European Banks: Should You Continue to Play Along?

STOCK STRATEGIST: For those who don't need exposure, it may be time to take profits

Erin Davis 15 April, 2013 | 7:04PM
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European bank stocks have outperformed the market significantly since European Central Bank president Mario Draghi announced in July 2012 that he would do "whatever it takes" to save the euro. As markets absorbed this statement, the discount associated with the possibility of a eurozone break-up faded. In the following nine months, the shares of European banks have shot up more than 47% compared with just 12% for the FTSE 100. This impressive performance has led many investors to wonder whether there is still upside in European bank shares, or whether markets have got ahead of themselves. We argue that it is the latter that is true and that European banks are now, on average, fairly valued. We think their stock prices are built on the current calm in the market, which we see as mere complacency. We argue that significant risks to Europe's economic outlook remain, and that European banks will not return to their former profitability and instead will struggle to earn their costs of equity. Moreover, we think material risks remain to the market's generally sanguine view of European banks, as evidenced by Cyprus' recent deposit grab, and that at an average of 1.0 times tangible book, most European shares face more downside than upside.

The Key Question: Will the Rally Continue?

The rally in European bank share prices has piqued the interest of many investors, who are now asking whether the outperformance is likely to continue, and whether dips—like the one associated with the recent Cyprus deposit tax brouhaha—should be viewed as a buying opportunity. We assert that the shares of European banks are, on average, fully valued and that the current prices do not offer investors a sufficient margin of safety, given the still-large risks facing the European economy and the risk of additional shocks to the banking system. We think the recent events in Cyprus highlight the risk of unexpected negative shocks and demonstrate that the rules in Europe are being written as we go along.

Prices Assume a Certain Recovery

For all but the most troubled European banks, our fair value estimates are based on the assumption that there will be a slow economic recovery in Europe. In this scenario, we forecast that most European banks will, over the medium term, produce returns near their cost of equity (typically 12%), plus or minus a few percentage points depending on the quality of the bank's business model, geographic footprint and management. Our fair value estimates, therefore, tend to average 1 times book value.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Barclays PLC187.06 GBP0.00Rating
HSBC Holdings PLC437.30 GBP0.00Rating
Julius Baer Gruppe AG59.60 CHF0.00Rating
Standard Chartered PLC434.70 GBP0.00Rating
UBS Group AG16.43 CHF0.00Rating

About Author

Erin Davis  is a senior banking analyst for Morningstar.