COLUMN-Be careful fishing for bargain stocks in southern Europe
By Conrad de Aenlle
LONG BEACH, Calif., April 25 (Reuters) - Economic turmoil in Spain, Portugal and other southern European countries has depressed their stock markets to the point where they look downright cheap. But the favorable price-earnings ratios and dividend yields - some in double digits - could be deceiving.
Those enticing dividend payouts could always be cut; many already have been, and woeful growth prospects - the International Monetary Fund forecasts at least a second straight year of economic contraction for Portugal, Spain, Italy and Greece in 2013 - make the low valuations seem justified.
The advice of professional investors such as Harry Hartford, co-manager of the $2.2 billion Causeway International Value Fund , is that if you want to bottom-fish in such brackish waters, be careful what you hook.
"Undoubtedly the markets look cheap based on earnings and dividend yields, but you have to analyze companies case by case to see whether they make sense," said Hartford, whose fund has outperformed the average large-capitalization value fund by about a three-to-two ratio since it was introduced in 2001.
"It would be an unwise move by investors to say they're going to buy a basket of stocks in Italy, Spain, Portugal or Greece."
Some of the investments in his portfolio are turnaround stories that have middling to high valuations based on reported earnings and compared to their apparently cheap neighbors.
The companies he mentioned typically have experienced difficult operating conditions or poor decision-making by executives. Now, their business climate is improving and faults are being corrected. As they continue to recover and profits improve, their valuations will come down, he predicted.
EDP Energias de Portugal SA, for instance, an electric utility that trades at nine times trailing earnings, compared to 7.4 for the average global utility, "has gone through a variety of management missteps over the last decade", he said.
The company took on too much debt, he said, much of it for renewable energy projects that bore little fruit. While Hartford acknowledges the company still is debt-burdened - its ratio of long-term debt to equity is 250.52 percent - he sees management focused on generating cash flow and bringing debt down.
His other selections include Snam SpA, an Italian utility, and Tecnicas Reunidas SA, a Spanish company that builds energy infrastructure such as refineries and power plants.
Snam, at about 16 times trailing earnings, is more than twice as expensive as the average utility stock, but Hartford believes that its 13.3 percent return on equity - profits expressed as a proportion of the company's net asset value - in a sector where ROE is otherwise negative, justifies the high multiple, as does its 6.7 percent yield.
Tecnicas trades at about 15 times trailing earnings, roughly two-thirds the valuation of the energy services industry, and its ROE is 34.5 percent, more than double the industry average.
Hartford points out that the share prices of EDP and Snam have risen around 10 percent in the last few weeks. That makes them "not as undervalued as they were", in his view, but he finds them still to have "fair risk-adjusted returns".
Hartford's selections are heavily exposed to economic conditions in their home countries. Nick Kaiser, manager of the Sextant International Fund, a strongly performing large-capitalization foreign stock fund, would rather own companies that earn money from outside the region.
"There are many companies worth looking at that are based in Italy or Spain but do business in (other) places," he said. These companies often trade cheaply, in his view, because investors are fixated on the addresses of their headquarters instead of their financial results. Avoiding them "just because they're located in Italy or Spain is silly", he said.
An example is Santander. The Spanish bank has extensive interests in Latin America and Britain, and trades at less than 10 times trailing earnings, one-fourth the average valuation of global financial services companies.
Its dividend yield is a whopping 11.2 percent, and "it looks like they'll be able to pay it", Kaiser said, alluding to the dividend cuts that some European companies have inflicted on shareholders.
The research firm Markit reports that over the last four years, there have been 38 dividend cuts or suspensions among the 46 banks in the Eurostoxx 600 Index, which encompasses companies across all of Europe. What convinces him that Santander's payout is safe is its financial strength; it is as well capitalized as institutions like Wells Fargo & Co, he said.
Kaiser also owns and recommends the main Iberian telephone companies, Telefonica SA in Spain and Portugal Telecom , in large part because most of their customers are in Latin America, where he expects stronger economic growth.
Telefonica is dirt cheap, trading at roughly four times trailing earnings, compared to 17.5 for the average telecommunications company, and its return on equity is higher, 19 percent versus 15 percent. One reason it's such a bargain is that the company has suspended its dividend in the interest of shoring up its balance sheet.
The situation is the reverse for Portugal Telecom. It has a much richer valuation - 16.6 times trailing earnings, still slightly below the sector average - and its yield is about 15 percent. "The stock has done quite well as investors have bid it up to get the dividend," he said.
Kaiser holds all three stocks. He said he would consider selling if their valuations rose above those of their industry peers.
John Buckingham, manager of the vaunted Al Frank Fund, a value-focused outperformer, owns Portugal Telecom, too, even though he warns that its dividend might take a hit. He likes the company's management and thinks the 3.38 billion euros ($4.4 billion) on the company's balance sheet leaves it room to sell assets and keep a healthy cash flow.
He plans to hold the stock until it hits $6.35; it closed Wednesday at $5.10. A modest dividend cut "would still leave them with quite an attractive yield", he said, one that he is happy to benefit from while he waits.
Buckingham also holds Eni SpA, an Italian energy concern, and has a target price of $66 for the stock, well above its Wednesday close of $46.57. He says he believes that Eni's low-cost mix of exploration and production projects makes it a true bargain, rather than one of the many southern European companies that just look that way.
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