by Erin Davis
With many European banks trading at tiny multiples of book value and the word "Grexit" (short for Greek exit) now appearing in mainstream publications, investors may be asking themselves whether all of the bad news (and then some) has finally been priced into these banks' share prices and whether now is the time to buy. While we subscribe to Warren Buffett's credo, "Be greedy when others are fearful," we would exercise caution here.
We have repeatedly warned that European banks require more capital in order to withstand the ongoing crisis. Our analysis of how share prices performed during 2007-11 prior to capital raises shows that markets rarely fully anticipate the negative impact that bank recapitalizations have on shareholder value. Three months before a capital raise, we find that shares are typically priced at a 44% premium to their price on the day of the capital raise.
What does this mean for investors? Stay away, basically. European bank shares, even at 0.2 times-0.7 times book value, are far from dirt-cheap bargains.
European Banks Have Insufficient Capital
European banks are poorly capitalized relative to their U.S. peers. We see their tangible common equity ratios (averaging 4.7% among the major European banks we cover) as far too thin to absorb the deepening crisis in the eurozone.
The most troubled European banks, including Banco Popular (BPOP), UniCredit (OTC:UNCFF), and Credit Agricole (OTC:CRARF), are the most likely to experience dilutive capital raises and should be avoided. Only the strongest European banks, such as Julius Baer (JBARF.PK), HSBC (HBC), and Standard Chartered (OTC:SCBFF) do not need additional capital, in our opinion.
Capital Raises May Not Be Fully Priced Into Shares
An efficient markets theory would hold that the dilutive effects of capital raises are already priced into shares. In order to examine this conclusion, we reviewed stock price performance before and after all major capital raises by the European banks under our coverage during the first phase of the financial crisis. On average, share prices were 86% above the announcement-day price six months before the announcement of a capital raise, 44% above three months prior, and 10% above until a week before the announcement. In our study of 17 major capital raises, the capital raise was fully (or more) priced into the stock price in only five cases three months prior to the announcement.
If the past is any guide to the future, the announcements of capital raises at European banks are likely to send share prices sharply downward, in our opinion. We urge investors to wait for better buying opportunities.
U.S. Banks Recovered Only Slowly After TARP Was Announced
We think that Europe should embark on a sizable, coordinated, and forcible injection of capital into its banking system, as the U.S. did in late 2008, which eventually stabilized the banking system. However, we note that U.S. bank shares did not rally when the Troubled Asset Relief Program was authorized in October 2008, and continued to fall for several months as TARP funds were disbursed. Share prices did not stabilize until after credible stress tests and plans for recapitalizing banks were announced in late February 2009. This reinforces our thesis that bank rescues are not yet priced into shares, and that share prices are unlikely to experience a sustained recovery until after credible recapitalizations are announced.
We would be encouraged by a European announcement of a program similar to the U.S. Supervisory Capital Assessment Program, or stress tests. The SCAP was designed by U.S. bank regulators to assess whether important U.S. financial institutions had large enough capital buffers to withstand both a baseline scenario and a more pessimistic scenario. Importantly, the tests were conducted in a transparent manner, the adverse scenario was designed to be creditably harsh, and program managers had enough funds on hand to recapitalize the banks. European leaders have attempted to replicate the success of SCAP in the past, but failed to design harsh enough stress tests, in our opinion, and as a result their past efforts have lacked credibility.
Going forward, we expect that credibility will remain an issue, as will the question of whether European countries have the funds necessary to sufficiently recapitalize their banking systems. We advise investors to remain on the sidelines until sufficiently harsh tests are conducted, and until a large pool of funds is made explicitly available to recapitalize the banks.
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