Key Takeaways
- European stock markets have much less tech exposure but a higher concentration in financial and industrial sectors than the US.
- In terms of undervalued sectors, European healthcare and consumer defensive stand out.
- Luxury is one sector where Europe has a competitive advantage that is hard for other regions to emulate.
Many investors may not think about diversifying their exposure while markets are rising. But recent wobbles in AI, to which the US has outsize exposure, have made investors mindful of the downside of overconcentration.
As a region, Europe seems to offer genuine diversification benefits. While exposures to sectors like energy, consumer goods, and utilities are not wildly different across the two regions, technology is where the two differ dramatically. In the US, tech makes up 37% of the entire stock market. In Europe, the number is much smaller at just over 8%, and is dispersed across more than 30 different stocks. Europe’s most valuable stock, chip tool maker ASML ASML, is still just a third of the size of the smallest Magnificent Seven stock.
While Europe is more balanced away from tech, it’s important to remember the tradeoffs this involves. What investors gain in diversification away from tech, you lose in terms of more concentration in sectors like financials and industrials, which together comprise 45% of the European equity market, relative to less than half this level in the US.
European Earnings Growth Has Accelerated
There are diversification benefits to being invested in Europe, where recent earnings growth has also been strong. Despite the Iran war, a spike in inflation, and the threat of rising interest rates, European earnings growth has been accelerating since its nadir in the fourth quarter of last year.
Energy has been a driver of this, with oil majors like BP BP. and Shell SHEL reporting earnings growth of more than 50% year over year in the second quarter, a result of higher oil prices and volatility, which has allowed the trading arms of these firms to generate huge profits.
Including energy, earnings growth across European companies is close to 25%. But stripping out this sector brings growth to around 12%. That is still a strong figure and well above the 6% longer-term average, but lags growth among US peers.
Financial stocks continued to perform strongly, with economic conditions and interest rates hovering at levels profitable for banks. Utility firms are benefiting from capital investment as Europe continues to shift toward renewable energy. Structural growth evident in some areas of the industrial sector drove firms like Siemens SIE in the second quarter, while beleaguered chemicals companies like Solvay SOLB and DSM-Firmenich DSFIR finally caught a break, reporting solid earnings.
The Economic Backdrop is Supportive for Europe
Some investors will point to the relatively buoyant US economy and question whether Europe’s macro backdrop is sufficiently robust to invest there instead.
The US has grown at an average rate of 2.6% over the last three years, a solid rate of growth given the various headwinds the economy faced through this period. European growth was more lackluster over this period, and remains so today: Second-quarter growth was just 0.4%, compared to 1.5% in the US.
Growth is certainly not running at the same level as in the US, but the conditions for improvement are there. Interest rates in Europe remain low, at 2.25%, significantly below those in the US, even after the European Central Bank raised rates in response to the Iran war. Inflation, even after the latest energy-driven spike, sits at just 2.9%. Core inflation, the measure that strips out volatile parts like food and fuel, is even lower at 2.5%.
Where to Find Undervalued European Stocks
Trading at just a 4% discount to Morningstar fair value estimates, Europe is not cheap right now. While US stocks are trading more cheaply, the difference is marginal.
Where Europe gets very interesting, however, is on a sector basis. There are some key sectors in Europe that are not just trading cheaply on an absolute basis but are cheap relative to buying similar exposure in the US market.
Healthcare is a sector that should have been buoyant in the current market, given its defensive qualities and strong growth outlook. In Europe, the sector trades at a 7% discount to our fair value estimate, a discount that has narrowed over the last few quarters. In the US, however, this sector now sits firmly in fairly valued territory, trading at a slight premium to Morningstar’s fair value estimate.
The consumer defensives sector also offers opportunity. Inflation has hit consumers hard since the pandemic, forcing them to downgrade to cheaper, often private-label goods, and indeed resort to simply buying less. Recent earnings from firms like Unilever, however, give cause for optimism, with volumes and pricing slowly etching upward again. This sector trades a modest 4% discount to our fair value estimate in Europe, relative to an 8% premium in the US.
Last year, European stock markets marginally outperformed the US. This marked a turnaround after years of the US thumping Europe when it comes to equity returns. A major driving factor at the time was European defense stocks, which had their best year ever, rising by as much as 75% over the course of 2025.
Proximity to the war in Ukraine, a more fragmented market less reliant on a single client such as the US Department of Defense, all make European defense stocks an attractive place to invest, with structural growth supporting the sector. Recent selloffs, particularly in large names like Rheinmetall RHM and Dassault Aviation AM have created some very attractive opportunities with Rheinmetall now trading at less than half its fair value.
