gazprom, while Siemens jumped 10% as the conglomerate's turnaround shifted into high gear. We think both companies still offer good potential as Europe's biggest economy continues to power ahead. The two Swiss pharmaceutical firms we picked--Roche (up 19%) and Novartis (up 11%)--also remain solid bets, as they are among the best-positioned companies in the global drug industry. Similarly, HSBC (up 19%) is poised for future gains, in part because of its dominance in booming Asia. Although France's Total (up 16%) remains a robust energy giant, this year's pick in the oil patch, BP, seems to offer better value going forward. So now might be a good time to take profits in Total and bet on a comeback from BP.

* From Jan. 3, 2006, to Nov. 29, 2006. Fortune table

Spain's IBEX-35 index has returned 32% this year. other european exchanges are also hot.

" Germany's dax is up 15%.

" France's CAC 40 is up 15%.

" The FTSE 100is up 11%. Top of page