A number of interesting valuation opportunities have emerged among Europe’s banks in recent years as concerns over the sector have taken root, according to several fund managers.
Banks have struggled to return to the levels of profitability seen before the global financial crisis of 2008, due to a combination of regulatory action and a much-changed operating environment.
The global financial crisis ushered in an era of rock-bottom interest rates, which has been unfavourable to earnings in the sector as it reduces interest rate spread – the difference between the average yield that a bank receives from loans and the average rate it pays on deposits and borrowings.
Costly regulatory changes for the sector have also been introduced to curtail some of the behaviour that contributed to the crisis.
On a global level, asset allocators have moved to an underweight position for the first time since September 2016, according to the Bank of America Merrill Lynch Global Fund Manager Survey. The recent sell-off of bank stocks on news that the Federal Reserve was going to halt rate hikes was the latest sign of ongoing negative investor sentiment.
And negative sentiment towards the sector has also been seen in Europe, where it is the fourth largest underweight position. Relative to history, the sector ranked as the third most under-owned.
Source: BofA Merrill Lynch Regional Fund Manager Survey
European financial services (excluding banks) and insurance sectors have fared much better, both showing improvement over the last three years.
However, some market participants have begun to take a second look at the battered banking sector.
As a result of more rigorous post-crisis regulations, banks are better capitalised today and in a much better position to withstand another shock to the system. They have also been forced to sell assets to reduce their exposure to risk.
Yet, European banks remain out-of-favour.
“We have seen plenty of value across bank stocks recently,” said Steve Magill, head of European equity value at UBS Asset Management. “Many have gone through long periods of restructuring which have boosted cashflows and bulked up capital positions. These should benefit future returns.”
Chris Hiorns, who manages the £91.3m EdenTree Amity European fund, agreed, adding that the sector is currently “very cheap”.
“You can find some of the biggest discounts to book in Europe,” he explained.
Historically the European banking sector has been plagued with problems, said Hiorns, noting that the low rate environment remains an issue.
“There’s a lot that needed to be restructured in European banking. Certain countries still have a fair way to go,” he said.
Hiorns said the US cleaned up its banks following the crisis and “was happy for them to be profitable,” which had a positive impact on the overall economy. He said Europe has been lagging behind in comparison.
Yet, the outlook for the sector looks positive particularly against a stronger economic backdrop for the region with very low levels of unemployment in Europe providing a positive environment with growth opportunities.
“If we get a stronger economy, the prospect for a rate rise being introduced in Europe augurs well for the sector”, he said.
As such, Hiorns has invested in Spanish bank Santander, which he describes as one of the best run banks, with good prospects in other markets like Latin America.
Performance of MSCI Europe/Banks vs MSCI Europe over 10yrs
Source: FE Analytics
Europe’s emerging markets are themselves an interesting space for banking sector opportunities.
Matthias Siller, investment manager in the Baring Europe, Middle East & Africa equities ream, said that broadly emerging Europe remains attractive relative to the region’s developed markets, and that financial stocks are no exception.
“We take note of the positive developments in Russia where we have witnessed an acceleration in loan growth,” he said. “This serves to highlight how the market has managed to adjust and thrive despite the US sanctions regime, positively surprising in contrast to developed Europe which has observed stagnation.”
In addition, the Barings manager said Polish financials offer sizable dividend generation, providing a unique combination of growth and yield.
Siller pointed out that central European economies find themselves amid a supportive macro-economic backdrop of rising household incomes and consumer confidence which is expected to build a strong foundation for future profitability in the banking sector.
Yet, some experts are a bit more negative on European banks given the numerous challenges they face.
“We are concerned about the level of bad debt in some of the European banks and wouldn’t invest in them,” said Tony Yarrow, co-portfolio manager of the TB Wise Multi-Asset Income fund.
Yarrow instead prefers UK-listed banks HSBC, Standard Chartered and Royal Bank of Scotland, applying the same stock selection criteria it uses for all companies: seeking strong and experienced management, sound finances and a business model strong enough to resist competition.
One of the big concerns that has dogged the market since the crisis is capitalisation and the all-important Core Tier One ratio, said the Wise manager, yet this have improved over the past decade.
“On this measure, the banks we look at are two to three times better capitalised than they were going into the financial crisis in 2007,” he explained.
However, low inflation and low interest rates are more pressing challenges.
“While inflation remains subdued, interest rates are unlikely to rise significantly,” said Yarrow. “The economic recovery of the last decade has failed to create any significant inflationary pressures.”
European inflation over 10yrs
Source: Eurostat
He said there were two camps in the inflation debate.
On the one hand, those who argue that macroeconomic forces (such as debt, demographics, etc) are at work and would suppress inflation for the foreseeable future. On the other, those who believe that full employment and skills shortages will create inflation sooner rather than later.
Yarrow does not sit in either camp, however.
He explained. “We think the investment case for the banks we want to invest in works either way around. Banks are traditionally beneficiaries of rising interest rates, because their margins increase at such times.”
If rates don’t rise, said the TB Wise Multi-Asset Income manager, there’s still an investment case, which is that banks are better-capitalised and better-managed now than they were a decade ago; that they are cheap; and that the regulatory environment is unlikely to be as punitive in the coming decade as it has been in the last one.
“Banks are unlikely to pay as much fines in 2019-29 as they have in 2009-2019, for example,” he concluded.