Nov. 5 (Bloomberg) -- Spain, suffering from the highest unemployment rate in Europe, is producing the best stock returns among countries in the region with shrinking economies as sales to Latin America grow.

The IBEX 35 rose 17 percent in the 12 months through yesterday, the steepest advance in any euro-region economy that is still contracting, data compiled by Bloomberg show. Spain’s benchmark index beat Europe’s Dow Jones Stoxx 600 Index by 15 percentage points in the same period as Madrid-based Telefonica SA, Europe’s second-largest phone company, and Banco Santander SA, the country’s biggest bank, benefited from Brazil’s growth.

While Spain’s economy is projected to contract by 0.7 percent, IBEX members receive about 40 percent of earnings from Latin America, with 15 to 20 percent from Brazil, where the economy grew 1.9 percent in the second quarter, according to estimates by Bilbao-based Banco Bilbao Vizcaya Argentaria SA. Santander and Telefonica, which account for 45 percent of the index’s weighting, get more than 34 percent of their operating income from the region, data compiled by Bloomberg show.

“For companies that make a lot of sales there, the potential is certain,” said Kilian de Kertanguy, a fund manager at Cholet-Dupont Gestion SA, which oversees about $2.3 billion and shares of Telefonica and BBVA, Spain’s second-biggest lender. “These big companies exposed to Brazil can have a contagious effect and lift the index. As a result, the whole market benefits.”

The IBEX 35 rose 1.4 percent today, the biggest gain among 18 western European markets. The Stoxx 600 added 0.6 percent.

Latin America

Spanish companies invested 125 billion euros ($185 billion) in Latin America since 1993, a third of which went to Brazil.

Earnings from Latin America may encourage investors to buy Spanish stocks as an alternative to emerging markets, according to Bob Parker, who helps manage about $600 billion as vice chairman of Credit Suisse Asset Management in London.

“If you ask which European country is most exposed to Latin America, it’s Spain,” said Parker. Investors who believe “emerging markets have climbed too far, too fast” can switch into Spanish equities with lower valuations, he said.

Brazil’s Bovespa index is up 70 percent this year, pushing its valuation to 25.5 times reported earnings. Spain’s IBEX 35 is valued at 12.5 times profits. Itau Unibanco Holding SA in Sao Paulo, Latin America’s largest bank by market value, trades at 3.3 times net assets, more than double the 1.3 price-to-book ratio for Santander.

BRIC Nations

Brazil’s economy, bracketed with Russia, India and China as part of the BRIC group of largest emerging markets, will expand 4.8 percent next year after growing 0.18 percent in 2009, according to a central bank survey of about 100 economists published on Nov. 3. The Brazilian real is the best-performing of the world’s 16 most-traded currencies this year.

“Spain is one of the few markets in Europe where you can play the BRIC theme,” said Herbert Perus, Vienna-based head of global equities at Raiffeisen Capital Management. Still, “you can’t buy the whole market as there are a lot of problems in Spain,” he said.

The nation has been harder hit by the global recession than other countries after real estate prices slumped and more than 1 million newly built homes went unsold, government data show.

Highest Unemployment

Spain has the highest unemployment rate among 27 European countries at 18.9 percent, according to Eurostat data. The economy may contract 0.7 percent in 2010, while Germany, France, Italy, the Netherlands, Portugal and the U.K. grow, according to the International Monetary Fund. Only Ireland’s economy will shrink more in Europe, with a 2.5 percent decline in gross domestic product, according to the Washington-based group.

Santander, which is based in its namesake Spanish city, plans to open 600 branches in Brazil by 2013 and last month raised 14.1 billion reais ($8.2 billion) in an initial stock sale of its Brazilian unit. The division may earn 4 billion euros in 2011, compared with an estimated 3.2 billion euros from Santander’s Spanish retail-banking business and 2.5 billion euros at its Abbey unit in the U.K., analysts at Evolution Securities wrote in an October report.

Telefonica is competing with Paris-based Vivendi SA to buy Curitiba, Brazil-based telephone company GVT (Holding) SA. The Spanish phone company boosted its offer to about $3.99 billion yesterday. Madrid-based Mapfre SA, the country’s biggest insurer, has reached an accord with Brasilia-based Banco do Brasil SA to develop in South America.

Such expansion “can be a plus for Spanish companies that have business in Brazil,” said Louis de Fels, a Paris-based fund manager at Raymond James Asset Management International, which oversees about $35 billion worldwide. “Growth in Brazil will help pull the market higher.”

To contact the reporters on this story: Alexis Xydias in London at axydias@bloomberg.net; Adria Cimino in Paris at acimino1@bloomberg.net.

Last Updated: November 5, 2009 12:12 EST