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by Tawhid Ali and Jorgen Kjaersgaard

Europe's recovery is becoming reality. In our view, successful investing in the continent today requires a selective approach that exploits dislocations by focusing on return-seeking assets across stock and bond markets.

The worst of the euro crisis finally appears to be over. After the most troubled countries exited recession last year, the recovery is broadening and the euro-area economy is poised to grow by 1.3% this year, according to our forecasts. Manufacturing indicators have turned up, unemployment has started to decline and the regional economic sentiment indicator is above its long-term average.

Of course, there are still risks. France and Italy are lagging, the euro could appreciate strongly and the threat of deflation looms large. On balance, though, we think Europe has shifted from recession and crisis toward modest growth and stability. So how can investors make money-in line with their risk appetite-in this tricky environment?

From Crisis to Stability

We think there are three components to getting it right in Europe today. First, identify the crisis-induced dislocations that persist and have created investing opportunities. Second, consider both stocks and bonds as return-seeking strategies. Third, be meticulous with security selection to avoid companies that haven't yet shaken off their euro-crisis hangover.

European companies are in much better shape than they were before the crisis. They had about €800 billion of cash on their balance sheets in 2012 (the latest data available)-a 36% increase from 2007. Over the same period, debt-to-equity ratios have dropped about 10 percentage points to 48%. And profitability is still subdued, with return on equity stuck at much lower levels than the long-term history (Display, left). This suggests there is ample room for improvement in European companies' earnings growth, yet markets have not fully acknowledged the potential.

Exploit Dislocations in Equity Markets

Indeed, in equity markets, investors still prefer low-beta stocks, which are perceived to be safer than high-beta stocks. As a result, the valuation gap between these two groups remains extremely wide (Display, right).

Meanwhile, stock correlations have continued to decline from elevated levels during the worst days of the crisis. This means that equities are no longer trading in unison to the tune of the market's worst macroeconomic fears. In this environment, we believe the best way to take risk is to focus on stockpicking strategies which use deep fundamental research to find companies that have been neglected by the markets to date- yet have sustainable long-term earnings power that should be rewarded in time.

Focus on High-Yield Debt

Fixed income investors should also take note of improving balance sheet health. As European companies continue to deleverage, their ability to service debt improves. This means that risk premiums are likely to tighten from current levels and default rates should remain low.

This is good news for investors in euro high-yield debt- a market that has grown exponentially in recent years (Display below). And there's more to come, as companies increasingly shift from bank finance to become bond issuers.

As banks recapitalize under the Basel III rules over the next two years, many lenders will utilize the bond market to issue high-yield debt. Separating the wheat from the chaff with careful security selection is essential to generating returns. As more issuers come to market, investors must be even more vigilant in selecting those capable of delivering value.

Outside financials, we would generally avoid BB-rated issuers, where spreads are tight and it's harder to make money. But just a step down the credit scale, B-rated non-financials offer attractive high yields and investors are being more than adequately compensated for the risks.

It's a challenging but exciting time for investors in Europe. By searching across the capital markets and using an active approach, we think investors can find a variety of ways that fit their personal risk appetite to capture the potential of the unfolding European recovery.

Tawhid Ali is Director of Research, AllianceBernstein European Value and Jorgen Kjaersgaard is head of European Credit Portfolio Management, both at AllianceBernstein.

Source: Investing Across Asset Classes In Europe's Recovery