The Spanish equity market has entered an era of shareholder democracy as domestic investors begin to pile in seeking a higher risk-return profile than they can get from traditional fixed-income investments.
“We were forecasting an influx of Pta585 billion ($4 billion) in new investment in the equity market this year but what we’ve seen in the first five months has already exceeded our estimate,” says Cecilia Planiol, chief economist at Santander Investment. “We are in a situation where for the first time in Spain people feel that low interest rates are here to stay. Hence they are looking for ways to enhance the returns on their investments, and this means switching out of fixed-income instruments into the stock market.”
Most analysts agree that the economic environment could hardly be more favourable for the equity market. Short-term interest rates, now at 5.25%, are closing quickly on German levels and the market is convinced they will continue to drop sharply over the coming months. “In the next 12 to 18 months, Spanish short-term rates will have to come down by almost two points to reach convergence with Germany,” says Ignacio Gomez Montejo, head of equity research at Merrill Lynch in Madrid. “There is widespread confidence that Spain will be among the first wave of countries into Emu [European monetary union] and with the downward trend in rates there is very little scope for any major market correction.”
A record flow of redemptions
Inflation is running at about 1.7% and the Spanish consumer price index is expected to finish the year at slightly over 2%, helping to boost corporate earnings by a nominal rate of 15% compared with 11% in 1996. Macroeconomic figures continue to surprise even the most optimistic analysts, pointing to a further narrowing of the spread to Bunds and a 10-year yield falling to an historical low of 6.5%.
“We feel this is a good time to get into the Spanish market,” says Jerker Johansson, managing director of Morgan Stanley’s European Equity Capital Markets group. “Our view is that it still has upside and one reason for this is the underlying improvement in the economy. We are seeing large transactions for the first time. One or two years ago no-one would have thought of doing a $4.5 billion deal such as the Telefonica privatization. This is confirmation of stronger interest in the domestic market.”
Given this situation, and the fact that Spanish equities have appreciated close to 70% since last year, domestic investors see little sense in holding their savings in traditional money-market instruments. It is hardly surprising that redemptions from fixed-income funds have been flowing into equities at record rates.
“A couple of years ago you could earn 12% on treasury bills and that was considered a highly attractive form of investment,” says Mariano Colmenar, equity analyst at BZW in Madrid. “Taking fees into account, a money-market fund will today earn an average of 3.5%. Spanish investors are used to high returns so they are turning to the equity market and a higher risk-yield profile.”
At the end of 1996 equities accounted for less than 4% of most Spanish investment fund portfolios. They are now nudging 5% and according to most estimates could easily reach nearly 8% by the year-end. There is ample room for growth – most European funds have average equity holdings of 25%. Jorge Calvet, managing director at SBC Warburg in Madrid, estimates that each 1% shift of funds from fixed income to equities amounts to $6.2 billion in added investment in the market.
“We have been witnessing a snowball effect in the market,” says Victor Martinez, head of research at Argentaria Sociedad de Valores y Bolsa. “As soon as one fund manager starts increasing his exposure to equities the rest tend to follow suit. There is a vast pool of savings out there to provide the demand and market liquidity is certain to grow.”
Lower interest rates, a bullish view on Emu and a boom in corporate profits are only part of the story. Prime minister Jose Maria Aznar’s centre-right party, which came to power after last year’s general election, has been greeted with enthusiasm by the market after prolonged political uncertainty under the faltering socialist government. Aznar has accelerated privatization and made strides towards relieving tensions in the labour market.
“A factor in the recent strong performance of the Spanish equity market has been the new law on labour-market reform,” says Pedro Echeguren, an analyst at NatWest Markets in Madrid. “This is the first time that labour-market reform has been achieved through two-way negotiations without the government’s intervention.” The law approved on May 17 encourages permanent contracts and attempts to eliminate friction in wage negotiations. It also reduces compensation awards for unfair dismissals and helps companies to justify fair dismissal cases in court. “This will improve the social climate, dissipate fears and introduce changes beneficial to employers and workers,” says Echeguren. “The frightening alternative would have been for Spain, with 22% unemployment, to lose competitiveness in a growing global market.”
Aznar has also given direct encouragement to equity investment. A former tax collector, one of the first measures he brought in last year was a law setting a 20% capital gains tax ceiling on equity holdings. By comparison, money-market or current-account income computed as part of personal earnings can attract a rate of up to 56%.
Soaking up the paper
This June a massive Pta1 trillion will be released into the Spanish savings market with the redemption of the so-called special debt issued by the treasury five years ago at 2%. These bonds were issued as a type of fiscal amnesty for investors who had evaded income-tax payment. “In view of the favourable tax regime it would be logical to expect that money to go into equity investment funds,” says BZW’s Colmenar.
Domestic demand has been so strong in recent months that it has easily soaked up the paper left by foreign investors who, for the first time in a decade, have been net sellers of Spanish equities. “Foreign funds hold about Pta8 trillion in the Spanish stock market and so far this year they’ve been net sellers of up to Pta300 billion, or some 3% to 4% of their position,” says Merrill Lynch’s Gomez Montejo. “It’s not a vast amount, but we believe this process will continue for the rest of the year. The Spanish stock market is about 5% to 10% more expensive than most European markets and it will remain more expensive.”
Colmenar believes valuation is one of the major problems of the Spanish market. “It is well above fair value, especially if we compare it with the bond market. This is a particularly valid benchmark in Spain given the weight of banks and utilities in the index. If we take the 10-year bond as a reference point, we would extrapolate a current fair value level of 520 to 530 points for the Madrid index, which is already above the 555 level.”
The Madrid stock exchange is now standing on a P/E ratio of 18.7, higher than France and on a par with Germany. “Taking into account the 6.5% level of bonds, with a 4% risk premium and a 7.5% long-term growth level for corporates, 16 would be a sustainable P/E level for the Spanish market,” says Santander Investment’s Planiol.
Foreign funds hold about half the Spanish market’s free float and analysts believe domestic buyers will easily continue to fill the gap for another two or three years. The domestic market’s enormous appetite for equities became apparent this year when in the first quarter alone Spanish investors readily absorbed Pta750 billion in privatization offerings as well as almost Pta150 billion in equity holdings sold by foreigners.
Getting into Latin America
A feature that makes Spanish equities attractive to foreign investors is the ability to get exposure to Latin American markets by way of Spanish companies that are expanding in high-growth markets such as Argentina, Colombia, Peru and Venezuela. “The advantage for foreign investors is the ability to get into Latin America with limited exchange rate risk,” says Argentaria’s Martinez.
“The Latin American factor is quite a positive one,” says SBC Warburg’s Calvet. “It gives the Spanish market a definite relative advantage as Spanish companies can be used as a proxy for investing in the region. Bank stocks, for instance, have not fully reflected their Latin American investments.”
The two top Spanish banks, Banco Santander and Banco Bilbao Vizcaya (BBV), have spent about $5.5 billion buying into Latin American banks and are market leaders in half a dozen countries. The two banks expect Latin American businesses will eventually contribute up to 40% of group profits with an average 20% return on equity. “One of the reasons we favour bank stocks over utilities are the business opportunities they are opening up thanks to their Latin American expansion,” says Planiol. “Spanish companies have a natural language and cultural advantage in the region. Everyone finds Latin America attractive but the big Spanish banks and companies like Repsol and Telefonica have been expanding there for years.”
Oil company Repsol has said that a quarter of its capital expenditure over the next five years will go to Latin America, where its business portfolio ranges from oilfields in Argentina to petrol stations in Ecuador and nearly half of Peru’s liquified petroleum gas market. Telefonica, Spain’s largest company in terms of profits as well as assets, is the largest supplier of telecommunication services in the Spanish-speaking world with more than 10 million lines in service in the region through its subsidiary Telefonica Internacional (Tisa). Analysts say British Telecom’s interest in the high-growth Latin American market was a factor in its forging a strategic alliance with Telefonica and US telecoms company MCI. The Latin American telecoms market is expected to grow to more than $60 billion by 2000 from $36 billion now.
The Spanish government’s decision to accelerate privatization will have a major impact on an equity market whose liquidity has doubled in the first half of this year, with daily turnover averaging Pta120 billion.
“More than 40 companies listed on the Madrid exchange have a turnover of $1 million or more a day and this can be considered an acceptable level of liquidity,” says Merrill Lynch’s Gomez Montejo. This applies primarily to the Ibex 35 index of most liquid stocks, mainly banks, utilities and telecommunications, which account for more than 50% of market capitalization.
The successful exit of Gas Natural
The biggest privatization so far this year was telecoms group Telefonica, in which BBV Interactivos acted as global coordinator. “The Pta600 billion for the final 21% tranche of the company in March was the largest single sale in Spain and it was four times oversubscribed,” says Luis Ruigomez Sanchez, BBV Interactivos’ deputy director. “The state has successfully exited Gas Natural and Repsol so far this year and if there is a common denominator of these three privatizations it is the huge demand shown by domestic investors.”
Spanish investors have routinely taken up some 60% of new issues and in the case of Telefonica they were not disappointed, as returns have increased by about 25% since the previous IPO last October.
Some of the smaller issues have yielded even more impressive returns. Telepizza is up fourfold, while fashion retailer Aldofo Dominguez and hotel group Sol Melia are both showing increased yields of 50% since their listing on the Madrid exchange.
Ruigomez is confident that the next big IPO coming up in the autumn will be readily taken up by domestic investors. The government plans to sell about 33% of electrical utility Endesa for up to Pta900 billion. “The Spanish market is prepared to absorb that issue without problems,” he says.
The most important phase of privatization will come to an end next year with the final tranche of Endesa, the last 25% stake of banking group Argentaria and the rest (53%) of state tobacco company Tabacalera. Together, the three sales will provide the government with receipts of up to Pta1.3 trillion. “Given the shift of funds to equities, Spanish investors are in a position to take up the entire offering as well as whatever stocks foreign funds may sell in the market,” says Merrill Lynch’s Gomez Montejo.
The Madrid stock exchange is making a pitch to smaller-cap companies in order to increase market liquidity and make its index more representative of the broader economy. Bourse chairman Antonio Zoido recently launched Proyecto Empresa (corporate project) aimed at 204 Spanish companies with high growth potential. The companies have a combined capitalization of Pta2.5 trillion and are drawn mainly from the processed food, retail and service sectors. “The equity market is a golden opportunity for Spanish companies and the logical way forward for family-owned enterprises, privatizations and share offerings,” says Zoido.
Argentaria’s Martinez sees this sort of diversification as a way to reduce the interest rate sensitivity of the market, which is top-heavy with banks and utilities. “There are relatively few industrials in the Madrid index and there is a need to bring in more high-growth companies,” he says.
Most brokers are recommending banks over utilities, since the electricity companies are more sensitive to long-term rates and have also been penalized under a tariff agreement that calls for a cumulative 6% reduction in rates over the next three years.
“Our model portfolio would be slightly overweight in banks versus utilities,” says Merrill Lynch’s Gomez Montejo. “We are a bit more sceptical about the construction sector since public spending is going to take some time to recover. We also like Repsol although it has suffered from a price freeze on butane gas.”
Santander Investments’ Planiol says there is relative value in banks and cyclicals. “Banks will likely deliver a greater than 30% increase in earnings in 1997 and a further 17% in 1998,” she says. “Despite huge underperformance, utilities are unlikely to provide market-like returns. Uncertainty about margin erosion from competition will continue in the medium term.”
There is also evidence that investor confidence has been driven by a shift toward greater attention to the interests of shareholders. Last April, for instance, Banco Popular announced a major share buy-back programme and greater efforts to reduce operating costs. This followed similar moves by supermarket chain Pryca, electrical utility Endesa, Tabalacera and several leading banks. “Spanish companies are paying more attention to shareholders,” says BZW’s Colmenar. “The level of information is better, there is more transparency and hence the risk premium has been greatly reduced.”
Benito Vera, an analyst at Salomon Brothers, says the bullish performance of the Spanish market is a reflection of strong liquidity, improving economic fundamentals and investor enthusiasm for shares. The market, he says, has reached levels “far exceeding” his most optimistic forecasts and the Wall Street turnaround is also fuelling momentum on the Madrid exchange. “We remain bullish but reiterate our caution regarding utilities and regulated sectors in general,” he says. “We recommend that investors stay with banks, industrials and stocks sensitive to the economy, such as the construction sector.”
