The European stock strategy team at Morgan Stanley (MS: 25.29, -0.70, -2.69%) has come up with an interesting way to screen for bargains. For investors with cash to spare, now seems an opportune time to test their methods.
First, a couple of background points: A stock's price-to-earnings ratio is its price divided by a year's worth of earnings per share; the historical average for U.S. companies is about 15. A dividend yield is a year's worth of dividend payments divided by the stock price; the historical average is higher than you might think, close to 5%, but in recent years it has been closer to 2%.
For a given stock, the P/E is almost always larger than the dividend yield, because it divides into rather than by the stock price, and the stock price typically dwarfs the dividend payment and earnings per share. Occasionally, however, a stock's price becomes so battered that its dividend yield ends up larger than its P/E. For example, a stock might come to trade at six times earnings and yield 8%.
That's apparently a promising sign. According to the Morgan Stanley team, an investor who screened the universe of European stocks each month since 1985 would have found about 10,000 instances of the phenomenon, and if they bought shares each time, they would have beaten the market by an average of 28% over the ensuing two years, absent fees and taxes.
Share prices have fallen the world over in recent weeks and last week the euro sagged to a four-year low versus the U.S. dollar (the British pound has slid, too), so American investors have good reason to turn keener on European shares. Here's another reason: Historically, just 0.7% of European companies by stock market value have had dividend yields that are larger than their P/Es, but recently the figure rose to 2.4%, suggesting extreme bargains are relatively abundant.
Below are listed three companies that turned up on Morgan Stanley's recent screen. Each carries that firm's "overweight" recommendation and trades in dollar-denominated form on a U.S. exchange.
Aviva
Dividend yield: 9%
The U.K.'s largest insurer, Aviva (AV: 9.34, -0.26, -2.70%) sells life, home and car policies, pension products and more. The company lost money in 2008 but has since reduced its work force by 19% and last year returned to profitability. Management says the company has about 900 million pounds ($1.3 billion) of exposure to sovereign debt in the south of Europe, an amount equal to just over two-thirds of last year's profit. Greig Paterson of investment bank Keefe, Bruyette & Woods called the stock "cheap, cheap, cheap" in a pair of early May notes to clients, even using an earnings estimate based on "1929-style default assumptions." According to Paterson, the company's rate of cash accumulation suggests future dividend increases are likely.
British Petroleum
Dividend yield: 9%
Is it too soon to look for value in British Petroleum (BP: 36.76, -0.40, -1.07%) shares, considering that oil is still spewing from one of the company's deepwater wells into the Gulf of Mexico? Gordon Gray of investment bank Collins Stewart thinks so, but have a look at his math if you don't. The company generates between $6 billion and $8 billion in free cash in a typical year, has spent $1 billion on cleanup already, and is expected to spend another $3 billion over the next six months, but the company's ultimate liability is "unquantifiable" for now, wrote Gray last week in a research note. Using a $10 billion placeholder estimate, the stock looks 49% underpriced, according to Gray, but a liability of $40 billion or higher would make the stock a bad deal, and such an amount is "within the realms of possibility." The dividend payment is a tricky matter. British Petroleum can easily afford it for now, and the typical tack for a company in its position would be to assure investors that payments are safe, but doing so now would likely draw wrath from the U.S. government.
Telefonica
Dividend yield: 7.2%
Spain's Telefonica (TEF: 53.81, -1.10, -2.00%) has grown faster than many of its European telecom peers over the past decade by pushing into Latin America, which is now its biggest region. The company's mobile revenues in Spain have been weak of late – the result of a sour economy – and a currency devaluation in Venezuela has reduced the value of the company's holdings there. Also, the company recently increased its bid for Portugal Telecom's (PT: 9.93, -0.12, -1.19%) stake in Brazilcel to 6.5 billion ($7.7 billion) euros from 5.7 billion euros; the additional payment would amount to just under 1% of Telefonica's stock market value. Promisingly, profit for Telefonica increased 2% in the first quarter despite the company's challenges, and Iberian Equities, a Madrid investment bank, foresees stronger growth for the company in coming quarters.
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