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Wednesday, November 6, 2013 - 08:30
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Wednesday, November 6, 2013 - 08:30

The Hottest Market In Europe: Still a Bargain?

Wednesday, November 6, 2013 - 8:30am

With a 23% spike since Labor Day, the Spanish stock market may be the hottest in the world right now.

Considering that Spain has one of the world's highest unemployment rates (exceeding 25%), and that its economy that grew a scant 0.1% this summer, the euphoria is simply unexpected. But investors are often well-served by focusing on distressed assets that may have hit bottom.

In fact, three of the world's richest men (Warren Buffett, Bill Gates and Mexico's Carlos Slim) are taking the plunge. They're not buying Spanish companies because business conditions are good. They're doing it because Spanish assets are quite cheap in relation to both the money that has been invested in them already, and in comparison to other European assets.

News of an emerging Spanish revival among global investors was triggered by a $150 million purchase by Gates' investment firm of Fomento de Construcciones y Contratas (FCC), which is not traded on U.S. markets. The company has cleaned up its balance sheet and diversified its country exposure, but more than half of sales are tied to Spain, mostly in cement-making. Yet Spain, like China, has a massive glut of unsold homes that were built at the height of the bubble, and construction-related plays may not be the safest way to such a rebound.

Indeed any investments that depend on Spanish consumer confidence look risky. High levels of unemployment have been exacerbated by a sharp drop in wages. That's great news for corporate profits, but bad news for consumer spending.

Following the moves of Buffett and Slim is also challenging. They each invested in a set of assets (life insurance policies and bank branch leasebacks, respectively) that most investors simply can't do.

But that's no reason to ignore this opening. That's because in recent years, the Spanish government has enacted tough policies that led to short-term suffering but set the stage for a healthier long-term economic foundation. For example, labor laws have been loosened; provincial and municipal debt loads are starting to come down, thanks to a sharp drop in spending. Other rays of hope:

• Monthly retail sales turned positive in September for the first time in more than three years

• Foreign direct investment (FDI), a key measure of global interest in Spanish assets, is on track to hit 30 billion euros (about $40 billion) this year, roughly twice the levels seen in 2012

• Spanish bond yields are dropping, reflecting higher confidence that the risk of a major financial meltdown is receding.

Meanwhile, Spanish assets remain fairly inexpensive. The average Spanish stock, for example, trades for 1.38 times book value, which is near the bottom of the range of European markets (with Italy being the most inexpensive market). Spain's average dividend yield is also well above the pack.

Still, it's wisest to avoid focusing on any one company (as Gates, Buffett and Slim have) and instead take a broad-based approach. The iShares MSCI Spain Capped (NYSE: EWP) exchange-traded fund is the most popular find targeting the country. This ETF has posted strong gains over the past few months but remains below pre-crisis levels. In contrast, many other global markets have already exceeded their pre-crisis peaks.

Notably, this fund has almost no exposure to the still-beleaguered Spanish consumer (with a zero-percent concentration in real estate and just 5% of the fund tied to consumer cyclicals). Instead, banks and insurers are a big focus (44%) as are industrials, utilities and telecoms (making up another 37%).

According to Morningstar (Nasdaq: MORN), the portfolio is valued at just 4 times trailing cash flow, and the average holding sports a dividend yield of 4.7%. The 0.53% expense ratio is a bit better than the peer group average as well.

Risks to Consider: It's a bit too soon to sound the all-clear on Spain and Southern European laggards. Though signs are emerging that the economy has turned the corner, it will be quite some time before extremely high unemployment levels will come down to global norms, which will create an ongoing drag on government finances and economic activity.

Action to Take --> It's crucial that you take a long-term view. The recent sharp gains for Spanish stocks means that shares could tread water in the near term as traders take some profits off the table. But when you consider that the iShares MSCI Spain Capped ETF has been flat for the past five years, even as the S&P 500 has surged 80%, then it's clear that considerable upside remains over the long haul.

P.S. The average holding in EWP pays a sneaky dividend of 4.7%. For more "hidden" yields, check out our brand-new report on "Hidden High-Yielders." Our research shows that some stocks with reported yields of 1% or 2% actually have "hidden" yields of 6.1%, 7.7%, 10% or higher. Click here to learn more...

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.