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Stock Strategist

Beware of European Bank Value Traps

Despite recent price falls, most European banks are not bargains.

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With the European sovereign debt crisis dominating the headlines and many European banks trading near half of tangible book value, many value investors are drooling over the potential for bargain hunting. While many European banks' regulatory capital ratios look fine--most are near or above the new market-imposed 10% target--this disguises wide variation among firms, in our opinion. As we illustrate below, other measures show that many European banks are undercapitalized and have poor funding relative to U.S. banks. These banks may need to raise new capital not only in the near term as they prepare for write-downs on sovereign debt, but also in the long-term as investors become more conscious of the importance of investing in banks with sturdy capital bases. These capital raises are likely to be highly dilutive for current shareholders. We caution investors to beware of the value traps that may lie among Europe's many undercapitalized banks, and stick to the high ground of the best-capitalized, most liquid banks--namely, HSBC(HBC) (HSBA), Standard Chartered (STAN), and Julius Baer (BAER).

Hunting for Well-Capitalized Banks
With nearly all banks reporting adequate regulatory capital ratios, it can be difficult for general investors to distinguish between the best- and worst-capitalized banks. The chart below shows the core Tier 1 capital ratios of the major European banks, along with those of the top four U.S. banks. Core Tier 1 capital has largely replaced Tier 1 capital as the market's favorite gauge of banks' capital. Core Tier 1 capital measures the ratio of equity capital excluding preferred equity (and other types of debt-equity hybrids) to risk-weighted assets. As you can see, banks almost uniformly nearly meet or exceed the market-imposed 10% target and seem broadly comparable to U.S. banks. A couple, like Julius Baer and UBS (UBS) stand out as having capital well above the 10% level, but none stand out as having too little.

Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.