Weekly Top Stock Idea

Each week, Motley Fool editors cull a top stock idea from the pitches made on CAPS, the Motley Fool's 165,000-member free investing community. Want your idea considered for this series? Make a compelling pitch on CAPS with a minimum length of 400 words. Want to follow our weekly picks? Subscribe to our RSS feed or follow us on Twitter.

Telefonica profile

Sources: Capital IQ (a division of Standard & Poor's), Yahoo! Finance, and Motley Fool CAPS.

This Week's Pitch :

Much like in the movie Gladiator when Maximus Decimus Meridias rises up from ruin to become the hero of a nation, I expect another Spaniard, not a person but a company, to rise from the ashes of a country in economic turmoil to eventually produce outstanding returns for investors.

The company that I'm talking about is Telefonica. I added TEF to my CAPS portfolio a little over a month ago. The stock is down around 6% since then, versus a 3.5% drop in the benchmark S&P 500.

My thought process in giving Telefonica the green thumb in CAPS is that it is an outstanding global company that pays a huge dividend, but is being unfairly punished because it has its headquarters in one of the infamous PIIGS nations. The reporter who follows European stocks for Barron's, Vito Racanelli, agrees. He penned a bullish article on the stock for this week's magazine titled "Don't Hang Up on Telefonica."

Yes, the Spanish economy is a mess. The official unemployment rate there of 20% makes the 10% that we're experiencing here in the United States today look like a utopia. Spain's Ibex 35 index has been the worst performing European index thus far in 2010, and that's saying something. It's down 20% YTD. Telefonica's U.S.-listed ADR-TEF, which trade in dollars instead of Euros, have been hammered even worse, down over 33% YTD.

Since Spain is such a mess, why would I want to buy stock in a company from there? Even though TEF is a Spanish company, it derives nearly two-thirds of its revenue from outside of the country. A huge chunk of that comes from its rapidly growing operations in Latin America. Telefonica's foreign operations were so strong that even though its revenue in Spain fell by 6% during the first quarter, it managed to grow its revenue and earnings by 2% companywide.

Cheap companies that pay dividends always catch my eye. Telefonica has both of these attributes. Its ADRs are trading at their lowest multiple of earnings in history. They currently sit at around only 8.5 times analysts' estimated 2011 earnings.

European companies pay dividends a little differently than companies here in the United States that generally make a fixed payment to shareholders every quarter. Most European companies pay dividends only once or twice per year, and their payments are much more variable (depending upon earnings). In 2009, TEF made two dividend payments to U.S. ADR holders, $1.999 in May and $2.207 in November for a total of around $4.21/share. At today's stock price of $59, that's equivalent to a dividend yield of over 7.1%.

TEF has already made one dividend payment so far in 2010, $2.558 in May. As you can see, this is already significantly better than its payment in May of last year. I don't know what the company's November payment to shareholders will be at this point, but we're probably looking at a company that will have an ADR dividend yield of 8% to 9% for the year, which, needless to say, is outstanding.

Are there risks in investing in Telefonica[?] You bet, that's why I have not committed any real money to this idea yet. First and foremost is currency risk. After a short breather in the short term, I expect the euro to continue its decline versus the U.S. dollar, perhaps falling as low as parity at some point.

There's also a risk that the company will spend its money on a huge acquisition; it is rumored to be interested in Dutch telecom Royal KPN and the 50% stake in Brazilian telecom Vivo Participacoes [(NYSE: VIV)] that it doesn't already own.

And of course, the global economy could always collapse, or the euro could implode. Neither of those things would be good.

To me, at this level a lot of bad stuff is already priced into Telefonica's stock. I plan on holding it in CAPS for a long time.

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