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Eyeing Southern Europe? Proceed with caution, experts say

Bryan Borzykowski, Special to CNBC.com
Thursday, 19 Dec 2013 | 8:00 AM ET
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For the last few years, Joseph Kelly, a certified financial planner, has kept most of his client's money far away from Southern Europe.

It was simply too risky a region, according to Kelly of VALIC Financial Advisors, Bedminster, N.J. Six months ago, though, he had a change of heart.

"People have given up on the region, but things are starting to move now," he said. And it seems like a lot of people share Kelly's view.

After years of seeing outflows from Southern European funds, investors are starting to come back. According to EPFR Global, a firm the tracks worldwide fund flows, $13.4 billion has poured into funds focused on Portugal, Italy, Greece and Spain—also known as the PIGS—since January.

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That's a massive jump over the $1 billion invested in these funds a year ago.

Country indexes are also doing well. For example, Spain's IBEX 35 Index is up nearly 12 percent year-to-date, Greece's Athens Stock Exchange General Index is up 21 percent, Portugal's PSI 20 Index has climbed 10 percent, and Italy's FTSE MIB Index is up 8 percent.

Flows and market returns are still underperforming in other parts of Europe—the entire area saw $48 million in fund inflows this year. However, investors are clearly starting to look at the PIGS for opportunities again.

"There's been a real change in investor sentiment over the last year," said Bertie Thomson, a London-based portfolio manager with Aberdeen Asset Management. "Investors were concerned with losing money; now they're concerned with losing out."

People are excited about the region because it appears that these hard-hit countries have turned a corner. There's now an expectation of modest gross domestic product growth, banks have stabilized, lower wages are bolstering manufacturing sectors and there's no longer a threat of a eurozone breakup.

Sovereign debt yields have also narrowed in Spain and Italy—from 6.5 percent in the summer of 2012 to about 4 percent today. That helps companies borrow and grow again, said Alec Young, a global equity strategist with S&P Capital IQ. He expects company earnings in Spain to grow by 17.3 percent in 2014, while earnings in Italy could climb by 30 percent.

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Kelly's attracted to the region for all of these reasons, but he also said that these countries have been so devastated that there's nowhere to go but up.

"Countries have basically bottomed out, so there will be an uptick here," he said. "Southern Europe will be the Japan of 2014."

While better economic growth could translate into higher returns in 2014, not everyone is as comfortable as Kelly is with the region.

Bob Sewell, president and CEO of Oakville, Ontario–based Bellwether Investment Management, has put some Southern European countries on his radar, but he's not ready to dive in.

It wasn't that long ago that people were rioting in the streets and governments were being toppled, he said. With unemployment still sky-high in these countries—Greece and Spain have a 27 percent and 26 percent unemployment rate, respectively—he's not convinced that the country's citizens are feeling as positive about Europe as many investors are.

"How long do these populations wait for action?" he said. "Do you get another political shift? That creates some concern."

While Aberdeen's Thomson thinks that the most aggressive austerity measures are in the past, he does say that municipalities still wield too much power and many have been resistant to change their ways. That makes it difficult to push through new cost-cutting measures and could impact the recovery.

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Whether you're ready to buy in or are still watching from the sidelines, the message from financial experts to investors is to proceed with caution.

It does help that the region is cheaper than other parts of the world. While valuations are higher than where they were a year ago, Europe as a whole is trading at 13 times forward earnings, which is less expensive than America's 15.1 times forward earnings, S&P Capital's Young said.

Within the PIGS, Spain is trading at a 13.5 times price-to-earnings ratio, Italy is trading at 12 times earnings, Greece is at 20.9 times earnings, and Portugal is at 19.6 times earnings.

Greece and Portugal are more expensive, but that's partly because there's higher growth expectations in those countries, some financial experts say.

"Valuations may no longer be dirt cheap, but they're not expensive," said Young, who adds that Europe's overall earnings growth could increase by 13 percent next year.

For investors who want to buy into the region, Kelly suggests looking at exchange traded funds.

(Read more: Country-specific ETFs explode)

He's putting his more aggressive clients into the two largest PIGS countries via the iShares MSCI Italy Index (NYSE Arca: EWI) and the iShares MSCI Spain Capped ETF (NYSE Arca: EWP).

Meanwhile, conservative investors who still want exposure to Southern Europe can look at the SPDR Euro Stoxx 50 ETF (NYSE Arca: FEZ), a more broadly based fund with exposure to Central and Southern Europe.

While Sewell buys European ETFs as well, he also likes purchasing individual companies. Stock pickers should stick to multinational businesses with diverse revenue bases, he said, adding that it's still too much of a risk to buy a company that derives all of its revenues from a single European country.

Although he doesn't own any Southern European names at the moment, he does have his eye on Eni SpA (NYSE: E), an Italian oil-and-gas operation; and Ferrovial SA (OTCPK: FER), a Spanish transportation infrastructure company. Both are multinationals.

Investors should also be careful about valuations, Thomson said. A number of companies have become more expensive over the last year, while others are still dirt cheap. A good company should be inexpensive and have good growth prospects, though in today's environment it's difficult to get an accurate picture of that growth.

"We won't see the type of demand we saw before 2008, so you have to be careful about what level of growth you're expecting," Thomson said. "What is the underlying growth is one of the key questions that I'm still trying to ascertain."

Kelly's well aware that Southern Europe is still volatile, but he's now willing to take the risk. From what he can see, the region has stabilized, and it's time to take advantage of the recovery.

"The underlying economic factors look like they've bottomed out," he said. "I don't think it can get worse."

—By Bryan Borzykowski Special to CNBC.com

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