Lukas Strobl: Southern European stocks have been having a great year. While stocks across the European continent are up about 7% in 2023, Spanish stocks are up 13% and Italy’s FTSE MIB benchmark is up even 18%. I’m here with Morningstar Manager Research analyst Francesco Paganelli.
Now, Francesco, of course, this is a rebound after a very poor 2022, but this Southern outperformance is a year-and-a-half old. Why is this happening?
Francesco Paganelli: Well, indeed there are hot markets, not just for the torrid summer we’re seeing these days, but Italy, Spain, as well as Greece actually are having the best start of the year in a long time. And that’s really a continuation of a trend we’ve seen in the recent past, as you pointed out. So, over the trailing three years through June, the stock markets have actually done better than European or global stocks, which may sound surprising to some observers.
So, why is that? Well, for one, these markets have still a lot to catch up. So, the recent performance should be put in perspective as you’re pointing out. But then, if we drill down to see what were the underlying drivers, there’s one common denominator, which is the extraordinary performance of the banking sector, which has a significant weight in all three markets and thus an outsized impact with many large banks that saw their stock price double over the last year.
Strobl: Now, you say that they have a lot of catching up to do and yet many strategists are seeing clouds on the horizon and uncertainty for equities. So, does this outperformance have room to run or are valuations maybe caught up already?
Paganelli: No one knows really, but there are two things worth noting, I think. So, one, if we look at simple valuation metrics, for example, like the price to earnings multiple, the Spain and Italy markets are still cheap compared to European or global equities, for instance, in spite of the recent rally. But also, there is another interesting point. This market recovery was not driven by flows. If we look at fund flows into the Italy and Spain categories, we see mostly negative outflows actually going back several quarters. And we notice very little interest in these asset classes. Actually, these figures indicate that these markets have largely been ignored. In fact, assets under management in the Italy and Spain categories are basically unchanged relative to where they were in 2013 or 2014. So, basically, a lost decade for these instruments.
Strobl: So it sounds like there could be room to run. Now, if I want to get exposure to this segment, I mean, you are an expert for European funds. Through funds, what is a good way to play Southern Europe at this point?
Paganelli: So, one of the key question is whether you opt for active or passive exposure. Active managers often have the upper hand in these markets because they’re able to find bargains amongst more companies. Whereas passive funds track indexes that are very concentrated in their top holdings. So, to give you a sense, the top 10 companies account for two-thirds of the market or even more in Spain and Italy. But passives also have two big advantages. So, they are far cheaper, especially in Italy where many active funds charge a performance fee. And there’s often a lower mortality rate among passives as well as less risk of disruption. So, a portfolio manager may change shop or have more responsibilities assigned which requires more time spent on ongoing due diligence when you invest, of course, with active funds.
Having said that, our best ideas in the sector are active funds, namely Fidelity Italy whose people rating was recently upgraded to high and Magallanes Iberian Equity which carries a high people and process ratings.
Strobl: Got it. So expert stock pickers can help at this point in time, even though there is broad undervaluation still. Very interesting. Thank you for explaining this, Francesco.
For Morningstar, I’m Lukas Strobl.
