European equity prices, depressed by fears of a sovereign debt crisis, are cheap to such a degree that William Bernstein, author of The Intelligent Asset Allocator, called them a true bargain. Income-oriented investors, in particular, may be tempted by 4.2% dividend yields and a market-wide P/E ratio of approximately 11.  My analysis, however, contradicts Bernstein’s and shows the underlying risk those investments carry.

Credit default swaps (CDS) on both European and American banks have surged in price amid concerns about another banking crisis, triggered by sovereign debt defaults in the peripheral countries.  Money has flooded out of European stocks as investors become more risk averse, with the result that Euro-zone stocks are priced attractively by most objective standards, including the Shiller P/E ratio.

Those low prices and high dividends, however, do not represent a compelling value for income investors.

I have analyzed the relationship between yields on stocks and bonds and their risk levels, as captured by options prices.  In this article, I examine European stocks with this approach to show that the yields are unattractive in light of the risk. 

Research background

It is understood that the probability that a firm will default is related to the prices of its options.  Specifically, since put options on a stock insure against a decline in price, their prices in particular capture the market’s consensus view of the probability of default.  It is, therefore, unsurprising that CDS prices are correlated to the implied volatility of a stock.  In past research, I have demonstrated how the implied volatility of a stock was related to CDS prices and the probability of default.  There is a consistent and logical relationship between these factors.  Implied volatility from options prices provides a robust measure of default risk. 

In a related thread of research, I have found that the implied volatility of a company’s stock correlates to the firm’s probability of cutting its dividend, reflecting underlying financial distress.  As such, buying a high-dividend stock with very high implied volatility is likely a classic value trap: the yield is high because the firm is in a state of distress.  This result – a low risk-adjusted return – is not surprising. 

Applying this body of research, I examined whether the yields on European stocks are commensurate with the risks.  If so, European stocks are a relative bargain.  If not, investors need to tread very carefully in allocating to these stocks. 

I started by obtaining the current yields and implied volatilities of a representative set of dividend-paying stocks from European countries.  Foreign stocks have a unique source of risk for investors, of course: currency risk.  A dividend paid in a foreign currency must be translated into dollars, and the possibility of exchange rates declining adds another element of risk.  To avoid this source of risk, I focused on European stocks that are priced in dollars and are either jointly listed on U.S. exchanges or have ADRs.  I have also limited my analysis to stocks with options listed on U.S. exchanges.  Obviously not all European dividend stocks have ADRs or are jointly listed on U.S. exchanges, those that I have chosen represent a broad spectrum of European firms. 

Yield versus risk for European stocks

I started by creating a list of dividend-paying European stocks that should be of interest to income investors:

European Dividend Paying Stocks

Company

Industry

Ticker

Yield

France Telecom

Communications Services

FTE

11.0%

Telefonica

Communications Services

TEF

9.6%

National Grid

Electric Utilities

NGG

5.8%

Vodaphone

Communications Services

VOD

5.3%

Astrazeneca

Biotechnology and Drugs

AZN

5.8%

Glaxosmithkline

Major Drugs

GSK

4.9%

Total

Oil and Gas - Integrated

TOT

6.3%

Banco Santander

Regional Banks

STD

10.5%

Nokia

Communications Equipment

NOK

9.3%

Royal Dutch Shell

Oil and Gas - Integrated

RDS-B

4.7%

Unilever

Consumer Goods

UN

4.5%

British American Tobacco

Consumer Goods

BTI

4.4%

Sanofi-Aventis

Biotechnology and Drugs

SNY

5.1%

Transocean

Oil Well Services and Equipment

RIG

6.2%

British Petroleum

Oil and Gas - Integrated

BP

4.1%

Banco Bilbao Vizcaya Argentaria

Money Center Banks

BBVA

7.0%

Siemens

Electronic Instruments and Controls

SI

3.7%