European Bank Sell-Off Overdone
We see investment opportunities in the highest-quality stocks.
Many European bank stocks remain at multiyear lows, and we see an opportunity for investors to increase stakes in the highest-quality names at attractive discounts to our fair value estimates. We think the recent sell-off is overdone for several reasons. First, for most European banks, exposure to the energy sector--both direct and indirect--is more than manageable. Investment-grade energy bonds are pricing in losses of roughly 15%, which would result in losses of only 4.5% of common equity value, or six months of earnings for a bank otherwise achieving a 10% return on tangible common equity, and 3.6%, or just above one quarter of earnings, excluding the two most exposed European banks. Second, while lower-for-longer interest rates will be a near-term headwind for European banks, we've long anticipated a slow improvement in the economic environment, and we think recent optimism with regards to a strong European recovery was too much.
Some of the hardest-hit banks--such as UniCredit (UCG), where the CEO is under pressure to step down--have been some of the slowest to restructure postcrisis, indicating to us a level of frustration by investors at the pace of restructuring in the Italian banking system. This is a signal to other European banks they will be penalized with low valuations until management teams undertake more aggressive changes or risk being ousted themselves, as we've seen recently with the changes at Deutsche Bank (DB), Credit Suisse (CS), Barclays (BCS), and Standard Chartered (STAN). Finally, counterparty risk and notional derivative exposures are at the top of investors' minds. Here too we believe fears are overblown. Net exposures to individual asset classes, events, or counterparties are relatively manageable, especially in the case of interest rates, which make up a bulk of reported notional exposures.
Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.