Sagging European Market Creates Opportunities

Banks struggling to find funding? Hedge funds collapsing due to toxic subprime exposure? A panicked Central Bank pumping money into credit markets?

While the above certainly encapsulates much of the turmoil in the U.S. markets, it is also a good summary of the issues roiling European and U.K. exchanges recently. With the FTSE Eurofirst 300 Index at one point having shed 10% of its value over the last three months, we thought it would be an excellent time to revisit the state of affairs in this part of the world. We've concluded that while corporate Europe will continue to suffer from credit concerns over the coming months, we do think fear and panic have provided investors a chance to snap up shares of quality franchises, specifically in the banking group, at an appropriate discount to their fair values.

Looking at which sectors have carried the FTSE down while also eyeing the newest European stocks that merit Morningstar's 5-star rating, it quickly becomes clear that the banking sector is the real investment opportunity in this part of the world. The FTSE Eurofirst 300 Banks Index had declined 12% at one point in July, and this index is still down 8% versus three months ago. Other large FTSE sectors such as Building Materials, Beverages, and Consumer Goods have suffered half the pain, with an average maximum drop of 6% in the same period. Each of these have since recovered much of their losses.

Sorting through Morningstar's latest European 5-star rated stocks, you do see some of the usual suspects. National telecom firms such as  France Telecom (FTE) and  Alcatel Lucent  remain compelling values, and the consumer turnaround story  Cadbury Schweppes (CSG) is still a good investment, in our opinion. The new kids on the block, however, are a pair of wide-moat banks:  Credit Suisse Group  and the fast-growing  Allied Irish Banks . We'll provide a background for some of today's banking troubles and then offer up a case for these two new 5-star picks.

How This Mess Began
In hindsight,  HSBC's (HBC) February warning regarding subprime losses in its American operation was as much a canary in the coal mine for the European banking industry as it was for American lenders. Prior to this revelation, Europe's investment banks were gorging on fees related to the leveraged buyout boom and a frothy merger-and-acquisition environment while retail lenders were savoring yet another year of double-digit mortgage market growth. The bad news came in short order, however, and the months of July and August introduced the same market-freezing panic that is currently plaguing American lenders.

Just as markets were recovering from the collapse of  Bear Stearns'  hedge funds, French banking giant BNP Paribas blocked redemptions from its internal hedge funds exposed to asset-backed securities. Fellow French insurer  AXA  also owned up to failing investments in subprime markets. As American mortgage firms began to topple into insolvency, Germany had its own bank failures. Regional lender IKB had to be bailed out due to off-balance-sheet exposure to American subprime investments.

While subprime investments have been painted as the source of distress for many retail lenders, it is not the cause of death. Short-term funding vehicles such as wholesale bank loans and mortgage securitizations have increasingly been the oxygen that powers financial-services endeavors, and in each case of failure, this oxygen was withheld by panicked market counterparties. Because wholesale lenders could not assess the extent of subprime losses at their client base, they decided to stop lending all together. Similarly, trouble in the asset-backed security market killed demand for securitized loan packages, drying up another source of funds.

Why Credit Suisse and Allied Irish Look Strong
With the markets still uncertain about what lurks in various financial balance sheets, it is important to ask who firms have been lending to and how they have been funding an expansion. In the case of Allied Irish Banks, the data are comforting relative to the situation facing many of its U.S. peers. According to Morningstar equity analyst Erin Davis, "Allied Irish is a plain-vanilla bank that takes deposits, makes loans, and earns a moderate interest spread. We appreciate the bank's conservative underwriting, which should limit write-offs in the event of a downturn." Its use of deposits rather than wholesale loans to fund asset growth makes it one of the sturdier banks in the market.

Credit Suisse is on sale not for its retail exposure but for risks related to its considerable capital markets and investment banking division. It has lent freely to private equity clients the last few years, often on generous terms, in order to rake in transaction fees. Similarly, its trading desk has been delivering record profits. With the private equity market at all but a standstill and lucrative trading strategies suddenly freezing up, Credit Suisse will likely see a more sober contribution from its investment banks going forward.

Still, Morningstar equity analyst Ganesh Rathnam thinks that patient investors with long-term investment horizons should be adding this firm to their portfolios. "Credit Suisse's investment bank--the largest and most volatile profit contributor among its business units--has come a long way since the late 1990s. Today, it ranks easily among the top 10 investment banks on Wall Street. Its specialties include leveraged finance, M&A advisory, and alternative asset management. It has successfully overcome the Frank Quattrone saga, rebranded itself by dropping the First Boston name, and made a conscious effort to rein in expenses. The investment banking business is due for a downturn after several years of record profits, but we believe these moves will help Credit Suisse comfortably earn its cost of capital at the cycle bottom."

While we are comfortable with the long-term outlook for each of these firms, near-term credit challenges do represent a risk. Should liquidity remain scarce for a longer period than we anticipate, then Allied Irish shares could be punished. Also, if Credit Suisse's investment banking activities take a deeper swoon than we are modeling, then its market value might also take a drubbing. With the European Central Bank working furiously to avoid market contagion and a strong European economy continuing to benefit from emerging-market demand, however, we think the risk/reward ratio is in investors' favor.