Heavy clouds of pessimism loom large in certain corners of the European financial world these days. The tales of woe echo from the verdant vales of Ireland, across the sun-drenched plains of Iberia, to the noble monuments to antiquity in Greece. While the bad news has justly punished the wicked among banking stocks in these regions, we think it has also unnecessarily tarnished the righteous. While none of the European banks in our coverage universe are 5-star buys at the moment, many are trading a significant discount to our fair value estimates--and seemingly without much regard to quality. We think the market's apparent lack of differentiation between the winners and the losers is presenting an opportunity for investors with an eye on European financials.
We're highlighting examples from three countries: Spain, Switzerland, and the United Kingdom. We note with some surprise that the banks facing the strongest headwinds in these countries--Banco Popular in Spain, because of its lack of geographic diversification, UBS (UBSN) in Switzerland, because of its damaged reputation, and Royal Bank of Scotland (RBS) in the UK, because of its government rescue and ongoing breakup -- are priced at similar or less attractive discounts to fair value compared to their less risky peers. We think that the turmoil in Europe has frightened the market into tying valuations too closely to book values without differentiating between firms. In our opinion, this is an example of the market throwing the baby out with the bathwater, thus creating opportunities for long-term investors.
Banco Popular, in Spain, is a pure-play Spanish bank. At similar discounts, we'd much prefer to buy shares of either BBVA (BBVA) or Santander (STD), both of which benefit from exposure to Latin America. BBVA owns Bancomer in Mexico, the country's largest bank by assets, which keeps the group's growth and profitability well above the eurozone average. For example, during the first nine months of 2010, BBVA's Mexico unit earned a return on assets of 2.3%, and the group as a whole earned 1%, compared to near break-even results at many European banks. Similarly, Santander owns large, tremendously profitable banks in Brazil and Chile, which have kept returns high during the crisis, although the company is more exposed to slower growth and lower profitability in the UK Even in the best case scenario, where harsh austerity measures ward off a Spanish bailout but cause a protracted downturn, we think Banco Popular is in for a rougher road ahead than either of its two more diversified cousins. In the nine months through 2010's third quarter, Banco Popular's returns were only half that of its two more diversified cousins because of heavy losses in Spain, and we think returns have yet to find a floor.
We're also surprised to see Credit Suisse (CS) and UBS trading so closely together, when Credit Suisse is clearly the more attractive of the two. UBS took on too much risk leading up to the crisis, and while write-offs have slowed to a trickle, the bank is still paying the price for its excess. Its cash-cow private bank was only able to attract net new assets for the first time post-crisis in the third quarter, and then only by a hair. We wouldn't be surprised to see this number turn negative again. In comparison, Credit Suisse has been gaining share and attracting net new assets at a steady clip since 2008's first quarter, and suffered outflows in only three quarters. Moreover, we think Credit Suisse's investment bank is better positioned to cope with the new higher-regulation, more risk averse, environment, as this is less of a departure from its pre-crisis strategy. In contrast, UBS is only now implementing an integrated "one bank" strategy similar to that adopted by Credit Suisse in 2005.
Finally, we're seeing the same pattern in the UK when we compare the relative valuations of Barclays (BARC) and Royal Bank of Scotland. While both face significant regulatory uncertainties and higher capital requirements, we think it is much less clear how RBS is going to fare. Both in order to comply with EU directives related to its rescue, and to adjust to the coming Basel III capital requirements, RBS must sell huge chunks of its businesses and riskier assets. How quickly it is able to do so--and at what prices-- remains a question mark. Barclays, on the other hand, faces somewhat easier questions about how its expansion in investment banking will pay off, and whether it will have to roll back some of its growth. Moreover, with Barclays likely to post returns on equity of around 10% in 2010, versus a near break-even year at RBS, and the lack of government ownership at Barclays, we think Barclays is much further along on the path to recovery, and therefore faces a less risky future.
In summary, with most European banks trading at a discount to our fair values, we think now could be a good time for investors to round out their portfolios with strong European banking franchises. While we're all for discount shopping, we see little reason to invest in off-brand stocks when market leaders beckon at similar discounts.
