Appetite for disruption
Banks currently represent 8.9% of the broader European equity market index MSCI Europe. They have been the underdogs of the European equity markets since the financial crisis. This is in sharp contrast to the US market where US banks have also been underperforming the broader market, but to a much lesser extent than in Europe as can be seen from the graph below:
100 EUR invested in May 2010 in a market cap weighted basket of European banks resulted in a flat return and missing out on a 104% performance in the European stock market.
100 EUR invested at the same moment in a market cap weighted basket of US banks returned 220% while an equivalent investment in the S&P 500 returned 270%.
The list of what went wrong in European banks over the last 10 years is long. First, ultra-low and partly negative interest rates ate into the net interest margins. Then, the Euro-crisis disrupted the financial sector and let to a situation where our European banks were much slower than their US counterparts to digest the non-performing loans they carried ( and still carry ) on their books. They still carry a heavy weight of sovereign debt so are heavily dependent on the health of the Eurozone.
You add a non-competitive position in investment banking compared to their US peers and you have a toxic mix explaining fading profitability and shrinking earnings of European banks. Valuation looks compelling on headline numbers. European banks, as represented in the EURO STOXX Banks index, currently trade on 8.3 times 2019 estimated earnings and 0.59 times book value ( source: Bloomberg ). It is not surprising their weight in value indices is increasing and they now represent 13.5% of the MSCI Europe Value Index.
However, valuation is not enough to raise our appetite as value investors to invest heavily in this disrupted industry. To us, it is all about profitability : with the interest rates so low the main profitability engine of the banks remaining broken, return on equity for European banks on average is estimated to be 7.5% in 2019, less than half than the pre-crisis level in 2007 of 15.5%.
At ECP, banks are part of our investment universe and we are looking at them. However, we find it very difficult to get comfortable with the ability of these banks to generate earning power in light of the uncertainties at hand. We own only 2 banks, Austrian Bawag and Spanish Caixabank, with each having their own very specific investment story. Both are significant players in their home market where they hold solid market positions across diversified activities. Bawag is already one of the most efficient banks in Europe. Their return on tangible equity is 2x higher than the average European bank, yet the valuation is 15% below the average European bank. This looks to be a clear mis-valuation by Mr. Market. The management of Bawag is in agreement with us and is planning a share buyback of 10% of the total company. This is unheard of in Europe. Caixabank is the clear market leader for retail banking in Spain. The bank has closed down a problem from the past (repossessed real estate) and now tackles a too high cost base. Both items should serve to expand the earnings and increase the quality of the earnings.
Léon Kirch, CFA
Partner & Chief Investment Officer