By Joseph Hogue, CFA
I have been bearish on the European financials relative to their U.S. counterparts since July of last year. While those in the United States have not seen runaway success - the SPDR S&P Financials (Financial Select Sector SPDR ETF: XLF) is down 6.6% over the past year - they have outperformed on a relative basis.
In an article I wrote last year, I suggested a position in the U.S. financials with a short hedge in the SPDR S&P International Financial Sector ETF (IPF), with significantly more exposure to the European market. The bet has paid off with a gain of 15.6%.
With any bet, it is important to know when the easy money has been made and when to change your position
When we looked at the market last year, banks in the United States were starting to surprise on the upside for second quarter earnings and economic data was just showing signs of life. The debt-ceiling debacle in congress and an escalating situation in Europe maintained downside pressure on stocks through December, but domestic growth won through in the first quarter of the year.
The second attempt at Greek elections and fear of contagion to Spain and Italy have pushed shares of European financial companies to bargain basement prices. While the banks are not in pristine shape, evidenced by last week's need for a bailout to the Spanish banking sector, a lot of the sovereign exposure has been sold to the governments in the region. European financial stocks are selling below tangible book value, an estimate of their liquidation value, and pay healthy dividends.
Things will most likely get worse before they get better, but I am not trying to call the bottom on this one. Investors should be looking to relatively strong banks in the region that can withstand further pain or diversify through a larger fund. Short of apocalyptic Armageddon, the financial system will survive in Europe and the shares will shed the significant fear discount.
Barclays PLC (BCS) is trading at just 0.41 times tangible book value, with a strong 26.7% operating margin. The shares are off their 52-week high by 30.0% and down to almost a fifth of their pre-2008 highs. Revenue is globally diversified with only 15% coming from the European Union, while the bank has larger stakes in the U.K. (40%), Americas (25%), Africa (15%) and Asia (5%). The shares pay a 2.1% dividend yield, slightly below average for the sector.
Credit Suisse Group (CS) is trading around 0.65 times tangible book value. The shares got hammered on Thursday, falling more than 9%, as the Swiss Central Bank told the bank to boost capital. New regulations under Basel III have placed heightened capital adequacy requirements on the banks in the region. Switzerland has self-imposed a higher standard of requirements on its banks even though losses due to the regional debt crisis are believed to be small. Revenue at Credit Suisse is globally diversified with only 23% coming from its Europe, Middle East, and Africa segment (EMEA), while the bank has larger stakes in the Switzerland (28%), Americas (38%), and Asia (10%). The shares pay a 4.0% dividend yield.
Investors with a lower tolerance for risk may want to look at the iShares MSCI Europe Financials Sector Index ETF (EUFN) for a more diversified bet on the sector. The fund trades at 0.81 times its book value and pays a 3.4% dividend yield. Shares are off their 52-week high by about 35%, but up just over 3% since the beginning of the year.
Contrast these valuations with the 1.06 times book value at which the SPDR Financials is trading, along with a yield of just 1.7%, and you start to see a compelling case for investment. Valuations at the individual U.S. banks may have risen too far relative to international peers. Wells Fargo (WFC) trades at 1.24 times book and is just 8.1% off its 52-week high. The bank has a larger exposure to residential real estate than domestic competitors, which may pressure shares if foreclosure activity increases after the recent multi-state settlement.
Greek elections over the weekend could lead to a volatile week when markets open on Monday. The Syriza party, opposed to E.U. imposed austerity measures, is threatening to demand a renegotiation of terms. A win by the party could mean the exit of Greece from the European Union and increased risk of contagion to Spain and Italy. This is a possible outcome, but not necessarily probable as some polls still show the New Democracy party in the lead. I think the pro-bailout parties will surprise and come out ahead in elections. Greeks overwhelmingly support their continuance in the eurozone and the popularity of anti-austerity parties in the first election may have been more carthartic statement than lasting support.
Even if markets do open sharply lower on Monday, the banking system will survive. The emergency and permanent funds set up by the E.U. to firewall the crisis are being implemented soon and global central banks are seen adding stimulus to spur growth. The iShares bank fund surged more than 25% from December to March after the first long-term recovery organization (LTRO) was implemented.
Spain and Italy see the majority of their funding needs through the first half of this year, while debt auctions and accompanying risk taper off into the second half. An escalation of the crisis over the next couple of months could see the credit markets freeze up, which would increase significantly the cost of needed funding.
A Hedged Strategy
While these shares do not necessarily have to be bought before the weekend, and the Greek elections, they could see a significant pop if pro-bailout parties win in Greece. This would take a lot of the easy money off the table.
A long position in high quality European banks can be played as a long- or short-term investment. Significant risks should subside through the next couple of months as emergency funding mechanisms come on-line and the E.U. designs policy response to a possible Greek exit.
Investors could wait until mid-July to initiate long-term positions, but can also take positions for a short-term bounce with downside hedging. Investment in the larger, more stable banks can be offset with a short in the regional fund to hedge some systemic risks. Conversely, put options sold on any of the positions can help protect investments in the short term, while still allowing for long-term gains.