Our Favorite Foreign Banks

Most foreign banks have 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	$14	$70.60	504%	127.38%
Kookmin Bank (KB)	$30	$72.60	242%	87.11%
Banco Itau Holding Financeira	$13	$27.25	210%	84.75%
Credicorp (BAP)	$12	$24.30	203%	60.71%
Bottom Six Performers
Allied Irish Banks	$52	$43.77	84%	10.00%
Banco Bilbao Vizcaya Argentaria	$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 ,  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.

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.

Lloyds TSB is scaling down its overseas operations to concentrate solely on its home market in the U.K. We applaud management's courageous decision to eschew acquisitions, but this is not to say that management has totally given up on growth. Lloyds has stepped up the cross-selling of products in an effort to grab "wallet-share" after identifying such opportunities. For example, it discovered that its insurance customers didn't have Lloyds as their mortgage bank and vice versa. Growth from these initiatives requires no additional capital and will directly impact measures such as returns on invested capital, our litmus test for a company. The bank pays out 75% of its net income as dividends to enforce capital discipline.

Developing Titans
In our opinion, all banks in developing countries are wildly overvalued. What's more, we don't believe that every bank on this list is of the highest quality. Therefore, we want to shine a light on the few high-quality banks that merit attention should they ever drop in price.

Unlike parent bank  Banco Santander Central Hispano (STD), we have a favorable view on  Banco Santander Chile (SAN), Chile's largest bank. Chile is perhaps the most investor-friendly developing nation, having adopted a market economy long before neighbors such as Brazil and Argentina. The bank pursues retail and small business customers, a segment that traditionally generates higher returns on assets. At the same time, it controls credit quality to minimize charge-offs. Rock-bottom efficiency ratios around 44% ensure that the bank is solidly profitable. Return on equity averages 20%, solidly higher than the 11.5% cost of equity that we assign the bank.

Although we have reservations about the Brazilian banking system, we think that  Banco Itau  has found a way to thrive and generate superb results. Itau is countering compressing net interest margins by focusing on higher-margin retail customers. Acquisitions have bolstered Itau's fee-generating businesses such as credit card issuance and transaction processing, payroll processing, payday loan operations, and investment banking. However, we think Itau's cost structure is the distinguishing characteristic. The bank's 60% efficiency ratio outpaces competitors such as Banco Bradesco and  Unibanco . As a result, Itau's 4% return on assets is far superior to Bradesco's 1.9% and Unibanco's 1.3%. Management is committed to further reduce efficiency ratios to 50%, discontinuing less-attractive businesses and reducing head count. We think that Itau shares could be a very intriguing play on Brazil's economy if acquired in 5-star territory.

 HDFC Bank (HDB) is India's best-run bank. We think that this bank is superior to rival  ICICI Bank (IBN) even though the latter gets all the press. Success stems from a clearly defined corporate strategy of funding high-quality loans with low-cost deposits. HDFC has stuck with this mantra in the face of pressure to rapidly grow market share by any means possible. Net interest margins touched 3.9% in December 2005, more than double those of ICICI. Since India does not have a national credit rating process, the bank follows a rigid due-diligence procedure, making loans only after three different officers have approved them. The result: Only 1.5% of HDFC's loan portfolio is composed of nonperforming assets--rivaling banks in developed countries. By comparison, ICICI Bank's nonperforming ratio clocks in at 16.7%. Fee-generating services--mortgage origination, check-clearing, cash management, and credit card processing--have enabled HDFC to quintuple its fee income over the past four years, and returns on invested capital have averaged 19% over the past four years. While not spectacular, it easily bests HDFC's 14% cost of equity and could get higher still as the bank moves out of its rapid growth phase, becomes more efficient, and builds on its fee income. The management team has mostly remained intact since the bank's inception in 1994, which implies that HDFC's success is largely a result of management committing itself to a proven strategy.

Though in it is tempting to lose one's head nowadays, we strongly advocate that investors employ the same investing strategy with foreign banks as they would with any company: Identify superior companies and adopt a contrarian bent by buying when no one else is interested or holding out for a better price.