The peripheral economies of the Eurozone – the likes of Portugal, Ireland, Italy, Greece and Spain who, in recent years, have laboured under the unflattering acronym ‘piigs’ – are once more back among the financial headlines. This time, however, it is for purely positive reasons, as the stock markets of the p, the two I’s and the g, if not the s, were each up more than 5% over the first two months of 2014.
Predictably enough, this has caused quite some excitement among certain market-watchers, who have been shouting about how cheap these markets are and how many opportunities now exist for investors looking to take on more risk. Similar commentary has also started to appear in relation to the Russian stock market as tensions with Ukraine have heightened.
Now, out-of-favour and, by extension, cheap markets are obviously natural ponds for the value perspective to fish in but, in this instance, we would urge some caution. Over the last few years, the Eurozone’s peripheral economies have certainly proved happy hunting grounds for contrarian investors and opportunities still exist there. The problem is, the bold and generalised ‘top-down’ statements currently being bandied around often turn out to be a good deal less clear-cut when analysed from the more company-focused, ‘bottom up’ perspective we focus on.
First of all, before getting too excited, would-be investors in peripheral Europe should understand that these stock markets tend to be dominated by a handful of large companies. Around 40% of the capitalisation of the Spanish equity market, for example, comes from three companies – global banks Santander and BBVA and telecoms giant Telefonica, which owns O2.
Meanwhile the top three in Greece account for 37%, in Portugal 41% and in Ireland 52%. By way of comparison, the biggest three stocks in the UK’s FTSE all-share, which is often described as being a ‘top-heavy’ market, have a combined weighting of around 17%.
Very large companies can clearly have a distorting effect on how cheap the overall index looks, as these top-down metrics are normally calculated on a market cap-weighted basis. As a result, what might on the face of it appear to be an index stuffed full of cheap stocks may turn out, on closer inspection, to contain only a few larger companies that look like bargains alongside a lot of other businesses that may not be attractively valued in the slightest.
As a related aside, these markets are also often concentrated in one or two sectors. As an example more than 60% of the Russian market is made up of energy and mining companies, meaning profits are heavily dependant on the prices of oil, gas and other commodities.
A big reason for the apparently rock-bottom price/earnings (PE) ratio of the Russian market is its exposure to these sectors, with developed-market peers also tending to trade on modest PE ratios due to concerns over the long-term sustainability of profits. The fact they are in Russia undeniably adds an additional discount but that is far from the only factor.
Our second point is that, just like any other potential value investment, not everything that looks like a bargain will turn out to be one once work has been done to assess the risks involved. The cyclically-adjusted PE metrics we often refer to, such as Graham & Dodd – while perfectly valid in and of themselves – do not always capture all the baggage that comes with these businesses.
In other words, in the peripheral markets, a lot of companies are still highly leveraged or have other liabilities about which investors need to take care. Telefonica is a notable example of a Southern European business with a lot of debt but it is by no means alone in that across those markets.
So, even if there are plenty of peripheral European businesses that appear cheap on a PE basis at the moment, there may also be very good reasons for that which have nothing to do with where they are located and, when we adjust for high debt levels, things might not look quite so rosy. They may not have risk profiles with which investors feel comfortable and that further decreases an already small pool of opportunity.
Finally, to highlight just how ludicrous sweeping top-down investment statements can be, because of its well-publicised difficulties, Greece is now classed as an emerging market by many index providers. As such – and somewhat ironically – Greek companies are now seen as more attractive than some of the other available emerging market options.
Given the situation in Ukraine, for example, the more benchmark-constrained members of the investment fraternity have suddenly become a lot more interested in owning a Greek telecoms operator, say, than a Russian gas network – and certainly more so than when Greece was considered an ‘emerged’ market and telecoms business alternatives would have included the likes of Vodafone and Deutsche Telekom.
So, yes, there are cheap businesses in Europe but far fewer than there were a year ago. After all, the very reason this subject is making headlines is because, as always, most of the really interesting stocks have already been bid up and generated eye-catching returns. Now, in order to identify cheap businesses, investors need to look harder and be much more discerning than the current press coverage would have people believe.