Walk around virtually any city in Europe, and you'll get a glimpse of deep economic strains.
Many store fronts are boarding up, people are walking the streets with hopes of finding employment and landlords are evicting tenants who are far behind in rent.
Yet, economists increasingly expect the gloom to lift slowly. And if history is any guide, then you want to invest in troubled Europe before the region's economy is back in full force.
This notion hasn't been lost on some investors who are already profiting from increased exposure to Europe. But these investors were mostly focused on the riskiest stocks that appeared to be the most distressed. Many Italian bank stocks, for example, have risen 50% or even 100% since bottoming out last summer.
Focus on stocks and funds that remain near lows, but have a high degree of economic sensitivity. Once investors have become convinced that Europe will indeed exit a recession in coming quarters, then it's the deeply-cyclical (often industrial) stocks that will likely greatly benefit.
Here are three examples...
ArcelorMittal (NYSE: MT)
This Luxembourg-based steel maker derives more than half of its sales from Europe. The deep recession has dealt a double-barreled blow to the company as European auto sales plunge to new depths and commercial building construction grinds to a halt. These two industries are huge consumers of steel.
From a peak of $117 billion in sales in 2008, sales are expected to come in at just $84 billion in 2012. Analysts expect only modest improvements, perhaps to $86.5 billion in sales in 2013. Yet, the tepid top line masks a vastly streamlined cost structure that should start to bear fruit this year.
ArcelorMittal generated a $3 billion free cash flow loss in 2011, and likely a small free cash flow loss in 2012 as well. But analysts at Merrill Lynch say that recent cost cuts and constrained capital spending should enable free cash flow to rebound to $2 billion this year, and perhaps $4 billion in 2014. By the time the European economy is back on its feet in subsequent years, free cash flow could really take off. After all, the company averaged $7.8 billion in annual free cash flow in 2007 and 2008, the last time the cycle was at its peak.
Fiat (Nasdaq: FIATY)
The European auto industry is in brutal shape. Only the German manufacturers have been able to sideswipe the deep sales plunge, thanks to a focus on the high end of the domestic market and exports to the United States. As operating losses mount, European automakers are finally taking action, shutting down excess capacity and rewriting labor agreements. It's a slow process that has only begun to play out, but the industry should emerge from this brutal period in stronger shape.
Perhaps more important, Europe may soon start to see a snapback in car sales. As was the case in the United States when consumers began to replace aging vehicles while our economic downturn receded from view, so will European consumers.
Fiat may be especially well-positioned. Not only could the Italian car market rumble back to life, but Fiat is now generating impressive returns from its investment in Chrysler. How important was that purchase? The roughly $30 billion in sales that Chrysler brought to Fiat replaced a similar-sized hole created by the plunging Italian market for Fiat. In other words, Fiat's reported $83 billion in 2011 sales would have been closer to $53 billion, or a 40% plunge from the 2007 peak.
Analysts expect Fiat's sales to rise to $109 billion in 2012 and to about $115 billion this year. Profits are returning as well. After bottoming out at 28 cents a share in 2012, consensus forecasts call for earnings per share of about 75 cents this year.
Yet here again, the long view is warranted. As the European economy finally starts to grow again in coming years, Italian consumers will need to replace their aging vehicles. By the time that happens, this stock won't be anywhere close to current levels.
A pair of ETFs
Though it's hard to find investors who squarely focus upon European industrial firms, a pair of these types of funds give more general exposure to the region. The PowerShares FTSE RAFI Developed Markets ex-US ETF (NYSE: PXF) and the First Trust Developed Markets Ex-US AlphaDEX ETF (NYSE: FDT) could likely generate strong returns if the European economies can sustain an upturn in coming years.
Risks to Consider: There is always the chance that Europe's economies stumble anew. This would be especially bad news for heavily-indebted companies such as ArcelorMittal and Fiat.
Action to Take --> It's time to start positioning your portfolio for this impending bounce. Europe's possible exit from recession later this year is likely to be met with little fanfare. Companies and consumers alike will still be in a foul mood. But as we've seen with U.S. stocks, investments in troubled areas can start to rally long before the champagne corks have been popped.