Michael Wilson explains why, despite a relatively sound banking system, investors are still shunning Italian stocks.

It is odd how little we seem to hear about Italy’s investment scene. Europe’s fourth-largest economy is still something of a mystery, even to those of us who will happily buy shares in French energy companies or German engineering concerns or (on a good day) Spanish telecom companies – there are only about 200 companies listed on the whole of the Milan Borsa – but there is also the fact that the level of sophistication isn’t very high.

That is because Italian companies of all sizes are still happier borrowing from their local banks than inventing sophisticated securitised thingamajigs in the bond markets.

Old-fashioned virtues
So the truth is that we simply don’t see them in the headlines very much. Indeed, it is not much of an exaggeration to say that Italy’s financial markets are still back where ours were in the 1980s.

Although, in some ways, as we’ll see, that’s not an altogether bad thing, these old-fashioned virtues have not been enough to protect Italian stocks from a pretty horrendous price crash. In the 24 months since April 2007 the Milan MIB stock market index has plummeted from 42,000 to less than 14,000, with share prices halving during the past six months alone.

The problem is not so much that Italian businesses are overloaded with toxic debts,
as ours are. Rather, it’s that Italy’s productive economy is dropping out of the sky at such a rate of knots that Silvio Berlusconi’s government seems paralysed by the mounting G-forces and completely unable to pull back on the joystick. Nobody has a clue what will happen next.

Too little, too late
That is a serious accusation, so let’s start backing it up with some figures. The latest economic statistics, issued in March, show that Italy’s economy shrank by an alarming 2.6 per cent during the final quarter of 2008, and that its industrial production was down by a massive 15 per cent year-on-year (by comparison, Britain’s figure was closer to nine per cent).

The final-quarter losses were enough to pitch the overall economy into a one per cent loss for 2008 as a whole, confounding expectations that it could pull off some actual growth. And, as a result, this year’s government projection of a 0.6 per cent decline is now regarded as hopelessly optimistic. The private sector reckons that a three per cent fall is more likely.

With seven per cent of Italy’s workforce now unemployed (and that’s just last autumn’s figures, by the way), the country needs a huge stimulus, and fast. But it just isn’t happening yet. Obviously, you’ll have heard about the government’s recent ?17 billion plan to kick-start the construction industry, with projects that include linking up Sicily with the mainland via the world’s longest bridge.

Mr Berlusconi has also relaxed the planning controls on domestic buildings, presumably in the hope that all those millions of moonlighting builders will be able to give the black economy a timely boost. All well and good, but it isn’t what you would call a bold and decisive national plan from a premier who likes to portray himself as a man of action.

Leaning on the private sector
Nor is the government putting up much of the money. At least half of the ?17 billion is expected to come from private sources. There was another plan last December to put up an additional ?88 billion worth of more general support for business, but even that only included about ?5 billion of new funding – the rest was simply promises and private sector ‘whip-rounding’.

Compare and contrast Mr Berlusconi’s excessive reluctance to spend with Britain’s excessive enthusiasm for doing the opposite: we have already committed well over £1 trillion of direct Treasury aid to the problem.

In fairness, we do need to remember that Italy’s banks really haven’t been affected by the credit crunch as badly as ours. Milan’s finest have always been rather conservative organisations, a throwback to the 1960s days when many banks were effectively branches of the Italian civil service and, consequently, relatively few banks ever got involved in the toxic risk taking that has plagued everyone else.

Okay, there has been a bit of damage at Unicredit, the country’s second-largest bank, which is more exposed to commercial business risks than its competitors, but that is about as far as it goes.

The free float trap
So why don’t the financial markets like Milan? Partly, as we have said, it is because the government shows no sign of having a properly funded plan for stabilising the national economy. Allowing a nation of illegal builders to pick up their trowels is not a deeply thought-out strategy by anybody’s standards. But it is partly also a matter of something called ‘free float’, which makes life tricky and unpredictable for private investors.

We have already said that Italian companies love their banks. The trouble is that, in exchange for all those loans, the banks and other large investors have often been awarded huge slices of equity in their client companies, which leaves them pretty much calling the shots in the boardrooms. And the government often retains a hefty stake to boot.

The more of these ‘golden shares’ there are, the better the chance that small investors’ interests will get ignored. But unfortunately it also means that the actual free float pool of shares (the proportion of shares that are owned by truly independent investors) is really much smaller than it looks: for instance, the Benetton clothing group has a free float of only 33 per cent, and many building firms are below 30 per cent. Which in turn means that when the time comes to sell your shares, you might find that there simply aren’t many people looking to buy them at a fair price. The liquidity just isn’t strong enough.

Less attractive
That is a frightening prospect. And, in an age when foreign investors have plenty of other places to go, Italy’s stock markets have been losing what limited international support they had to other investment centres. What’s more, we haven’t even touched on the possibility that rising inflation and falling bank rates might put the kibosh on the dividend yields that foreigners can get from Italian stocks.

But let’s return to our usual question. What is Italy like as a place to invest? Illiquid, as we have said, and rather short of free float. And moderately expensive too – you’ll typically pay a p/e of about ten for an Italian stock, which means the price of the share is about ten times its last recorded profits. By comparison, Britain’s p/es tended to be around six in mid-March.

Add to this the fact that the strong euro and the weak pound have been conspiring to make everything in the eurozone unusually expensive for a UK investor to buy, and you have rather a lot of reasons for agreeing with those who reckon that this is not the right time for an Italian adventure. Maybe next year?