Why I’m buying Italian stocks

The euro may not exist ten years from now - but Italy will, says John Stepek. And according to this key ratio, it'll be a good bit more expensive than it is today.

Politics matters. If the eurozone crisis has taught us anything, it's that. As we go to press, investors are holding their breath, waiting to see if European Central Bank (ECB) boss Mario Draghi can deliver on his promise to do "whatever it takes to save the euro", or if it'll be yet another case of European leaders over-promising and under-delivering.

However, there's something else that matters more than politics. And that's price. As Russell Napier told Merryn Somerset Webb in last week's issue (we've posted the full, unedited transcript here it's well worth reading, even if you caught the original), things may look bleak now, but eventually you reach a point where equity markets are discounting virtually every scenario bar the very gloomiest.

There was a very compelling illustration of this on Mebane Faber's World Beta blog a few weeks ago. Faber, portfolio manager at Cambria Investment Management in America, writes regularly about the Shiller price/earnings (p/e) ratio, one of our favourite valuation measures.

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The Shiller p/e gives a clearer view of whether markets are cheap or not by averaging out earnings over ten years. This means you don't get fooled by spikes or troughs in earnings driven by ups and downs in the economy.

Faber and his team looked at Shiller p/es for 32 different countries. "We found most cyclically-adjusted p/e ratios (CAPEs) averaged around 15-20, bottomed out around seven, and maxed out around 45." In fact, on only nine occasions (out of around 1,000 total market years' surveyed) did the CAPE fall below five, as measured at the end of each year. Among these was America in 1920 (amid a short-lived but vicious recession), and Britain in 1974 (at the end of a bear market that had seen stocks tank by more than 70% from 1973).

Other examples include Ireland in 2008 (when it looked like the next Iceland) and South Korea during the Asian crisis in 1997. As Faber notes: "Can you imagine investing in any of these markets in those years? Me neither." Yet on average, within a year those markets had rallied 35%. After five years, they were showing compound annual growth rates of 20%.

Why am I telling you this now? Because the most recent example in Faber's list was Greece at the end of 2011. Then the Athens Stock Exchange was sitting at around 680. It's now at around 600, having fallen as low as 476. As of the end of June, the Shiller p/e was just above three, according to Faber. So there's still time to buy while it's cheap.

I've not been brave enough to take the plunge and I'm not sure I will. But I have started buying into the Italian stock market (on a Shiller p/e of seven or so) via the iShares FTSE MIB (LSE: IMIB) exchange-traded fund. The euro may not exist ten years from now, but Italy will. And I suspect it'll be a good bit more expensive than it is today.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.