Watching for European bargains

It's summer 1998.

Mutual-fund manager Adrian Holmes breaks from the pack and sells almost all his stock in high-priced European banks, risking an embarrassing performance ranking if the huge sector soars.

Sure enough, an October flaring in global financial markets transforms the absurdly priced banks into absurd steals. Mr. Holmes and his team at Merrill Lynch EuroFund leap in and buy them by the armful.

"The sector was absolutely decimated," says Holmes by telephone from London. "People thought that everything was going down fast, sentiment was atrocious." Since then, many of those blue chips have ballooned by 100 percent to 150 percent.

The gambit reveals why Holmes's fund has been a leader in European mutual funds over the past 10 years. In the past three years the fund has risen on average by 23 percent.

Holmes and his small team of fund managers have thrived in part because of their flexibility. They seek out value, snapping up underpriced stocks in neglected sectors.

Most important, they shrug off the passions of the herd. "We are least likely to be swayed by what the market is thinking or doing than anybody I know," says Holmes.

Today, for instance, as European and US stock markets hover around record highs, Holmes over the past month has sold a big chunk of equities and raised cash levels of his fund from an average of 2 percent to 24 percent.

Holmes expects Wall Street will eventually tumble because it is more expensive in comparison to bond yields than any time in more than a decade. "All the key drivers of this bull market [on Wall Street] are going in reverse," he says.

Judging from past US corrections, European markets will fall domino-like and cry out for buyers at bargain prices.

"I expect a big fall in the US to lead to a big fall in Europe," he says. "That would be a major buying opportunity," Holmes adds, "because the economic cycle is really just starting here [in Europe], whereas in the US it is putting on a chill."

In both structure and outlook, Holmes's fund appears well poised to jump at bargains. Unlike many of his large counterparts, Holmes runs a lean team that he says is quicker at finding a clear consensus. They work at a common table, exchanging ideas constantly and avoiding the lags that come with occasional meetings.

"The key thing [for the fund's strong performance] is our very different working environment, particularly our very small team," says Holmes. "Instead of decisions made to fit in with meetings," he says, "decisions are made absolutely when they are appropriate."

Rapid decisionmaking gives them much of their edge. "These markets move so quickly that if you don't make the decision on a timely basis you can lose the first 5 or 10 percent" of a surge, he says.

The EuroFund's method for selection is simple: identify an underpriced sector, focus on inexpensive, overlooked "value" stocks within it, and when necessary size up the companies first hand. The method tends to lead it to make bigger bets on particular sectors than its counterparts that follow a European benchmark.

The fund in recently lit on neglected cyclical stocks related to commodities, including producers of paper, steel, and chemicals. "Valuations got down to quite incredible levels," he says. Commodity prices will continue to rise, thereby further lifting these stocks, Holmes says.

But Holmes expects a broad-based equity advance in Europe after a correction triggered by New York. The region's economies "are moving off the bottom quite nicely," he says.

Also, the euro is prompting consolidation across a full range of industries as companies seek greater efficiency and cross-border opportunities created by the new regional currency.

Finally, stock markets should enjoy a steady rise in liquidity as European pension funds, mutual funds, and common investors steadily shift from bonds into stocks in line with allocations by their US counterparts, he says.

Despite some weaknesses in Europe, especially its comparatively inflexible labor practices, Holmes says, "most factors are pointing in the right direction."

How Holmes sizes up European stocks

Identifies and buys inexpensive "value" stocks within neglected European sectors.

Expects US markets to tumble and Europe to follow, creating a "major buying opportunity."

Builds a large cash position to be able to jump at bargains quickly.

Visits attractive companies for a first-hand look when other analysis leaves unanswered questions.