Why Europe Still Deserves a Place in Your Portfolio
Rachel Koning Beals

Reasons long-term investors should look past the European region's short-term struggles

Europe might seem too treacherous for investors just now. The region's broader stock market is down more than 20 percent so far this year. The near-term fate of debt-strapped Greece, Spain, Italy, and Portugal and the impact of their fragile condition on the regional, and even global, banking system is not yet clear.

But some asset allocation advisers and fund managers believe there is a place for European exposure in a diverse portfolio that can tolerate at least some level of risk, particularly if investors look past the current situation and focus on company fundamentals and valuation.

Select European multinational companies, like their U.S. brethren, stand to benefit from emerging market demand for their goods and services. Emerging markets are expected to lead this global recovery, outshining the established economies that remain bogged down by debt as well as consumer and business spending hesitation.

Analysts aren't ignoring Europe's troubles, but they find a different story in the details. Even the Greek situation, as risky as it seems currently, is likely to be handled in a controlled way. That's particularly true given the lessons learned from the Lehman Brothers failure and ensuing 2008 credit crisis, says Jonathan Bergman, certified financial planner and vice president at Palisades Hudson Financial Group in Scarsdale, N.Y. He expects an orderly restructuring for Greek debt, which he admits might include an actual default.

"Financial markets fear a domino effect, in which there's a 10-domino lineup, with the first domino Greece and the 10th domino a global depression," Bergman says. "It's true that it takes a bit of chaos to get government leadership to act, but they will act -- before the 10th domino falls. The market is trading as if we're already past the fourth or fifth domino; we're not there yet."

Focus remains on limiting the spread of certain European Union member debt burdens throughout the banking system. The Financial Times reported in early October that European Union finance ministers are examining ways to coordinate recapitalizations of financial institutions after agreeing that additional measures are needed.

There has been some disagreement over the level of help that should be given to countries that have run up steep debt tabs; Greek's austerity measures have fallen short of the expectations among some of its regional peers.

Germany, the strongest eurozone member financially, has a powerful incentive to stay in the group, Bergman points out. The relative weakness of the euro due to weaker eurozone economies has helped make Germany, with just 82 million people, the world's second largest exporter, behind China and ahead of the United States. If Germany still had its own currency, its relative strength would hurt exports. It's an argument that has political implications for officials trying to soothe a public upset that they are shouldering the responsibility for Greece's spending extravagance.

It's that export story that leaves Bergman optimistic. He advises putting 40 percent of an international equity portfolio in Europe -- a bit less than most international indices allocate to Europe. Since his firm recommends allocating 35 percent to foreign stocks, that equals 14 percent of total equities in Europe.

Put 70 percent of your European investments in a large-cap European index fund or ETF, he says. That will bring exposure to multinational powerhouses like Royal Dutch Shell, Nestle, Roche and GlaxoSmithKline, to name a few.

Investors should consider adding a slim percentage of small-cap companies, but focus on those with strong exports outside of the European continent. With small caps, active management adds enough value to make it worth the management fee, Bergman says.

He recommends mutual funds such as DFA International Small Cap Value, Oakmark International Small Cap, and T. Rowe Price International Discovery.

Banking sector volatility prompted Oakmark's fund managers to address the issue in an August website posting to their customers. "Like everyone else, we are unsure when the market volatility will end. We believe, however, that our holding of select European financials with strong profitable franchises, formidable balance sheets and very attractive valuations will not only be survivors, but will improve their competitive positioning and build shareholder value," David G. Herro, portfolio manager and chief investment officer of international equities, said in the letter.

"We remain disciplined and are closely monitoring the ever-changing global equity market situation. We are ready to exploit the short-term dislocation in the share prices of quality businesses, no matter the sector they operate in," he said.

Oakmark is focusing on banks with less capital-intensive businesses, such as asset management or advisory. Its holdings also include banks with strong deposit franchises and liquidity, which would have a funding-cost advantage over wholesale-funded banks and be better-positioned during times of crisis. It also favors banks with significant scale and diversification that would allow for a more efficient cost structure.

Other fund managers remain hesitant to tread in the financial sector. "We really haven't owned any banks for quite a while, also because we've always been slightly uncomfortable about really knowing what we are buying when we're buying a bank," Columbia Acorn European Fund's Andreas Waldburg-Wolfegg said in a Morningstar video interview, available on the fund tracker's website.

"And then, secondly, when looking at companies that are exposed to specific drivers and have strong niches, when we go into German companies such as ElringKlinger, the maker of specialist equipment for diesel engines, where they have such strong market shares and where the global recovery in engine growth has been very beneficial for them. So, these are kind of things where we look at individual drivers for individual little companies," he says.

A company-by-company approach and careful placement of European investments among other international choices is advised.

"Don't give up on Europe," Palisades Hudson's Bergman says. "There are great franchises there. But don't over-allocate. You'll want to leave room in your international portfolio for investments in Australia, Canada, and the emerging markets. Those countries and regions have less fiscal debt; some are even running current account surpluses."