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Co-Authored by Christopher Gannatti, Research Analyst, WisdomTree

“Buy low, sell high” is a timeless investment principle that does well to exemplify the mindset of a value investor. It is clear that few sectors have declined to the degree that banks have, especially European banks. Price-to-book value ratios[1], commonly used metrics to judge the relative value of financial equities, are in some cases less than .5x, meaning that theoretically these stocks have book values that are at least twice as high as their current market capitalizations.

However, as is the case with many financial principles and accounting equations, what looks clean and simple on paper is much more complex in reality. Price-to-book value ratios, to be accurate, depend on the veracity of the denominator—book value per share, which should indicate the book value of equity on the firm’s balance sheet divided by the total number of shares outstanding. There is a lot of uncertainty regarding whether the book value figures currently reported for many of the European banks are an accurate reflection of the current market environment[2].

The fact is that many of the largest banks in Europe hold significant amounts of debt, the value of which is related to the ability of the debtor to continue to make payments of interest and principal. Sovereign debt gets the most attention, but other types of debt issued by corporations and individuals are just as significant in terms of magnitude. A European recession, if it occurs, will increase pressure on governments, corporations, and individuals for the continued funding of their debt obligations. In a recent research commentary, we looked at the top 10 European Banks by market cap. Their average YTD performance through 10/31/2011: -23.79%[3]. Their average price-to-book ratio: .63x[4], with 4 less than .5x. You can see all of the underlying numbers for these averages in more detail within our longer piece, entitled “Financials: Value or Value Trap? Why Bother with Financial Sector Risk When Compelling Opportunities Abound,” accessible here (.pdf).

Many might be lured into seeing value within these stocks, but we pose the question: If there is uncertainty as to whether the banks have written the full amount of their debt exposures to current market values, what does any book value measure truly represent? It is important to point out that these 10 banks in our study have an average leverage factor of 22x[5], meaning that any percentage write down in terms of assets is magnified 22x when its effect is transferred to the firm’s equity. In other words, in our view leverage magnifies the potential risk and uncertainty within these firms.

During periods of extreme stress, bank CEOs frequently emphasize the strength of their firms’ capital positions. When European leaders announced recently that one of their plans along the path to solving the current sovereign debt crisis was to have all of the major banks in Europe meet tier 1 capital[6] levels of 9% by June 30, 2012, not one bank stated that this would be a problem, and the echoing message across the institutions was that it would be done without issuing additional equity, an action that would dilute[7] current shareholders. The market seemed skeptical that this would be possible, and with some banks beginning to consider issuing shares that skepticism may have been well placed.

On November 14, 2011, Unicredit, an Italian Bank, reported a third quarter 2011 loss of 10.6 billion Euros, which included asset write-downs of 10.2 billion Euros[8]. As a result, the bank’s current financial metrics would indicate that it is about 7.4 billion Euros short of the amount of tier 1 capital required to exhibit a 9% tier 1 capital ratio, leading to a plan to issue 7.5 billion Euros in an offering of common shares[9].

Banks, especially when faced with market pressures rarely act alone, and analysts suspect that BNP Paribas (OTCQX:BNPQY), Societe Generale (OTCPK:SCGLY), and Deutsche Bank AG (NYSE:DB) (3 banks also included in our longer piece) may be forced to undergo similar share issuances[10]. Given the risk inherent in the high leverage and further potential equity dilution, we feel that international equity investors might be better served by deploying their equity allocations into other sectors. Bank stocks may look cheap, but so to do other sectors that do not have the same levels of leverage and other risk factors.

To learn more about one way to potentially avoid European Bank equity risk while still maintaining an exposure to international equities, click here to view our full-length commentary.(.pdf)

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Funds focusing their investments on certain sectors increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, call 866.909.WISE (9473) or visit wisdomtree.com.

Read the prospectus carefully before you invest.

WisdomTree Funds are distributed by ALPS Distributors, Inc.

Jeremy Schwartz and Christopher Gannatti are registered representatives of ALPS Distributors, Inc.

WIS003674 11/2012

Sources

[1] Price-to-book value ratio: ratio used to compare a stock’s market value to its book value. Lower numbers indicate potential to get more book value per dollar in stock price.

[2] Book value per share numbers may not fully incorporate the write down of sovereign debt holdings from carrying value to market value.

[3] Bloomberg. Calculated as a total return value, including dividends, in U.S. dollars.

[4] Bloomberg.

[5] Bloomberg. Leverage is calculated as total assets divided by total equity. Higher numbers indicate greater potential risk because asset write downs will have larger negative impacts on equity.

[6] Tier 1 Capital: measure of a bank’s highest quality, most liquid capital, frequently represented in a ratio over risk-weighted assets. Risk-weighted assets indicate capital that the bank must hold against its loan portfolio. Higher risk-weighted assets indicate a riskier loan portfolio.

[7] Dilution: increasing the shares outstanding implies that each share is entitled to a lower proportion of the firm’s earnings, making it less valuable as a claim on the firm’s profits.

[8] Jolly, David. “Unicredit Loses 14.6 Billion and Seeks to Raise Capital.” New York Times. November 15, 2011.

[9] Jolly, 2011.

[10] Enrich, David, et. al. “At Unicredit, Job Cuts and Share Sale.” The Wall Street Journal. November 15, 2011.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Value Or Value Trap: With The Risks Present In European Banks, Why Not Look For Value In Other Sectors?