The Daily Interview: The Outlook for Europe

The companies we watch and the stocks we own are increasingly exposed to the rewards, as well as the risks, of global reach. Moreover, European companies are moving into the U.S. as competitive players. As the boundaries among U.S. and European multinationals become increasingly blurred, a savvy investor needs to keep abreast of market trends and events outside our borders.

How is the corporate and investing landscape changing in Europe? How has the burst tech bubble in Europe influenced that market and investors? We check in with T. Rowe Price portfolio specialist Kurt Umbarger, who advises Price's European and international funds, for the answers.

Kurt Umbarger Portfolio Specialist, T. Rowe Price

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TSC: How have T. Rowe Price's international portfolios reflected the broad trends in corporate Europe?

Umbarger: The types of companies that we invest in are those in the process of corporate restructuring. This would be true whether we're talking about our (PRITX)International Stock fund, which has about 70% of its assets invested in Europe, or about our (PRESX)European Stock fund, which is 100% invested in Europe.

By corporate restructuring, we mean shedding unprofitable operations, merging businesses to gain scale and global competitiveness, and focusing on profitability and shareholder value. We want to see companies with increasing returns on equity, and this theme cuts across a number of different industries: business services companies such as temporary employment agencies, where Swiss temporary employment firm Addeco(ADO) comes to mind. Compass Group is a more traditional company that's going through a "demerger" to give another example.

While wireless telecoms haven't been the place to be in the last nine months -- and we have reduced our exposure to a neutral level in the sector now -- given the environment and marketplace for wireless telephony, European companies have a cutting edge in this area. Longer term, we think that these companies will have clear global competitive advantages.

TSC: What is your assessment of the market for these stocks, given the recent collapse of telecom, media and technology (TMT) stocks, and disappointments in the third-generation wireless services?

Umbarger: While we're neutral in wireless telephony, we have positions in Vodafone(VOD), Telecom Italia(TI) and Orange. But with regard to technology in Europe, we're overweight. Our view is that valuation is more reasonable now, although I would agree that they are not dirt-cheap.

In some cases, however, there are companies that offer compelling value. We are not of the mindset that expects TMTs to go back to their former levels in the near-term. But in the next one to three years, we think they offer above-average earnings prospects relative to other industries. It has been well borne-out in the media that things were overdone on the upside and are now overdone on the downside.

The debt loads in the telecom sector still present a big concern. It has forced companies to take aggressive action to cut back on capital expenditure. This is the right thing to do, because that really had led up to the sharp downturn in the sector. They overpaid for their licenses and incurred tremendous debt levels. While debt levels remain high, you'll begin to see more companies working harder to leverage and merge their resources to build common platforms, rather than undertaking these projects on their own.

Our view on telecom is shifting to a more positive level, even in comparison with a month ago. We think that a corner is being turned.

TSC: What is your view of the role of the European Central Bank (ECB) on Europe's interest rate environment, as well as the effect of the strength of the dollar against the euro on European stocks going forward?

Umbarger: We would like to see the ECB take more aggressive actions to lower interest rates. They don't have to do it as aggressively as the Fed has done in the U.S., because there are a number of factors in Europe that do not signal that there is as strong a need to cut rates. First, growth will hold up better in Europe than in the U.S. this year. Inflation is running at about 2.6% this year, vs. what the ECB would like to see, which is about 2%.

Because of the amount of leverage that U.S. corporations built into their balance sheet over the past several years, U.S. companies may feel the slowdown harder than their European counterparts. Europe is somewhat insulated in the sense that they don't depend entirely on exports to the U.S.; a lot of trade is done intra-Europe. While the slowing economy in the U.S. will have an impact, it won't be as great on Europe as it has been on some of the emerging markets.

TSC: What is the role of a European fund as a diversifying measure in a well-balanced portfolio? Many European companies tend to be viewed by investors as similar to well-known U.S. multinationals.

Umbarger: It is a fair assessment that there are many global European players and global U.S. players that are becoming increasingly alike. You think of them less as European companies or U.S. companies but more as simply multinationals. For investors who are interested in European funds such as ours, they give you a greater exposure to areas where Europeans have more of a cutting edge. Wireless telephony would be a prime example.

Europe-specific funds also give you a greater exposure to some of the trends that have worked very well in the U.S. in the past 15 years: restructuring, cost-cutting measures, deregulation, greater attention to shareholders, tax reform and pension reform ... All of these have been significant catalysts and drivers in the equity market here in the U.S., but are just now coming to bear fruit in Europe.

That is a very important point for investors to understand. It's not that these trends are not continuing in the U.S. But it is by now a process of diminishing return, since the substantial improvements have been achieved in the system. In Europe, however, these forces will continue to play out for some time. Higher returns on equity will lead to higher profitability for many of the companies there.

Certainly something that has worked against the corporate earnings in Europe has been the euro. While the euro may not appreciate strongly in the near term, it's unlikely that it will fall sharply, as it has done in the past 18 months or so. So the euro will be less of an offsetting factor in corporate returns.

TSC: Which sectors do you consider as attractive long term, and which companies within them are you investing in?

Umbarger: We're looking to invest in growth-oriented companies with reasonable valuation. We're not a value shop. As we've talked about, wireless telephony continues to be an area in which there will be significant growth opportunities, and this will be true more on the wireless side rather than the fixed-line side. Within technology, there will be continued buildout of the Internet infrastructure, where you've seen a steep rise, then a steep fall in many Internet companies. However, the Internet as a market force is here to stay. Those are our broad themes.

In the proprietary semiconductor companies, we see ASM Lithography (ASML) as offering good long-term prospects. In health care, we like GlaxoSmithKline (GSK), which is a large holding in our international portfolios. It presents stable growth with reasonable valuation given their global scale. Vodafone is a perennial holding, which has a great long-term position in the wireless telecom sector. In telecom equipment, Nokia (NOK) is a company that continues to gain market share despite recent market turmoil. The company has been hit by the slowdown in telecom spending but nonetheless remains a favorite within the portfolio.

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