Our Favorite Foreign Banks

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Most foreign banks enjoyed a phenomenal run in 2005, with banks in developing nations such as Brazil and Colombia leading the way. The six top-performing foreign banks in Morningstar's coverage universe averaged returns of 108.2% in 2005, the common theme being that they were all from emerging economies. Our six worst performers averaged a return of just 5.6%, and all of those were based in Europe.

While we do think that it is possible for business values to change a huge amount (e.g., a biotech company with a newly approved drug) in a year, we certainly don't believe the business values of banks are as volatile as their returns suggest. Certainly, we don't believe that intrinsic value can increase by 160%, as investors in Banco Bradesco BBD seem to believe. Either the bank was terribly undervalued to begin with or investors are expecting Bradesco to deliver the moon. We're strongly inclined to believe the latter. Going forward, we think investors in developing-nation banks should temper their expectations and maybe consider taking profits from the most overvalued names.

2005's Best- and Worst-Performing Foreign Banks
	Fair Value Estimate	Price*	Price/ Fair Value	1-Year Return**
Top Six Performers
Banco Bradesco BBD	$9	$32.30	359%	159.86%
BanColombia CIB	$15	$30.83	206%	129.39%
Unibanco Uniao de Bancos Brasileiros UBB	$14	$70.60	504%	127.38%
Kookmin Bank KB	$30	$72.60	242%	87.11%
Banco Itau Holding Financeira ITU	$13	$27.25	210%	84.75%
Credicorp BAP	$12	$24.30	203%	60.71%
Bottom Six Performers
Allied Irish Banks AIB	$52	$43.77	84%	10.00%
Banco Bilbao Vizcaya Argentaria BBV	$15	$18.53	124%	9.13%
ABN AMRO Holdings ABN	$22	$27.12	123%	7.24%
HSBC Holdings HBC	$77	$84.36	110%	3.38%
Lloyds TSB Group LYG	$44	$36.20	82%	3.16%
Barclays BCS	$56	$44.09	79%	0.64%
* as of 01-12-06 **Returns from 01-01-05 through 01-12-06, including dividends

Banks in the Bargain Bin

As the table suggests, our most-compelling ideas are Allied Irish Banks AIB, Barclays BCS, and Lloyds LYG. All three banks share some common characteristics. Their primary operations are in the decidedly underappreciated U.K. banking market, they have strong corporate governance standards, and they have returns on equity greater than 20%. The management teams of all three banks are compensated for delivering economic profits and total shareholder returns (dividends plus capital appreciation) measured on a multiyear rolling basis. The chairman and CEO roles are split. Total compensation is very modest, especially when compared to U.S. peers, and options dilution is minimal.

Allied Irish Banks is one of our favorite international banks. Ireland's phoenix-like rise is not the only reason for Allied Irish's success. Competition in Ireland is limited to five big banks, dominated by Allied Irish and Bank of Ireland. Allied Irish focuses on the basics of running a good bank--collecting deposits, controlling credit quality, diversifying among different sectors and keeping costs low. Nonperforming loans and charge-offs are minuscule. PAGEBREAK

Despite Barclays' current struggles in the U.K. retail banking market, we like its collection of diverse businesses and strong market positions. Barclays boasts a world-class investment bank that specializes only in debt, allowing for rapid innovation and introduction of new products to capture trends early. Barclays' card business--a business where scale bestows tremendous advantages--is the biggest in Europe, propelled by affinity marketing programs. But perhaps most exciting is Barclays' asset management division, spearheaded by its stable of ETFs. Though it contributes just 7% of operating profits currently, asset management is a wide-moat business with above-average growth potential. All the while, management has taken stern measures to bolster the cash cow banking business by hiring new managers like Deanna Oppenheimer, credited for turning around Washington Mutual's WM retail bank.