Stocks and Shares

Italian stocks could implode… Part I

Stand aside! Stock analysts are getting desperate…Italian stocks could implode.

Another day, and another optimistic email lands in the OfWealth inbox. This time trying to convince me that Italian stocks are trading at cheap levels, and I should pile in.

It’s enthusiastically written, and I can see why many people could be persuaded by the arguments. And it’s not the first time in recent months that I’ve seen people making the case for Italy. But something doesn’t ring true.

Don’t get me wrong. I don’t mind optimism. There’s enough doom and gloom around for anyone’s tastes these days. But I prefer realism, especially when it comes to investing. Big claims need to be challenged with a sceptical mind. That’s what being in the OfWealth Thought Club is all about.

With such a high starting P/E it makes that mountain much harder to climb.

A quick check, and I find that the Italian stock market has a price-to-earnings ratio (P/E) of 17.6 and a dividend yield of 3.6%. That’s a decent dividend yield in today’s low yield world. But longer term it’s the capital gains that count for two thirds or more of the profits from stock markets. With such a high starting P/E it makes that mountain much harder to climb.

In simple terms – which are the kind that we like here at OfWealth – a stock’s price can be broken down into two things. These are the P/E ratio and the earnings per share (EPS). Price equals P/E multipled by EPS. For the price to rise you need one or both of P/E and EPS to grow. Or at least one to grow more than the other one falls.

Here’s simple example to illustrate. Let’s say we have a stock with EPS of €10 and a P/E of 17. That means the price will be €170 (10 times 17).

Then let’s say that EPS grows to €15 after five years, up 50%, which is equivalent to 8.4% compound growth a year (where there is growth on the growth). That’s a pretty typical rate for a large and successful company.

If the P/E stays at the same high level of 17 then the share price will also go up by 50% – to €255 (17 times €15). And let’s say this stock yields 3.6% of dividends as well – just like the Italian stock market. Finally the dividend goes up in line with the EPS – meaning the company pays out the same share of profits each year as dividends (also called the “payout ratio).

That would give a total return of 72.5%, before taxes and investment costs. That works out as 11.5% a year, compounded over five years. Sounds pretty attractive, right?

But wait, there’s a problem. The P/E is starting out high. That means it could fall in future. In part two (Italian stocks could implode…Part II)  I’ll explain how that could destroy any chance of future profits for investors.

Until next time,

Rob Marstrand,

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.