by Ivan Martchev | October 2, 2012 7:00 am
The present action in European financials reminds me of a slow-motion repetition of U.S. financials’ action in 2008. It is more orderly and grinding, but is it really that different? At the risk of oversimplification, the problems with U.S. financials were their overleveraged balance sheets and the collapse of various mortgage securities that were improperly rated for the risk they carried. The problem with European financials is the decline in the prices of euro-denominated sovereign bonds — many also improperly rated for the risk they carry — as well as the mounting nonperforming loans in peripheral banking systems.
The European situation is more multi-faceted in nature and probably more difficult to solve, as the problem is as much political as it is financial. Investors looking for opportunities in the wake of the European Central Bank’s plan of unlimited, but conditional, buying of peripheral sovereign bonds have many options, from emerging markets’ small-caps to bombed-out European financials.
While I see upside in emerging markets’ small-caps, I am less confident about European financials. Put frankly, I do not know if the euro will survive. If it does, plenty of European banks that currently trade at discounts to book value will perform well – but after the storm has passed. If the euro does not survive, the resulting currency volatility and spiking interest rates in the periphery are sure to make matters worse for European financials with large exposure to exiting countries.
Although they are cheap, trying to bottom-tick European banks is an exercise in futility. I felt this way in the spring stabilization in European financials, and I feel the same way now. This problem is as much about European bank stocks as it is about sovereign bonds, as no stabilization in the former will come without stabilization in the latter.
Spanish 10-year sovereign bond yields surged 31 basis points last week, closing at 6.06% on Wednesday before retreating a bit into today. The closing high from this past summer is 7.62% on those same bonds; you don’t need more than a couple bad bond auctions and the typical news that comes out of Spain to trade above that level. Should this happen, Spanish bank stocks – the ones heavily long Spanish government bonds — would likely trade toward their summer lows.
There is a lot of value in some of those financials, yet it is difficult to unlock. Banco Santander (NYSE:SAN) is a good example: On the day it spun off its Mexican subsidiary by selling a 24.9% stake, SAN shares were down 4.1% with the rout in Spanish bonds. The shares of its freshly IPO’ed Mexican unit were up 6.9% on the first day of trading. (Investors placed $20 billion in orders, or 4.8 times the IPO shares offered, to get their hands on the Mexican subsidiary.) This offering prices the Mexican unit’s shares at 2.4 times book value, while the shares of the parent — which keeps a three-quarters stake — currently trade at 0.8 times book.
Santander is a good example of how the whole can be worth less than the sum of the parts. Banco Santander-Chile (NYSE:BSAC), one of the main banks in South America’s most-developed economy, trades at 3.1 times book value, while Banco Santander (Brasil) (NYSE:BSBR) trades at 0.9 times book. (The Brazilian economy has slowed significantly on fatigue in consumer spending, which is pressuring all Brazilian banks.) Still, if it were possible to separate the shares of the Spanish-only part of Santander and let the separately funded international subsidiaries go on their own, the book value multiple for the parent may be even more depressed.
This is because in 2011, Santander’s lending in Spain and Portugal fell by 4.6% and 5.6%, respectively, due to deleveraging, while lending in the U.K. was up 4.6% and Latin America up a whopping 17.9%. (Loans in local currency rose 20.3% in Brazil, 7.3% in Chile, and 30.9% in Mexico.) Continental Europe accounted for 42% of Santander’s 2011 total lending (29% Spain), the U.K. 34%, Latin America 19% (11% Brazil), and Sovereign 5%. While fiscal 2012 is still ongoing, we are witnessing very similar trends.
I do not mean to pick on Santander, which is a banking conglomerate that has made progress in Latin American emerging markets — the issues it is facing at home are not of its making. Spain’s other large financial, BBVA (NYSE:BBVA), also trades at a price to book of 0.8 and is facing the same problems.
If you want to bottom-fish for value with European financials, you may be better off with their separately funded emerging markets’ subsidiaries with no exposure to Europe.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates does not hold positions in any of the stocks mentioned in this article for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.
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