Getting Bullish On Germany

Ever since European countries buried part of their national identities and combined forces into an economic bloc with a single currency, investors have looked upon the region as a giant sector bet. Getting bullish on, say, Italy made as much sense as getting bullish on Saskatchewan or Maine.

But this year's stock market returns show that investors should take a more nuanced approach to Europe. No, there is little reason to get excited about Italy. Germany, on the other hand, is super heisse.

Germany's benchmark DAX index of 30 blue chip stocks is up 19.7% in euro terms this year, well ahead of France's CAC 40 (up 8.2%), Spain's IBEX 35 (up 6.5%) and Netherlands' AEX (up 12.2%), even after Wednesday's downturn. The iShares MSCI Germany index fund (EWG), which converts returns into U.S. dollars, is up 27.4% this year and 63.5% over the past 12 months, thanks in part to the rising euro.

Nick Nelson, a strategist at UBS, has argued that Europe is in fact a collection of disunited states, where diverging macro-economic conditions creates vastly different investing themes. In Germany, Europe's largest economy, there are two themes working in its favor: economic restructuring and a strong pickup in its exporting might.

Anyone who takes a quick look at Germany's economy can easily understand why its stocks are performing so well. Gross domestic product expanded at a decent clip of 3% last year and is expected to rise about 2.8% this year.

It has restructured to give greater flexibility to its workforce, so that economic output has risen at a faster pace than wages and companies can rely to a greater extent on part-time workers. Even with more offshoring, the unemployment rate has dropped dramatically, from 8% last year to 6.4% in April, according to the International Labor Organization, and domestic consumption has improved.

At the same time, Germany has benefited from the fact that it is recognized as a big producer of sophisticated machinery, which is just the sort of stuff needed in fast-growing China, India and Russia. It has also emerged as a big producer of environmentally-friendly technology, which is being devoured worldwide.

It is not surprising, then, that German manufacturers such as MAN AG and Siemens AG (SI) have been among the country's top-performing stocks, with year-to-date returns of 59% and 41%, respectively.

Analysts are growing more upbeat. According to Merrill Lynch, Germany's earnings revision ratio during the second quarter led the world, at 1.76 (this ratio shows the number of stocks where consensus earnings estimates have risen versus the number where estimates have fallen. A ratio above 1 means that there were more upward revisions than downward revisions, a bullish sign because it shows that analysts are being too conservative with their estimates).

The average earnings revision ratio among European nations lagged at 1.29. Germany also beat the likes of the United States, where the revision ratio was 1.01, and Japan, where it dipped to 0.73.

There is nothing wrong with a broad bet on Europe, of course. But if you want to focus on the region's powerhouse, Germany is the place to be.