Six cheap, contrarian, eurozone plays

Screens based on the approach of famous US investor David Dreman fall into the 'I-need-convincing' category for me. Rather perversely, this is possibly because the approach has just too much gut appeal when it comes to testing for value. The starting point for the Dreman approach is to look for stocks that are among the fifth cheapest on the market on four popular measures - price/earnings (PE), dividend yield (DY), price to cash flow (PCF) and price to book value (PBV). While such cheapness suggests there could be major upside, it doesn't take too much investing experience to know that such low valuations are often a stark warning of trouble to come rather than an opportunity.

But maybe my problem is simply that I am not bold enough. Mr Dreman, a top-performing fund manager in his Wall Street days, is considered an arch contrarian; happy to buy in the face of dour sentiment. And there can be few better gauges of sentiment than widely used metrics such as PE and PBV. And Mr Dreman uses a number of stringent criteria to assess whether a company is cheap for a reason or actually a value opportunity (see below) while also eschewing risk by focusing on larger companies.

And the eurozone, which is the focus of my screen this week, appears to have considerable potential as a hunting ground for contrarian investment opportunities. Indeed, according to investment boutique ING Investment Management, the cyclically adjusted PE ratio in Europe is at a 40-year low and represents a 30 per cent discount to the US market, which is more than double the long-term average European discount.

What's more, the result of our eurozone Dreman stock screen from last year goes some way towards helping me overcome my anxieties about focusing on very low 'headline' valuations. The screen delivered a total return of 24 per cent over the year, compared with 19 per cent from the S&P Eurozone index (see table and graph). And, hopefully, the six stocks selected by the screen this time around, which are detailed in the write-ups below, can produce another year of market-beating returns.

Source: Datastream

Last year's Dreman eurozone portfolio performance by stock

Source: Datastream

I've had to scale back the scope of our screen and water down the dividend growth criteria in order to generate more than one result from the screen, as RTL was the only stock to pass all the Dreman tests. RTL aside, all the other stocks passed all but one of the criteria.

Austrian Post

Austrian Post, which is majority owned by the Austrian government, is the only stock making a repeat appearance in our Dreman eurozone portfolio. That seems somewhat fitting, given the steady-as-she-goes nature of the business. The company is balancing a decline in its traditional mail business with growth in parcels, as well as its own efficiency improvement initiatives. While this is hardly a recipe for rampant growth it does provide the steady and reliable cash flows needed to support the bumper dividend yield. That said, the company's recent acquisition of a 25 per cent stake in Turkey's second largest parcel delivery business should aid growth prospects based on the country's parcel-delivery growth rate of 13 per cent a year. Management has also hinted in the past that they could further increase the dividend payout ratio, which could mean a pick-up in dividend growth, although broker JPMorgan is forecasting a rather uninspiring growth rate of just 1.3 per cent a year over the next 10 years. Indeed, the one fundamental test that Austrian Post failed was the requirement for above-average dividend growth.

Source: S&P CapitalIQ

RTL

RTL, Europe's largest TV and radio broadcaster with a presence in 62 countries, was in a rather confident mood when it reported half-year results last month. As well as announcing a higher-than-expected €2.50 special dividend, management said it looked increasingly likely that it would match or beat last year's cash profit. That said, the group's fourth quarter is key. But with confidence picking up in Europe, surprises during this busy period could be on the upside if advertisers start digging deeper into their pockets. Meanwhile, the company is pursuing a strategy of investing in digital media and improved content. The high dividend payout is also supported by the group's strong cash generation, with cash conversion coming in at 120 per cent at the half-year stage. RTL was the only company to pass all the Dreman tests. Free float is not all it could be, though, with 75 per cent of the shares owned by media giant Bertelsmann - even after a €1.4bn secondary listing in Frankfurt earlier this year.

Casino

There are high hopes that EPS growth is set to kick in again this year at international supermarket chain Casino. The company has some exciting international subsidiaries in countries such as Brazil, Thailand and Vietnam, but it faces tough conditions in its home market of France, which accounts for two-thirds of sales and over half of its profits once minority interests in subsidiaries are taken into account. The good news from Casino's first-half results in late July was that the deterioration in trading seen in the four weeks to 15 July had improved markedly on its second quarter, which saw a 10.5 per cent like-for-like sales drop. The company has also been significantly mitigating the deterioration by cutting costs. If a pick-up in the consumer environment in France starts to come through, the market may well start to focus on the retailer's international virtues rather than its domestic woes.

E.ON

German utility company E.ON certainly looks a risky play at the moment and that is the type of thing that can make investors push shares down too low. A key question, though, regards the maintenance of the high dividend yield that has made it one of our Dreman stock picks. The company is in the early stages of a significant restructuring plan aimed at reducing its European power generation activities and expanding both globally and into more promising areas, such as renewables. But these major upheavals have led many to question the sustainability of that fat dividend payout, as well as the potential trajectory of earnings in coming years. Last month's half-year results provided a little encouragement in so far as net debt came down from €14.6bn to €13.3bn over the six months and the headline numbers were marginally ahead of expectations. The company and its shares remained swamped in uncertainty, though, which makes E.ON something of a punt for income hunters despite the apparent value on offer.

Folli Follie

Greek department store group and luxury brand Folli Follie is looking forward to the prospect of a recovery in the devastated Greek economy, which management hopes could take hold next year. However, the group's prospects are pinned to a far broader geographic region than just its home market. Indeed, just less than a quarter of the group's revenues come from Greece and 65 per cent come from Asia, including Japan. What's more, as far as cash profits are concerned, it is not department stores that make the real money, but the group's jewellery, watches and accessories. The sale of these items generates 94 per cent of profits, compared with just 1 per cent from the big shops. Continued expansion in Asia is expected to be the key driver of growth. What's more, the group looks in a stronger position to finance this following the divestment of a 51 per cent stake in its travel business earlier in the year.

K+S

German fertiliser company K+S has a good long-term growth story behind its business, based on China's changing appetites fuelling demand for fertiliser (chiefly to grow more animal feed). Broker Hauck & Aufhauser reckons demand for potash, a key fertiliser ingredient that K+S mines, should grow by 3 to 5 per cent a year in the long term. But K+S faces more immediate problems. The company is considered to be one of the highest-cost potash producers and, what's more, there are growing fears of major price declines, with some predicting prices falling below $300 per tonne. Nevertheless, K+S is ploughing ahead with a €3.9bn Canadian mining project that has already suffered delays and significant cost increases. Broker JPMorgan reckons K+ S may have to issue new shares to fund development if the potash price drops below $310. The broker currently predicts $330 for 2014. Meanwhile, K+S is thought to need prices of between $420 and $460 to meet its targeted return on the project. However, for those prepared to subscribe to a bullish long-term view, the shares' current rating does not look demanding.