Stocks and Shares

Italian stocks could implode… Part II

In part one (Italian stocks could implode…Part I) I started explaining how a stock market like Italy needs some decent earnings growth for investors to make healthy profits. And also that the P/E needs to stay high and not fall in future.

But what if the P/E drops back to say 12 from over 17 today? Let’s continue the example I used in part one.

There we had EPS of €10, growing to €15 after five years, which is an 8.4% compound growth rate. The P/E started at 17, meaning the initial share price would be €170 (€10 times 17).

So if the P/E now falls to 12 from 17, that way the share price would be €180 after five years (€15 times 12). That is up just €10 from the starting price of €170, or 5.9% over five years. This works out as an average gain of 1.1% a year, with compounding.

Then there are the dividends. These would be the same as before, since they are linked to earnings and not to the share price. It turns out that the total return would now be 28.4% over five years, or 5.1% compound rate of return.

…after taxes and costs 5.1% a year would probably not be enough to match price inflation.

This is still positive, but much less attractive than before, when the P/E stayed up. In fact after taxes and costs 5.1% a year would probably not be enough to match price inflation.

So why would the P/E fall in future? Most likely if earnings growth disappoints.

This seems likely to a country like Italy. It suffers a potent mix of high government debt (over 100% of GDP), high unemployment (12% total workforce, 39% youth), weak economic growth (real GDP up just 0.4% in 2012, expected to fall in 2013), inability to decide which comedian should take the political lead (literally), being locked into the dysfunctional euro zone, falling competitiveness on international markets, and neighbouring countries that are stuck in recessions or depressions of their own (most obviously Spain, Greece and Portugal).

Does that sound like a recipe for high earnings growth in future?

Wait a minute! Are we saying that both Italian earnings could disappoint and the stock market P/E ratio could fall? Let’s look at that example again. What if EPS only grows by 5% a year and the P/E falls to 12. What then?

In this example EPS would increase from €10 to €12.76. At a P/E of 12 that gives a share price of €153, meaning a loss from the €170 starting point. Dividends would be lower too, since there would be less earnings to distribute if they are growing more slowly. Overall the five year profit would fall to just 10.4%, or 2% compound. That’s still before taxes, fees and inflation take their bite from returns…

I haven’t even talked about the currency risk either. There is still significant risk that the euro could be broken up. If Italy went its own way, or broke away from Germany with a group of other economically weak countries, the currency could fall sharply.

A quick look at a leading exchange traded fund (ETF) of Italian shares confirms this risk. 30% of the fund is invested in Italian banks and insurers, and 14% in local utility companies (water, energy, electricity). Both these sectors have high exposure to domestic earnings and a falling currency, without even taking account of the other domestic sectors. (And who wants to own Italian bank stocks?)

Italian stock market has another dubious distinction. It’s one of the worst performing stock markets in the world…

One more thing. The Italian stock market has another dubious distinction. It’s one of the worst performing stock markets in the world over the long run.

According to research by Credit Suisse, an investment bank, in the 113 years from 1900 to 2012 (inclusive) Italian stocks returned just 1.8% above inflation. And that was assuming no taxation and full reinvestment of all dividends.

In the 50 years from 1964 to 2012 (inclusive) it was even worse. Italian stocks lost 0.1% a year – again before taxes and with dividends reinvested.

I’ve picked on Italy today, but much the same can be said for most developed country stock markets. The earnings outlook is poor for the next five to 10 years, P/E multiples are already high, and dividend yields are unusually low.

Are you feeling lucky? Well you better had if you are heavily invested in developed country stock markets like Italy. About the only worse things are their bond markets! Your best bet is to look elsewhere for better bargains.

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.