If you’re getting tired of the daily beatdown in U.S. stocks, just be glad you don’t own European banks.
They’ve been pounded down to levels last seen when “Brexit” worries first gripped Europe in June 2016. European bank stocks roughly doubled after that train wreck. But now they’ve given it all back.
To feel a similar level of pain in the U.S., the SP 500 Index
would have to fall another 24% to 2,037 points, where it traded in June 2016.
Those kinds of moves are unlikely. A recession is not around the corner. But European banks have already taken these kinds of hits. So they look a lot more attractive than the FAANG names or most other U.S. stocks for that matter, as contrarian plays.
Read: Four reasons to expect a ceasefire in U.S.-China trade war
“I think it’s a great buying opportunity,” says Ian Lapey, who manages the Gabelli Global Financial Services Fund
Here’s his high level summary of the bullish factors at work.
European banks are trading cheap, or 20%-60% discounts to tangible book value. They’ve been recapitalizing, so their balance sheets are OK. Loan books look pretty clean. They’ve been cutting costs. And profitability will begin to improve once the European Central Bank (ECB) begins raising interest rates again, which will happen at some point. The upshot: “It is highly unlikely these really well-capitalized banks will be trading at such huge discounts in three to five years,” says Lapey.
Lapey is worth listening to when it comes to value because for years he worked alongside one of the great value investors — Marty Whitman at Third Avenue Value. During the roughly five years Lapey was co-manager and lead manager of the Third Avenue Value Fund
it gained about 12% a year, after fees.
What’s bugging European banks? Three things: Brexit, a Grexit redux featuring Italy this time and a possible recession. In each case, the fears are probably overblown. This suggests European banks hammered by those worries should recover.
Investors have been concerned about a possible no-deal “hard exit” when the U.K. parts ways with Europe in early 2019. That would leave the U.K. with no preferential European trade arrangements. Trade would be subject to default World Trade Organization tariffs. That would heighten the risks of recession in the U.K., hurting U.K. banks and European banks, which do a lot of business in the U.K.
Investors saw some progress last weekend when the European Union (EU) signed off on the beginnings of a deal proposed by the U.K. But lots of uncertainty remains. It has to be approved by Parliament. And even then most of the trade details remain to be worked out later.
Still, Causeway International Value Fund
portfolio manager Conor Muldoon thinks there will be no hard exit — so this disaster scenario for banks will be averted. He’s worth listening to because Muldoon and his team were awarded Morningstar’s International Stock Fund Manager of the Year in 2017.
Italy and the EU are wrangling over government borrowing levels in Italy. This has elevated fears that Italy might leave the EU, reminiscent of the worries swirling during the 2012 Grexit crisis. An Italian exit would raise concerns about the future of the EU and the value of Italian debt on European bank and EU balance sheets if Italy reverts to its own currency. This scenario would create such huge headaches that the EU and Italy will most likely find a way out.
Many indicators point to a sharp slowdown in Europe, most recently the weak purchasing manager reports for October. But a recession is unlikely.
“We still see Euro-area growth above trend next year in our central scenario given remaining slack, supportive credit conditions and a notable pickup in wage growth,” says Goldman Sachs economist Jan Hatzius. He doesn’t expect the ECB to start raising rates until late 2019.
While Euro banks may remain volatile near term, contrarian investor and Bear Traps Report author Lawrence McDonald sees upside over the next three months based on “attractive valuations and how much pain is currently priced in.”
When three smart contrarians like Lapey, Muldoon and McDonald line up against the crowd, I think it makes sense to consider going along with them. One way is to buy the Gabelli Global Financial Services Fund and the Causeway International Value Fund to get exposure to the expertise of Lapey and Muldoon. Here are six other ways to do so.
Under new management since 2016, this bank has raised capital, sold off non-core assets, cut costs and taken writedowns on non-performing loans. All of this has repaired the balance sheet and improved profitability.
Yet the stock has returned to 2016 lows before all these reforms, which doesn’t make sense, says Muldoon. “We see significant upside,” he says. “This is one of our highest conviction European banks that is right in the center of the storm.” UniCredit shares trade at a 50% discount to tangible book value.
Here’s another bank that has done a lot to improve its profitability without getting any credit for it, says Muldoon. Barclays has been restructuring by cutting costs and selling noncore assets. A Brexit “hard exit” is the main fear.
“Barclays is priced for a hard exit, but there won’t be a hard exit,” says Muldoon. Barclays looks cheap, trading at 60% of tangible book value and eight times this year’s earnings.
Deutsche Bank (TICKER:DB) and Commerzbank (TICKER:CRZBY)
Like the banks above, Deutsche Bank has fallen back to levels seen during the initial 2016 Brexit worries, even though it is now better capitalized. The bank has been posting profits, and its capital position continues to improve, says Lapey. “Barclays trades at less than 30% of tangible book value, a valuation like that implies much worse fundamentals than currently exist,” he says.
Commerzbank shares are also down sharply even though the bank has been recapitalizing and it has a strong loan book. Lapey points out that activist investor Cerberus Capital Management has taken significant positions in both Deutsche Bank and Commerzbank. This lends some credence to rumors that the two might merge.
NN Group (TICKER:NNGRY)
A spinoff from ING
NN Group is one of the largest insurance and asset-management companies in the Netherlands. Disclosure requirements established after the financial crisis give investors a much better picture of how well insurers can meet potential liabilities. NN Group has a very high solvency ratio and a strong balance sheet, says Muldoon, at Causeway International Value Fund.
Management has made good on promises to produce earnings and cash flow gains from its 2016 merger with Delta Lloyd Group. NN Group’s strong balance sheet means it can make more acquisitions like this one, or increase buybacks and dividends. The insurer looks cheap trading at about half of book value and ten times earnings.
iShares MSCI Europe Financials ETF (TICKER:EUFN)
McDonald at The Bear Traps Report thinks the European Central Bank will soon turn more dovish on monetary policy. “Any dovish positioning out of the ECB, and we’ll see Eurozone equities, especially the banks, rip higher on short covering,” says McDonald. (Short covering is when investors are forced to buy back shares they borrowed on hopes the stock would fall.) McDonald suggests this ETF as a way to play the move.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter, Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.
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Michael Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group. He attended Columbia Business School in the Knight-Bagehot program.
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