Madrid’s bull run

Investors are betting that Spain’s fast-growing economy and increasingly dominant multinationals will continue to deliver healthy share price gains.

For investors, Spain’s running of the bulls isn’t limited to the annual festivities in Pamplona. From January 1998 through December 15, 2006, the MSCI Spain index rose 164.55 percent in U.S. dollar terms, roughly triple the return of the MSCI world index. In 2006 the Spanish market was especially frothy. Through mid-December it rose nearly 30 percent in euro terms and 45 percent in dollar terms.

This strong performance reflects Spain’s impressive economic growth; the increasing power of its multinationals in key industries such as banking, retailing and telecommunications; and the country’s membership in the euro zone, which eliminated the currency risk associated with the highly volatile peseta.

Today the nation of 40 million occupies an enviable position on the Continent. Because the European Central Bank must calibrate interest rates based on the performance of the euro zone’s slower-growing core economies of France, Germany and Italy, Spain reaps the competitive advantage of rates that are much lower than they would otherwise be. A stable currency and low interest rates have combined to dramatically cut the country’s equity risk premium.

“Spain’s late [1986] entry into the European Union has promoted the development of one of Europe’s most open and competitive markets,” says Paul Casson, the London-based lead portfolio manager of the $424 million-in-assets Ivy European Opportunities Fund. Casson is overweight Spanish stocks and holds stakes in three of the country’s top multinationals: tobacco company Altadis; Banco Bilbao Vizcaya Argentaria, Spain’s second-largest bank; and telecom services provider Telefónica. Casson’s Spanish stocks, which account for 9 percent of his portfolio, helped him deliver three-year annualized returns of 26.10 percent through December 26, or 5.72 percentage points above the MSCI EAFE index.

Of course, with a trailing 12-month price-earnings ratio of 21.1 -- one of the highest among developed markets -- the Bolsa de Madrid looks vulnerable to a near-term pullback. Casson acknowledges this risk but believes there are more benefits to be harvested from Spain’s vibrant economy, especially from the current low euro-zone interest rate of 3.5 percent. Heavy capital spending, fueled by the transfer of billions of euros in EU development aid, has led, he says, to strong employment and consumer spending growth, a sustained construction boom and buoyant increases in corporate profits. These conditions have fueled gains in real GDP that have topped 3 percent annually over the past five years, more than double the rate in France and Germany.

This environment has promoted a flurry of public offerings and a big expansion in deal making. Mergers and acquisitions involving Spanish companies have nearly quadrupled over the past three years. Through mid-December, 860 deals worth $272.6 billion had been announced for the year, led by German energy concern E.ON’s pending $48 billion bid for Madrid-based Endesa and Spanish energy giant Iberdrola’s plan to acquire Scottish Power for $22.5 billion. In August, Spanish infrastructure developer Grupo Ferrovial completed its £10.3 billion ($19 billion) takeover of British airport operator BAA.

Fund manager Casson has focused on less-publicized energy plays. In August he established a E1.9 million ($2.4 million) position in Enagás at E16.90 per share. The company owns and manages 98 percent of Spain’s gas transmission pipelines and went public when industry deregulation forced its parent, Gas Natural, to unload its majority stake. Since the public offering in June 2002, Enagás’s profits have more than doubled; by early December its shares had risen by more than 300 percent, to E19.19.

Casson thinks the company’s growth will continue to accelerate given Spain’s recent adoption of a new regulatory framework that promotes infrastructure improvement. “With the government having assured utilities a return on investment of 150 basis points above the ten-year government bond yield and with current capital expenditures of E4.5 billion, we should see substantial profit growth going forward,” he says. Consensus earnings estimates suggest that profits could rise by 12 percent in 2007 and 17 percent in 2008.

Ana Besada, Madrid-based portfolio manager of the E101 million Morgan Stanley Bolsa Fund, expects Spain’s strong performance to continue, supported by strength in real estate and construction, job growth and consumer spending.

“Joining the euro zone has lowered the cost of business,” Besada says. “That’s a fundamental factor behind the Spanish success story, and it’s not going to disappear anytime soon.”

She is especially upbeat on Banco Santander Central Hispano, Spain’s biggest bank, which generates 78 percent of its income from retail banking. In the first three quarters of 2006, earnings were up nearly 29 percent compared with the year-ago period, aided by the bank’s $15.7 billion acquisition of U.K. bank Abbey National and a 25 percent stake in U.S. bank Sovereign Bancorp.

Through May, Besada added to an existing position in Santander at an average cost of E10.90. As of early December the shares were trading at E13.96, and she had 19 percent of her fund’s assets in the stock, 3 percentage points more than the bank’s weighting in Spain’s benchmark IBEX 35.

Besada has also been taking profits. In September real estate developer Grupo Martinsa made a $5 billion bid to buy competitor Fadesa Inmobiliaria, which Besada began buying at an average cost of E11.20 after the company’s IPO in 2004. She was attracted to the developer’s high-quality projects and solid management, which has overseen net profit growth of 71 percent over the past five years and an expansion into Bulgaria, France, Hungary, Morocco and Poland. When Fadesa Inmobiliaria’s shares soared north of E35 on news of the deal, Besada sold her stake for a profit of more than 200 percent.

Matthew Dennis, coportfolio manager of the AIM International Growth Fund, holds 3 percent of his $2.78 billion portfolio in Spanish stocks, which helped generate three-year annualized returns of 23.07 percent through December 26, 2.69 percentage points above the MSCI EAFE index during that period. Dennis is bullish on retail powerhouse Inditex Group, the parent company of the popular Spanish clothing chain Zara International. With 44 percent of its revenues generated in Spain, Inditex is a play on the country’s rising disposable income, which has been climbing at a rate of two to three times that of the rest of the Continent. With Zara planning to increase the number of its stores in Europe, the Americas and Asia from 2,800 to 4,000 by 2009, Inditex also offers a unique business model with global traction.

“With a design-to-store time frame of only one to three weeks,” says Dennis, “Zara has eliminated both seasonality and inventory risks -- the traditional bane of retailing.” This compressed product cycle enables the retailer to churn out fashionable designs and quickly correct missteps. Its strong production controls ensure that the company keeps to schedule, a discipline that Dennis says should help sustain Inditex’s 20 percent operating margins.

Since October 2004, Dennis has built a $35 million investment in the company. With the stock at E38.30 in early December, his holding was up 65.4 percent.

There are risks to the Spanish growth story. With cheap money comes inflation, and Spain’s consumer price index is currently rising at an annualized rate of 3.6 percent, well above the euro-zone average of 2.2 percent. According to the International Monetary Fund, low euro-zone interest rates are undercutting productivity improvements because Spanish companies can borrow instead of cutting costs. Spain’s soaring current-account deficit, projected to reach 8 percent of GDP by the end of 2006, suggests that the country’s competitive position may be eroding.

Meanwhile, EU assistance to Spain is declining as Brussels redirects capital to newer and needier Central European member states. Net budgetary transfers to Spain peaked in 2003 at E8.67 billion and will decline to E3.90 billion in 2007. The adjustment is likely to fall most heavily on Spain’s booming real estate and construction firms, which have a strong weighting in the IBEX 35. To cushion the blow, these companies are expanding abroad and diversifying into sectors like energy.

Global institutional investors, which by one estimate own as much as 55 percent of the Spanish index, have a lot at stake. Like the runners in Pamplona, they are striving to stay one step ahead of the bulls.