The Top PIIGS Stocks On Share Price Potential And On Quality

As an exercise to in relaying our view on the best stocks in the PIIGS equity markets to our clients, we screened the non-financial stocks of these countries that are listed on the Stoxx 600 Index. As our cash return on invested capital framework for European stocks is not yet in place, I used a similar approach but based on figures already available in the Bloomberg Terminal. Remember that our cash return on invested capital framework is built on many specific changes to the accounting data and thus requires a lot of work, something we have not built for European equities yet.

PIIGS stocks with biggest potential are dominated by utilities
Our approach is the ROIC/WACC to EV/IC framework which states that there is an approximately 1:1 linear relationship between the profit spread (ROIC/WACC) and the value spread (enterprise value to invested capital). Based on this assumption, I ran an analysis of the 41 non-financial PIIGS stocks in the Stoxx 600 and the table below shows the stocks with the highest potential.

Fiat (F) has the greatest potential as its enterprise value is currently half of the replacement cost (invested capital) of the business. The catalyst for Fiat is the stabilisation and the return to economic growth in the eurozone. What makes car manufacturers such as Fiat interesting is the implicit leverage on the balance sheet which amplifies returns if things go right.

Another striking observation is that the top 10 list is populated by four utilities. The driver here is not so much their profitability as the fact that on average they only cover their cost of capital by 20 percent. The real driver of their share price potential is their low enterprise value to replacement cost and part of that story has been the expectations of lower long-term profitability which have hurt their share prices (see chart for Eurostoxx 600 Utilities Index since 2011). If you believe improving economic conditions in Europe will take off in 2013 then these utilities could see a rebound in valuation pushing them more in line with their actual profitability spread.

Top 10 PIIGS stocks on quality are dominated by Spanish stocks.

If you are less interested in turnaround and mean reversion cases (which those stocks in the "biggest potential table" are all about) then the next table (below) with the top 10 stocks on quality may be more for you. It provides the 10 PIIGS stocks with the highest profitability spread without taking valuation into consideration. An interesting observation here is that Spanish stocks dominate the table with names such as Zardoya Otis, Tecnicas Reunidas, Inditex, Viscofan, Amadeus IT Holding and Telefonica.

These stocks should be able to continue to grow and will likely perform well in 2013 if they can keep their profit spreads steady.