john@johnducas.com

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EUFN: Betting on Europe’s Banks

 

It’s been a very troubled couple of years for Europe, and it seems like it still hasn’t exactly ended. Therefore you might think it silly to be invested in it. Although there is certainly a degree of risk, there is a much bigger chance of a larger payoff. In this article I will be exploring different economic histories and comparing them to the present, as well as give more insight into the banks’ prospects and potential.

 

 

 

Comparison of Economic History

 

 

 

Since the invention of modern day finance one thing we can learn is that problems come and go. This might seem very simplistic to you, but nevertheless it is true. As long as the problem can be manageable, it will be dealt with. There are countless examples of this. I won’t go through all of them but I’ll just give you a recent example. Take a look at America’s financial crisis. In March of 2009 the DJI bottomed at a low of 6626.94. At that point all hell had broken loose, the general public was panicking and the investors that had remained didn’t know what to do.

 

Now take a look at Bank of America’s stock. The same month that the Dow Jones reached the low, so did Bank of America. No one dared to buy it because of speculation that the government would step in and nationalize it. A few people dared to dip in, and the people who did had their most profitable years. A year later Bank of America had tripled in value. In essence what happened is that people overlooked the fundamentals, and instead focused on speculation and feelings. Feelings and speculation are always further ahead of fundamentals, but in the end fundamentals always catch up.

 

I feel like what is happened in the United States, is what is currently going on in Europe. We have already seen what happens when you ignore the fundamentals. It is for this reason that in the past year the EUFN index which is basically a collection of European financial stocks, has been up already 40%.

 

 

 

Macro-economy

 

 

 

David Herro who is the founder of Oakmark International Fund and recipient of the 2010 International stock fund manager of the decade said it best, ‘trying to predict the macroeconomy is extremely similar to trying to predict the weather, you can’t let the last storm impact the way you see the future’. He added ‘this is exactly what the investment community does, and it shouldn’t do—it gets obsessed with the macroeconomics, and it ignores microeconomics.’

 

You cannot forget that this investment is much more medium to long-term focused. Sure, in the short term there might be some disruptions that could possibly shake the economic balance. But recent European economic data released on August 14 2013 suggests a recovery in the region. After 18 months of contraction, GDP finally grew by 0.3% in the second quarter of the year. Olli Rehn, the commissioner for economic and monetary affairs and the euro said that the figure’s ‘combined with other recent positive survey data, are encouraging and suggest the European economy is gradually gaining momentum.

 

In order to help, Mario Draghi announced in early August that the Central Bank would keep interest rates on hold in order to ‘provide support to a gradual recovery in economic activity in the remaining part of the year and in 2014’.

 

This goes to show that the Central Bank is prepared to do anything for the economy to prosper and return to constant growth.

 

 

According to an article on BBC, ‘most diversified investment portfolios will have some exposure to Europe and because European stocks have been seen by some as cheap, it’s likely that exposure has increased since the eurozone recession began.’

 

An investment officer named Mouhammed Choukier at Kleinwort Benson which currently manages $7.4 billion stated that two years ago, he didn’t have any client money which was invested in Europe. Since the start of 2012, he has been adding to the positions and now his clients have about 20% invested in the Eurozone. ‘Without a doubt we think returns will increase’ he said.

 

 

I calculated the price-to-book ratio, which is one of the many indicators which can tell if a stock is undervalued or overvalued. The P/B in Europe is at a 25% discount to its longer term average. Countries like Spain are trading even lower at 45% discount. Germany on the other hand is at 15% discount. Another metric we can use is the Price-to-earnings ratio P/E, this will tell us how much someone is prepared to pay for every dollar in a company’s earnings. The Stoxx 50 which is a stock index in the eurozone is standing at 10 times earnings, in contrast the Dow is trading at 11.7 times earnings.

 

 

Banks

 

 

The growing confidence in the recovery in Europe has led big US funds to start lending to banks in the Eurozone. According to an article in the Financial Times, money market funds find that banks that are actually creditworthy are the larger institutions which act as a sort of equivalent to the central bank in each country. In 2011, when Greek banks saw a possibility that they might fail, US market funds cut their exposure to the banking sector in the eurozone. Short term financing providing to Europe has increased by 9 per cent since the start of 2013, on the other hand, lending to US banks has decreased by almost 13 per cent. According to Fitch, 15 per cent of the $652 billion in assets of the 10 biggest US money market funds were allocated to short-term deposits and debt securities with eurozone banks.

 

 

Along with the money market funds, big Hedge Funds have also started pooling into the Eurozone, with a particular focus on Greek banks. They feel that there is a huge potential for returns. Some of the Hedge Funds which are set to participate in the recapitalization of the country’s banks are Farallon Capital (AUM $21.5 bn), York Capital Management (AUM $14.4 bn), QVT Financial (AUM $11.7 bn) and a Greece-focused hedge fund managed by Dromeus Capital Group. This Greek focused fund has returned investors over 50 per cent in its first six months. Its managing partner, Achilles Risvas said ‘This is the mother of all recovery trades, the situation is hugely attractive because of the asymmetry of the pay-off’.

 

Even though this is focused on Greece, we are as well seeing an increase in investments to the eurozone.

 

 

EUFN- iShares MSCI Europe Financials ETF

 

 

The EUFN has holdings in the major European banks as well as minor holdings in insurance. The top 5 countries it has invested in are the United Kingdom, Switzerland, France, Germany and Spain. According to the 30-Day SEC Yield, it has a 2.07% interest rate. For protection against any news that could shock countries like Spain and Greece, the fund is invested in more stable countries like the United Kingdom which offer downside protection.

 

Screen Shot 2013-08-18 at 3.14.50 PM

 

As you can see from this chart, the EUFN has been on a long term uptrend and has gained over 38% in the past year, and about 14% since the start of 2013.

 

 

Let’s take a quick look at the fundamentals of some of the banks EUFN is invested in. The EUFN’s largest holding is HSBC which makes up 11.87% of the fund. HSBC Holdings Corporation ($HBC) is a ‘British multinational banking and financial services organisation’. It is one of the largest banks which has a global reach and has operations in all the major regions of the world.

 

Below is a table showing the sources of revenue as well as where assets are allocated across the six geographical regions as of 2011.

 

 

Asia Pacific, Ex- Hong Kong- 34.2% of profits and 12% of assets

Hong Kong – 26.6% of profits and 18% of assets

Europe- 21.4% of profits and 47% of assets

Latin America 10.6% of profits and 4% of assets

Middle East – 6.8% of profits and 2% of assets

North America – 0.5% of profits and 17% of assets

This data was found from an article on Seeking Alpha.

 

In 2012, when HSBC reported a loss in net profit, management stated that the loss was due to the slow growth of developed nations (Europe). On the other hand, emerging markets reported very strong results. This shows that once Europe recovers and sustainable growth takes over, HSBC will be in a very strong position thanks to its high exposure to Europe as well as Asia.

 

 

The EUFN’s second largest holding is Banco Santander, S.A ($SAN). Santander is a Spanish banking group which is centered on Banco Santander. It is the largest bank in the Eurozone and one of the largest in the world in terms of market capitalisation. Unlike HSBC which has gained 23% in the past year, Santander has only gained a meager 11.14% mainly due to the continuing turmoils in the eurozone. To compensate for its low performance and to attract investors, it has a dividend yield of 7.80%. Even though it is highly unlikely it will last long, it will at least probably last until things calm down in the eurozone.

 

One of the reasons I find Santander to be at such a price is because investors seem to be judging it based on the situation in Spain, even though Spain contributes for 14% of its total profits. Santander’s debt to equity stands at only 0.3 and has nearly zero debt. Most of its profits come from Latin America which made more than 40% in profits, Brazil being the prime country with 26%. Thanks to the rapid growth of these emerging countries, they will help fuel long-term growth for the bank.

 

All these are good points, but will benefit the Santander in the long run. There are still short term problems which need to be faced. Its profit margins will barely be touched by the crisis but since 30% of revenue comes from Spain, the crisis will cut into its revenue. Another negative is that Spain and Latin America’s non-performing loan ratio have gotten much worse which will lower Santander’s international credit quality.

 

 

Risks

 

 

Although all these points might all point to the upside, the downside risk cannot be ignored. As you already know, Europe, more specifically the Eurozone is still in trouble. I have calculated the book to leverage ratio of some of the larger banks in Europe as well as the United States.

 

 

Europe

Deutsche Bank- 2.6%

Barclays PLC – 3.5%

Bankia S.A. – 3.6%

 

United States

Bank of America- 9.9%

Citi Group – 10%

Wells Fargo- 10.2%

 

 

I would say that anything less than 10% would be too low. As you can see, European banks are clearly under-capitalized. This provides a great risk when thinking about what could happen in the future. If another, smaller crisis were to strike, banks wouldn’t have enough capital to offset the losses. And unless the ECB or any other sort of organization would lend money, larger banks could see the possibility of a default. The way this is being solved is through the LTRO program, which has so far been working. The program was done twice, but a third round is highly expected.

 

 

Stephen Lingard, who is the managing director of Franklin Templeton Multi-Asset Strategies has increased his allocation to Europe. He believes that in the next 6 to 12 months, valuations should climb back to historical norms which would in turn give investors a nice return. Even though he is invested in Europe, he cautions investors not to ‘get carried away’. He is still concerned with the current high unemployment levels and worries that ‘improving markets could cause policy makers to take their eye off many issues that are still pressing.’

 

 

Conclusion

 

 

While doing research for this article, I found a quote which I had written myself earlier in this article which is,

 

“The best time to own risky assets, like Europe, is when a country is coming out of a recession,” said Stephen Lingard. Take the US, for instance. Since the recession ended in June 2009, the S&P 500 is up 81%.

 

“When you get better economic data, you get big gains,” he said.

 

 

The main reason I’m positioned with the EUFN for this recovery is truly simple. During a crisis, the financial sector will usually be in the center of it. Therefore it will usually lose the most. This consequently means that when the economy recovers from the crisis, the sector which will gain the most will be the financial. We have seen this countless times during our history. Another way of playing this move in Europe would be to go with the more conservative Real Estate. It has very limited downside risk but not as big of a potential reward. That said, thanks to being invested in both more economically powerful countries such as the UK and Germany, EUFN is protecting itself from any turmoils countries like Greece and Spain could present.

 

In conclusion, Europe is still in its early stages of its recovery, and it still has a long road to go. This is why I like it so much, this ‘long road’ will bring bigger gains. Its still not too late to get in, the train hasn’t left the station just yet.

 

 

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