Bet on a recovery in Europe

Europe is expected to be the fastest-improving major economy in the world next year. That offers investors some compelling opportunities, says profressional investor Greg Bennett. Here, he picks six stocks to take advantage.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Greg Bennett, fund manager at Argonaut Capital Partners.

Europe offers some compelling opportunities, given that it is expected to be the fastest-improving major economy in the world next year.

This presents a very different scenario from the one that has dominated European markets for the last few years, where the emphasis has been on high-quality, internationally exposed businesses. It represents a huge opportunity in domestically-orientated stocks, which have largely been ignored.

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Of these, the construction and banking stocks offer some of the best gearing to domestic growth in other words, if domestic growth recovers, they should benefit the most. Intesa Sanpaolo (Milan: ISP) is Italy's largest retail bank and has been generating profits throughout the recessionary environment. It has made prudent provisions for loan losses, operates with a low degree of leverage, and has surplus capital. Although it is well run, there is further scope for cost-cutting.

As a company, it is well positioned to benefit from Italian growth. To some, this may seem an oxymoron, but UBS estimates that Italy's GDP growth rate will be 0.5% next year versus 1.8% this year. That represents a 2.3% shift, which is easily one of the most rapid changes in growth rates in Europe, and indeed the world. If these predictions are even close to accurate, and Italy does come out of recession, provisions for bad loans will fall meaningfully and profits rise significantly.

Given the bank's current valuation below book value, none of this potential upside seems to be in the share price. When analysing beneficiaries of this expected pick-up in Europe, you need to look at operational gearing, ie, those companies with high fixed costs and low capacity utilisation.

Analysts often underestimate the power of this metric: the construction sector is ripe with examples. Danish-listed Rockwool International (Copenhagen: ROCKB) is a leading manufacturer of stone wool insulation used in both residential and non-residential construction.

Europe accounts for most of its sales. Current utilisation rates across its plants are about 75%, according to DNB Markets, meaning there is plenty of operational gearing to any pick up in volumes (in other words, the company can do a lot more business without having to spend a lot more).

Better yet, Rockwool's main input cost is foundry coking coal, which has fallen in price by close to 20% this year, due to rising supply and slowing Chinese demand. A solid balance sheet has enabled the company to upgrade its plants and to eye expansion in China and America.

These two stocks each have potential for a turnaround in earnings momentum. Britain's housebuilders, on the other hand, should see ongoing acceleration in earnings momentum. After writing down the value of their land holdings and restructuring balance sheets after the downturn, the builders have reaped the rewards of fast-recovering new-build house prices.

But while sales volumes have risen, they are nowhere near the levels needed to satisfy demand. This potential rise in volumes, and hence asset turnover, will act as a powerful further leg to their earnings story. Also, development land prices have hardly recovered, meaning their key raw material cost remains low. The likes of Persimmon (LSE: PSN), Barratt Developments (LSE: BDEV), Taylor Wimpey (LSE: TW) and Redrow (LSE: RDW) should continue to see earnings estimates revised up.

The stocks Greg Bennett likes

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Greg Bennett is a fund manager at Argonaut Capital Partners.