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PORTFOLIO STRATEGY - Extreme Makeover

Portfolio managers are profiting from a restructuring of Europe Inc.

These are heady days for investors seeking to capitalize on the massive wave of corporate restructurings sweeping through the U.K. and continental Europe. With legal and cultural resistance to cross-border investment diminishing, merger and acquisition activity has been on a tear (see chart), outpacing deal making in the U.S. lately and helping push European stock markets to six-and-a-half-year highs. As European companies look to improve efficiencies and bolster margins by selling off noncore, low-return operations, portfolio managers are seeking to profit.

“Europe has been a blowout in terms of numbers, and much of that performance has to do with restructuring,” says Sarah Ketterer, CEO of Causeway Capital Management and co-manager of the $5.5 billion Causeway International Value fund. The institutional share class of the large-cap fund posted a 29.94 percent return for the 12 months through June 26, ahead of the 28.45 percent return of the MSCI Europe, Australasia and Far East index but slightly below the average return of international multicap core funds tracked by Lipper.

One of Ketterer’s favorite restructuring plays is engineering conglomerate Siemens. The Munich, Germany–based electronics and electrical engineering company has been aggressively streamlining operations and shedding such noncore assets as electronics assembly, postal automation and airport logistics to concentrate resources on health care, infrastructure and energy.

Siemens was recently hit by a corruption scandal involving allegations that some top managers engaged in bribery. But the company is under new management, led by CEO Peter Löscher, former head of global human health at U.S. pharmaceuticals giant Merck & Co. Ketterer expects Siemens to accelerate its streamlining. “Free cash flow from operations offers plenty of room for greater dividends and share buybacks,” she adds.

Ketterer and her team began buying Siemens a little more than a year ago at an average cost of E75 ($94) a share. At a recent price of E98, her roughly $500 million position, held in the Causeway fund and other accounts, has generated a total return, including currency gains, of more than 60 percent. Causeway’s 12-month price target on the stock is E120.

Deutsche Asset Management’s Oliver Kratz, who runs DWS Global Thematic, a $2.2 billion fund that invests in 12 long-term investment themes, says that virtually every investment proposal that crosses his desk these days is a restructuring play that involves cost-cutting, management changes, mergers, acquisitions or other strategies that demonstrate “a willingness and ability to significantly release value.”

One of his trades, German sportswear firm Adidas, is poised to deliver enhanced shareholder value, he says, if it succeeds in turning around its Reebok unit, which was acquired in August 2005 and suffers from subpar margins.

“If Reebok fails to work, it can always be sold,” says Kratz, who bought a $20 million stake in November at E37.70. With the stock recently trading at E45, his position was up 19 percent, or about 28 percent in U.S. dollar terms, he says.

Bertie Thomson, who helps run the Aberdeen Global European Equity Fund, says that about one quarter of its E100 million in assets are invested in restructuring plays. At 2.2 percent of the portfolio, British American Tobacco is the fund’s largest holding. The company has been steadily reducing its global footprint by selling off many of its cigarette-manufacturing plants.

“The restructuring has helped management improve margins and operating efficiencies,” says Thomson, who bought shares at 591 pence ($9.57) in May 2003. At a recent 1,650 pence, the stock has delivered a 247 percent return, including its generous dividend yield, versus 128 percent for Thomson’s benchmark, the FTSE World Europe index.

Another top-performing restructuring play in Thomson’s portfolio is Germany’s Commerzbank, which has shed most of its international operations. Thomson bought shares at E13.50 in 2004. At a recent price of E36.40, his position is up 170 percent.

Thomson also likes Austrian companies that are driving restructuring efforts in Central Europe. He owns two: Erste Bank, which operates across the region and earlier this year acquired Romania’s largest bank, Banca Comerciala Romana; and OMV, an energy group that owns a majority stake in Romanian oil company Petrom and recently agreed to buy stakes in two of that country’s gas companies. At a recent price of E60.80, Erste Bank is up 14.2 percent since Thomson bought the stock in October. Trading at E50 in late June, OMV has risen 26.5 percent since November, when Thomson purchased the shares.

Rising interest rates and higher bond yields could, of course, deflate Europe’s mergers and acquisitions boom. For now, though, fund managers are reaping the gains — and striving to stay a step ahead of the deal makers before the surge subsides.