Profiting From Europe's Downfall

 | Jun 20, 2012 | 5:00 PM EDT
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One of my regular discussions the past two nights -- besides my New York friends bragging about the Mets -- has been Europe. Is it cheap enough? Is it safe enough? What do we buy?

Europe is certainly at, or approaching, Sir John Templeton's point of maximum pessimism. The balance sheet and economy of sun-soaked southern European nations are a disaster, and their more sober northern brethren are reluctant to fund a new party. I have some exposure to Europe though Royal Bank of Scotland (RBS) and Aegon (AEG), but I have always been a fan of buying markets that have collapsed. I usually stick to domestic stocks, but some parts of the world are too intriguing to ignore.

The process of finding cheap stocks in foreign nations is more labor intensive than for U.S. companies. There are some American Depositary Receipts and I will be looking at them over the next few days. I will also be combing the portfolios of international value investors like Tweedy, Browne and Charles Brandes in search for quality ideas. I'll be calling my overseas friends as I look for quality ways to invest in the carnage of Europe. (I'll report my findings here, of course.)

Today, I want to do something that is almost against my nature. I am not a fan of most exchange-traded funds, but this is one instance where they may be useful. I ran a screen this morning looking at European equity ETFs and there may be a long-term opportunity developing. This is a stay-small-and-move-slow trade, but it has promise. I would start with a very small position and add to these names as events push prices down an additional 10% to 20%. I would plan on adding several times, as it is highly likely countries like Spain, Italy and even Germany see substantial price movements over the next year.

The iShares MSCI Spain Index (EWP) leads the list of biggest losers among single-country funds. The shares are down 29% this year and 46% over the past 52 weeks. With a 39% allocation, the fund is a little overexposed to the financial sector for my taste. But much of that is Banco Santander (SAN), a Spanish bank with substantial exposure outside Spain. Communications, industrials and utilities are the next highest sector allocations. Spain has serious financial problems and we will hear more than enough negative news to provide the downside volatility needed to scale into a long-term position in this ETF. Spain has been around for centuries, and I expect it to be here for at least a few more years. Trading at 8x earnings and less than 70% of tangible book, the Spanish ETF has enormous upside when Europe finally gets back on track.

It will come as no surprise to anyone with cable TV or a newspaper subscription that Italy is the second-worst performer. The iShares MCSI Italy Index (EWI) is down more than 15% year to date and 43% over the past 12 months. The same combination a weak economy, high entitlements and excessive debt that plagued other southern European nations also weigh on Italy. I am told they will probably need a bailout or other form of financial aid before all is said and done. Like Spain, Italy has been around a while and should be long enough to see a European, as well as Italian, recovery. The biggest sector allocations in the fund are financials, energy and utilities. With a price-to-earnings ratio below 8 and a price-to-book value below 60%, this fund also has the potential for outsized returns if the world does not end in the next decade.

I am not much of a macro guy, but I do know that buying disaster and fear usually works. I also know that prices usually go lower than I think possible before correcting. Be a scale buyer, stay small and move slowly if you invest in the mess that is Europe.

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