Baron Rothschild’s 18th century rule that, “The time to buy is when there’s blood in the streets,” is just as applicable today as it was 300 years ago. But today, we’re nearly eight years into a bull market and it’s tough finding value in stocks, let alone bargains around panic-selling.
The S&P 500 has returned 273% adjusting for dividends since the 2009 low and individual sectors are trading at bubble-worthy highs. Even the healthcare sector, one of the worst performing of the year, has jumped 360% since 2009 and trades at 16-times trailing earnings.
But investors in one sector are in full panic-mode. That sector is facing a perfect storm of fundamental and political issues. Several companies within the group are facing threats to their very existence.
Few investors are talking about the long-term upside in the group but one investment provides the opportunity to reduce your risk while still benefiting from the rebound.
Dark Clouds Over European Banking
European banks have lagged their US peers since the 2009 recession. The slower economic recovery in the EU and continuing problems in Greece have weighed on the sector.
While the European Central Bank was able to step in and avoid a systemic failure, negative interest rates have threatened the recovery. The yield on 10-year E.U. country government bonds is just 0.46% and while that means banks pay little interest on customer deposits, it also means rates on loans are also painfully low. The rate on new loans to corporations in July was just 1.92% across the common-currency region.
A group of the five largest European banks with U.S.-listed shares has risen just 142% since the 2009 lows, underperforming the 334% gain in the Financial SPDR (XLF) of US banks.
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This year has seen other risks adding insult to injury for the region’s financials. The June vote by the U.K. to leave the EU put its own financial sector on shaky ground. Top it all off with the recent decision by the U.S. Department of Justice to fine Deutsche Bank $14 billion to settle a case around pre-crisis mortgage-backed securities and investors have rushed to the exit on European bank stocks.
On a year-to-date basis, European financials have underperformed their U.S. peers by 17% — and that’s on relative weakness in U.S. banking as well.
Bankers Will Find A Way To Make Money
Extremely low interest rates are hurting profitability in Europe and headline risk has increased uncertainty in the space but banks in the region are much stronger than they were just a few years ago.
The European Banking Authority released the results of the most recent stress test last July, giving most of the region’s financial institutions a clean bill of health. Banks were tested for how much capital cushion they would have left on their balance sheets during a severe economic downturn.
Only 11 of the 51 banks measured were estimated to face a capital shortfall in the event of a severe economic recession, based on a cutoff of a fully-loaded capital ratio of at least 1.5% on a sharp economic downturn. That’s on the scenario of a three-year economic shock, a fairly unlikely event.
Headline risks this year may turn out to be the molehill rather than the mountain. The Brexit vote was only a referendum and it could be as much as six years for parliament to complete exit negotiations. Shares of Deutsche Bank jumped 14% Friday on reports of a $5.4 billion settlement with the U.S. DOJ.
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The European Commission may be about to ease rules around how regional banks build their balance sheets to meet capital requirements. A paper was released in March that pointed to easing regulations in the future and a global panel met in April to gather feedback from banks on proposed rules for capital they must set aside on trading activities.
Fundamental weakness around low interest rates could continue to weigh on the sector but if there is one thing I’ve learned over more than a decade as an equity analyst, bankers will always find a way to make money.
The iShares MSCI Europe Financials (EUFN) holds shares of 87 financials with banks holding the largest weight (53% of assets), followed by insurance (32%) and diversified financials (15%). The top ten holdings account for 43% of assets and Deutsche Bank has dropped to the 25th largest holding, accounting for just 1.23% of assets.
Shares of the European banking fund trade for just 0.84 times book value, a 24% discount to the 1.11-times multiple on U.S. banks. While the yield may come down as banks look to protect cash flow, the 4.8% dividend on the EUFN is more than twice the 2.1% yield booked on the fund of U.S. banks.
Risks To Consider: The fundamental backdrop of negative rates and slow growth will weigh on European banks to limit gains even as investor sentiment improves.
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Action To Take: As U.S. markets hit record highs, European banks offer strong long-term value on investor fears. Take advantage of the selloff to build a long-term position.
Shares could jump 19% to my target of $20.40 each on a modest 1.0-multiple on book value once headline risks around Deutsche Bank pass and on any new rules by the European Commission. A longer-term target of between $22 and $24 per share is within reach if interest rates start to rise.
P.S. We’ve identified the top “Crash-Protection” stock to buy now. It’s been around since the 1800s… and thrives during bad times. During the 2007 to 2009 recession, it had record profits. In fact, every time investors panic, this company increases its profits. Get the name of this stock here.
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