STRATEGY

Invest in European banks? At least you’re buying low

The Globe and Mail

Deutsche Bank, headquartered in Frankfurt, changes hands at 75 per cent of tangible book value. (Ralph Orlowski/REUTERS)

Economically speaking, Europe is a mess – a continent devastated by recession and anti-austerity protests.

The euro zone’s hard pressed banks look even worse. And for intrepid investors, that’s precisely the attraction.

One of the world’s most out-of-favour stock sectors is now available at deeply distressed prices. While the plight of the continent – and its banks – could easily get worse, at least one well regarded investor thinks the risk is worth the potential reward and is beginning to invest.

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The valuations are compelling. Unlike Canada’s well-regarded but pricey banks, many financial institutions on the continent trade at or below their tangible book values – indicating that the market is pricing them below their apparent breakup values.

Deutsche Bank, the world’s largest by assets, changes hands at 75 per cent of tangible book value. Royal Bank of Scotland is even cheaper, at half book. Bank of Nova Scotia, by contrast, trades for three times book.

Prices are low because of Europe’s sovereign debt crisis. Banks’ balance sheets are made up mostly of loans to governments, companies and individuals, so they are highly exposed should economic conditions deteriorate. There are also concerns that some of the assets on the banks’ balance sheets may be worth far less than the financial statements would indicate.

But for the brave, the banks may offer that most straightforward of profit-making stratagems: buying low and eventually selling high.

Europe’s many travails are not exactly unknown, suggesting that some, if not most, of the worry about its banks is priced into stock values at the moment.

If that is the case, further downside might be limited. Over the summer, European Central Bank head Mario Draghi announced that he would do whatever it takes to save the euro, a signal that he was taking the possibility of some kind of bank-destroying collapse off the table. When a recovery comes, as it inevitably will, the banks could do well.

A further plus: Very few high profile investors are plunging into the banks, even though many money managers profess to be contrarians. The skeptics may prove to be right about the dire prognosis but, if not, the rewards will be particularly large for those who dare to buy in at today’s prices.

One of the few big name value investors to take a flier is David Herro, portfolio manager at the Oakmark International fund, who plunked down about $1.5-billion (U.S.) of his $9.2-billion in assets on the sector.

That kind of concentrated bet by a well known money manager should turn heads. Mr. Herro has a strong record as a stock picker and runs a fund with an enviable 10.75 per cent a year growth record over the past decade. If he’s right, he will be further lionized. If he’s wrong, it won’t be a career-enhancing move.

Through a spokesman, Oakmark said Mr. Herro was not available for comment. However, letters to clients and publicly available filings show that Oakmark has taken a fancy to six institutions: Bank of Ireland (which has also attracted the eye of Prem Watsa, head of Toronto-based insurer Fairfax Financial); Spain’s Banco Santander, Italy’s Intesa SanPaolo; France’s BNP Paribas; Switzerland’s Credit Suisse Group, and Britain’s Lloyds Banking Group.

In his latest letter to clients, Mr. Herro lauded Lloyds, saying its strong deposit franchise in Britain, where it is a dominant retail bank, is undervalued by the market. The bank also has very little exposure to Europe’s problem countries and “we believe it is a great investment for our shareholders,” Mr. Herro said.

To be sure, most money managers hate Europe’s banks. Bearish U.S. fund manager John Hussman panned the continent’s financial institutions in a note to clients this week, saying the worst is yet to come. The banking system will be restructured in the next few years, “meaning receivership, a wipe-out of equity value, a writedown of liabilities to bondholders, and an eventual recapitalization as the restructured entities are sold back to private ownership.”

But even if Mr. Hussman is right in general, a few strong banks could still fare well. Erin Davis, an analyst at Morningstar, says Royal Bank of Scotland is worth a look, given that it trades for half of book, “which is really cheap” and “the worst” of the crisis for the bank has passed.

She also likes Swiss private bank Julius Baer, a pure play wealth manager. “That’s an excellent business” capable of earning returns on equity of 40 per cent or even more, she says.

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