Morningstar's "Perspectives" series features investment insights from third-party contributors.
Not owning banks isn’t an act of dogged or thoughtless contrarianism on our part. We simply believe that most traditional retail banks face a number of structural challenges. These make us sceptical of their ability to generate sufficient returns over the long term to justify their current share prices.
Credit growth in the private sector in Europe is low, at less than 3%. Not only is this lower than it was 2006-07, when it was running at 10%, but demographics suggest that credit growth will remain modest. The structure of the population matters to banks: Europe’s ageing population makes it hard for banks to grow their loan books. In the next five years, there will be 1.5 million fewer Italians, 1.4 million fewer Germans, 825,000 fewer Spaniards and 315,000 fewer French citizens in the 35-53 age cohort. So we think credit growth is unlikely to recover to its pre-crisis rate.
Low interest rates also make it hard for banks to earn a decent net interest margin on their loans. We are stock pickers rather than macro analysts; but it is unlikely that rates will increase dramatically over the long term. And, in the absence of higher rates, banks' revenue bases will continue to be eroded.
The third factor is that many European banking markets are very fragmented. There are 620 branches per million inhabitants in Spain, 558 in France and 484 in Italy. Contrast that with just 173 branches per million in Sweden or Denmark. Because the eurozone is overbanked, it deprives lenders – particularly in Spain and Italy – of pricing power.
The fourth structural challenge comes from the way in which many large banks were assembled. Having often been built through acquisitions, they tend to have a jumble of legacy IT systems. The ongoing costs of maintaining these systems are huge.
A final challenge faced by ‘legacy’ retail banks also points towards the area of the market in which we do find opportunities: banks are being ‘disenfranchised’ by smaller, nimbler, more specialised competitors. Although we don’t own banks, Nordea aside, we do find abundant opportunities in the financial sector. New specialists are often performing tasks that were once the preserve of banks – but doing them better than the former incumbents.
Alternative Financial Stock Picks
For example, the French ‘merchant acquirer’ Worldline (WWLNF) is the largest provider of payment services in the EU and the only truly pan-European processing platform. This is a low-margin business where economies of scale matter. Worldline is more efficient than the banks, and has compounded its revenues by 5% per annum and its free cashflows by 12%.
Italy’s doBank (DOB), meanwhile, specialises in helping banks to recover their overdue loans. Size is everything in this business, and doBank is six times larger than its nearest competitor, Cerved. As Italian banks are burdened with €325 billion euros of troubled loans, we think this is smart way to profit from the clean-up of the Italian banking system.
Italy has high savings rates but its traditional banks are poor managers of all this personal wealth. Given this, the success of Fineco Bank (FBK) – a pure online bank and asset manager – in gathering assets is no surprise. It is essentially a beneficiary of the disenfranchisement and poor performance of Italy’s legacy banks.
It has a state-of-the art IT system and offers its customers a high-quality one-stop solution in banking, brokerage and asset management. With only 1.4% market share of deposits in Italy, Fineco has years of profitable growth ahead of it.
We doubt whether the outlook for Europe’s banks is as good as some investors currently believe. The prospects for some of Europe’s financial stocks, however, do seem compelling. Unlike the banks, the success of such companies will not depend on the market retaining its faith in reflation or a hope in loan growth returning to its pre-crisis highs. Instead, their returns will be driven by the ability of these companies to take a focused approach to tasks that were once the remit of mainstream banks and, by doing them better, take their market share.
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