How to Gain From Pain in Spain

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm joined today by Mac Pina. He is our international banking analyst. We're going to talk about Spanish banks and an intriguing play that he's found.

Mac, thanks for joining me today.

Maclovio Pina: Thank you very much for having me.

Glaser: Since here we're going to talk about Spanish banks, and the first thing when I hear Spanish banks is to run for the hills. When you talk about European debt crisis, after Ireland, Spain is next. Why would an investor in their right mind want to be looking at the Spanish banking system right now?

Pina: Well, as you mentioned, there is a – recent news have hammered most of the Spanish companies, but there is one financial institution that we like very much, Banco Santander, and which in our view has been being treated down quite a bit. It's at a fair discount to our – steep discount, I'm sorry, to our fair value, and we think that there is a way to gain considerable upside on that play while hedging against a sovereign macro risk against Spain.

Glaser: So, Santander is really a global bank, an international bank, but they're still exposed to Spanish market. How are you going to reduce that risk of exposure to Spain?

Pina: Right. As you mentioned, Santander is very geographically diverse financial institution and has relatively good credit quality metrics, coverage metrics. It has a sound funding base and it has good profitability prospects, but it is housed in Spain. So, what we're proposing is to go long Santander, ticker is SAN in Spain, and go short, Banco Popular Espanol, POP ESP. That's a pure-play Spanish Bank who in and of itself is not a particularly bad operator. But, its future profitability prospects are definitely much dimmer than Santander's having full exposure to Spain.

Glaser: Sort of pair trade like this, you'd expect that if the Spanish economy completely explodes that the Banco Popular shares will – the decline of Banco Popular shares, because you're short of that, you'll gain from that and then hopefully the Santander shares won't fall quite as much because they have their global operations.

Pina: Correct. The reason is that, while Santander is a Spanish financial institution, it's only about a fourth or less than a fourth of their profits come from Spain. However, 25% of its profits come from Brazil, another 20% come from Latin America. So, it's really gaining exposure to these emerging markets with profitable growth prospects tagged to them, that you would assume that Santander shares will eventually, following a fundamental approach, will eventually appreciate against Popular, which in our view, at best to the Spanish recovery will be a very long, slow recovery.

So, even though Popular is not a bad bank per se, it is subject to the Spanish economy and with that there'll be, we think, very high credit costs associated with a downturn and still softness in the housing market. With regards to the sovereign debt issue, there is eminent risk of being downgraded by the credit rating agency. So there is a whole lot of risks surrounding Spain that's around Popular as well, but we think are unfairly punishing Banco Santander.

Glaser: So, let's talk about Santander's valuation a little bit. Do you think it looks cheap on its own or would you really only do it as a pair trade like this?

Pina: It looks cheap on the price to fair value's trading at around 65% of our fair value, and it is cheap on that basis itself. However, there is a good amount of macro risk embedded in the Spanish company just because its headquarters are in Spain, and most of its debt is linked to the Spanish sovereign debt.

So, perhaps we haven't been pounding the table so hard on buying Santander on its own, but if you pair traded like and short the Spanish banking macro risk, then you can get some very decent profits out of that trade in our view.

Glaser: So, you can get some nice international growth while mitigating a lot of the macro risk.

Pina: Exactly. The caveat would be, well, why don't you since Santander is also traded in a couple of other markets, namely Chile and Brazil – their local operations are traded in those markets, why not just buy them? The reason would be that they – on a standalone basis, they are much more expensive than the global company by itself. So, that's the reason why we think getting a good exposure to those markets, we are the holding company. It makes more sense.

Glaser: Sounds like a good way to do it. Mac, thanks so much for taking the time today.

Pina: Thank you for having me.

Glaser: For Morningstar.com, I'm Jeremy Glaser.