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Spain's pain may yield investor gains

"Freefall," "crisis," and "carnage." Spain's stock market has inspired recent headlines with these words and worse.

MSCI Spain, a broad index, fell 32% this year through Friday. That compares with a 6% decline across the European Monetary Union, a 4% gain worldwide, and an 8% gain in the U.S., according to MSCI.

Brian Singer, manager of the recently launched William Blair Macro Allocation Fund (WMCNX) , sees a buying opportunity. Investors who plunk money into a broad basket of Spanish shares today could see average returns of 20% a year over the next several years, Singer says.

The stock plunge in Spain is related to grim economic trends that are stoking fears of a default. Spain's gross domestic product, a broad measure of economic activity, likely contracted 0.4% in the second quarter from the first, or 1% in annual terms, its central bank said Monday.

Shrinking GDP helped raise the country's debt as a percentage of GDP to 72.1% from 68.5%. To reduce its deficits, Spain raised taxes and slashed spending on health care, education, unemployment benefits and more. But as its economy shrinks, tax revenues are declining, and unemployment stands at 25%.

Investors have fled Spanish bonds, pushing prices lower and yields higher. Yields on 10-year notes recently topped 7%. That increases Spain's cost to raise fresh funds. On Friday, one of its regions requested a bailout from Madrid; another says it is considering doing so. So what is there for stock investors to like? Valuations, for one. Banco Santander (SAN) , the largest bank in Spain and the top-weighted stock in the MSCI Spain index, carries a dividend yield of over 11%. (Dividend yields rise as prices fall.) Telefónica (TEF) , the largest phone company and No. 2 index holding, yields 12%.

Both companies draw most of their profit from outside Spain, especially Latin America. Investors may also underestimate the willingness of Germany, which has Europe's largest economy, to help Spain avoid defaulting and leaving the euro currency, Singer said. That willingness stems from its own exposure to loss. In the euro zone, individual central banks run ongoing surpluses and deficits, called Target2 balances, to account for money that depositors transfer across borders. Germany has amassed the largest surplus, and Spain, among the largest deficits. Germany's surplus gives it exposure to loss in the event of a Spanish bankruptcy. Just how much Germany stands to lose is unclear, but the most worrisome estimates put the figure at more than 700 billion euros in the event of bankruptcy in Greece, Spain, Italy, Portugal and Ireland. Other estimates put that figure at one-quarter as large.

"A Greek default isn't even a Lehman Brothers event," Singer said, referring to the 2008 investment company collapse that contributed to a global financial crisis. "But Spain is a much different story."

Singer, who managed $20 billion for Switzerland's UBS and is a former chairman of the CFA Institute, oversees $50 million in William Blair Macro Allocation, launched in December. As the fund name suggests, it targets broad asset classes, not individual stocks and bonds. During the first half of this year, it returned 4.8%, versus 3.2% for its benchmark, which is an index of 40% world stocks and 60% bonds. Fund fees are 1.35% of assets, with no upfront sales charge.

For his Spanish exposure, Singer is using futures contracts on Spain's Ibex 35 index, combined with other derivatives to cancel out the euro exposure. In other words, he thinks Spanish shares are headed higher, but he also believes the euro has further to fall against the dollar. Investors with an appetite for risk can bet on Spain by purchasing iShares MSCI Spain Index (EWP) , an exchange-traded fund. It costs 0.52% of assets per year, plus standard stock commissions to buy and sell. For betting against the euro without buying individual derivatives contracts, there's Market Vectors Double Short Euro (DRR) , an exchange-traded note. It costs 0.65% a year plus commissions.