In the last month of 2014, investors have two chief concerns: lackluster Black Friday sales and the sudden collapse in crude oil prices. On the surface, neither of these should be causes of major concern. Retail sales came in lower than expected on the day after Thanksgiving but remain higher than last year when you look at year-to-date figures for 2014. And falling energy prices mean more money available for discretionary spending.
There’s one big problem, however. U.S. stocks are very expensive based on traditional value metrics such as the cyclically-adjusted price/earnings ratio (“CAPE”), and continued robust growth had already been baked into share prices. If the growth that investors had expected fails to materialize, the U.S. market could be looking at a nasty correction.
The best time to make major new equity purchases are when prices are cheap and expectations are low. Any marginal improvement comes as a surprise to Wall Street and provides the impetus for a rally.
These are precisely the conditions in place today in Spanish stocks. Spain was one of the hardest-hit countries in Europe’s back-to-back crises. The 2008 meltdown crippled the Spanish construction and banking industries, and the following Eurozone sovereign debt crisis utterly crushed confidence in the Spanish economy. More than one in four Spaniards-and well over half of Spain’s youth-were unemployed by mid-2012.
Spanish stocks, as represented by the iShares MSCI Spain ETF(NYSEARCA:EWP), collapsed in value. Seven years after peaking in late 2007, EWP is still down by nearly 50% today, before taking dividends into account. At the pits of the Eurozone crisis, EWP was down by fully 70%.
After a thorough thrashing like that, Spanish stocks are now priced to deliver solid returns. Spanish stocks sell for about 9 times cyclically-adjusted earnings (i.e. average earnings of the past 10 years). Meanwhile, U.S. stocks trade at about 25 times cyclically-adjusted earnings. Assuming that stock returns in both markets regress to their long-term averages, this means that Spanish stocks are priced to deliver returns of more than 50% over the next five years. American stocks are priced to deliver returns of less than 7%. And again, those are cumulative returns over the next five years, not annualized.
In my view, these figures actually understate how cheap Spanish stocks are at current prices. Remember, the CAPE takes a rolling 10-year average of earnings. Well, Europe has been in an almost continuous state of crisis since 2008, meaning that earnings have been depressed for roughly seven of those ten years. Yes, earnings were abnormally high going into the bust due to Spain’s housing and finance boom of the early and mid 2000s. But after seven years of jarring economic turmoil, most of those bumper earnings are no longer included in the calculations.
Meanwhile, Spain is slowly creeping into growth again even while Germany and the Eurozone core stumble. Latest estimates have the Spanish economy growing at 1.2% in 2014 and 2.0% in 2015. That may seem modest, but it’s not wildly better than what the Conference Board expects for U.S. GDP growth. The Conference Board expects U.S. real GDP growth of 2.2% for full-year 2014 and 2.6% for 2015.
Now, what makes more sense: To own Spanish stocks trading at barely a third the valuation of U.S. stocks as measured by the CAPE or expensive U.S. stocks with lofty growth assumptions already built into prices? I think you know the answer.
I like EWP as a broad play on Spanish stocks, but I also believe that investors can do well by picking and choosing individual Spanish stocks. I’m currently long Spanish banking giants Banco Santander (NYSE:SAN) and BBVA(NYSE:BBVA) and global telecom operator Telefonica (NYSE:TEF). I’m also long two more exotic plays on a Spanish recovery, REITs Lar España(OTC:LAREF) and Hispania (OTC:HPVBF).
As newly-formed REITs that only began trading this year, book value is a reasonable estimate for the REITs liquidation value. And at current prices, Lar España is trading at a 10% discount to book value while Hispania is trading at a modest 4.7% premium.
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