More Than Lipstick?

Opportunities
To find opportunities in economies that are recovering, identify the sectors that respectively drive them.

Financials dominate Spain (47%), Italy (33%) and, to a lesser extent, Greece (19.50%) by market cap. But in Ireland, materials (27%), consumer staples (23%), and industrials (23%) are the dominant sectors. And in Portugal, utilities (26%) and consumer services (23%) make up half the market.

The reason banks were among the worst hit stocks (because of their leverage to the economy and direct exposure to the sovereign debt crisis) is the same reason some investors see them today as among the most compelling plays. The key reason: ECB president Mario Draghi’s pronouncement in July 2012 that the bank would do “whatever it takes” to backstop the region from imploding. Whether correct or not, many investors read this as an “all clear sign.”

Banks were big winners of this commitment, according to Richard Nield, manager of the $1.6 billion Invesco European Growth Fund. They used cash infusions from the ECB’s Long-Term Financing Operations (LTFO) to buy sovereigns, which helped bring down rates and boost the value of their own balance sheets.

As plays on reviving domestic growth, Nield favors large locally focused banks, with market caps of more than €5 billion, as a means of leveraging economic recovery. But he warns that the revival has to involve more than financial engineering. “Without real turnaround in the macro environment,” says Nield, “it’s hard to imagine that we’ll see material improvement in sales growth, operating margins and profits.”

The portfolio manager of the $3.5 billion BlackRock International Opportunities Fund, Nigel Hart, who realized gains of more than 22% last year, also sees opportunity in some of the region’s banks, especially after having seen some trade down as low as 0.5 times their book value. “Banks got badly hit by the sharp rise in non-performing loans and collapsing sovereigns on their books,” observed Hart. “The industry should likewise benefit from improvement as these trends reverse.”

Argonaut’s Norris is also sanguine on the banks. Since the middle of last year, he’s committed 15% of his portfolio to Italy’s Intesa Sanpaolo, Spain’s Bankia, and Greece’s Piraeus. “As new investors, we see substantial upside from restructuring and recapitalization,” explains Norris. “And as non-performing loan provisioning peaks and banks start to shift such assets back into P&Ls, coupled with a larger percent of operating earnings flowing directly into profits, we should then see re-ratings and higher stock prices.”

The portfolio specialist of the T. Rowe Price European Stock Fund, Andrew Clifton, says that despite the recent run-up in Spanish stocks, he still thinks many companies are still trading at a discount to fair value, especially cyclicals, whose recovery potentials still haven’t been priced into their shares. The fund also favors noncyclical utilities Gas Natural Fenosa and Enagas, which continue to offer relatively predictable earnings at attractive valuations, despite both having moved up sharply since the fund purchased them in mid-2012.

The Irish economy, which was the first of the PIIGS to escape recession in 2011 and which Norris almost hesitates to group with troubled Southern European markets for its more aggressive response to difficulties, is home to many large successful enterprises. Argonaut holds a position in building supply manufacturer CRH, which last year enjoyed sales of €18 billion. And since its shares bottomed out in the third quarter of 2011, the stock has more than doubled.

While manufacturing isn’t a lead driver of the Italian economy, Philippe Brugere-Trelat, manager of the $2.8 billion Franklin Templeton European Fund, is keen on the high-end tire maker, Pirelli. Though he’s far from convinced that PIIGS can fly, he likes this global industry leader. This helped the stock power through the euro crisis; it’s up fivefold since the start of 2009. Brugere-Trelat sees further upside as the company expands its presence in the replacement market and anticipates a shareholder structural change when the CEO announces his retirement.