Value Column von Hans Peter Schupp

22. FEBRUARY 2023

Banks – unrecognized real value gems

Since the introduction of the EURO STOXX Banks index, it has not been possible to win any pots of flowers with a buy and hold strategy. After 35 years, the banks index is still 5 percent below its initial quotation. Only the dividends, with a yield of less than 1.2 percent per year, remain with the investor. That is very frustrating. And today?

Gold rush from 2003 to 2007

First, let’s take a step back, because this was not always the case. Particularly in the period from 2003 to 2007, there was a gold-rush mood in the banking sector, or, as the former managing director of the International Monetary Fund (IMF) and later German President Horst Köhler once put it: „An entire industry was blind to risk and intoxicated with returns.“ Everything was bet on investment banking. All risks were ignored.

But as it is so often the case: the high exhilarating party is usually followed by a severe hangover. With the global financial crisis of 2007-2008, everything changed abruptly. Many institutions could no longer cope with the balance sheet risks and were rescued – if at all – only with state aid. It took years to clean up the books and many investors lost confidence in the sector. Investors no longer even touched bank stocks with a pair of pliers.

The long lasting collapse of the entire sector

Banking regulators responded by doubling capital requirements. This led to a profitability crisis in the banking sector, as only half of the previous business was now allowed with unchanged equity. In addition, the ECB penalized bank deposits with negative interest rates and acted as a competitor to banks in the traditional lending business by purchasing corporate bonds.

The crisis of confidence and profitability led to the banking sector being valued at only a fraction of its equity. Take, for example, the German industry leader, Deutsche Bank. It is currently trading at less than 40 percent of equity. The negative interest rates and competition from the central bank are no longer present or are expiring. The bank has massively reduced risks and the equity ratio has improved significantly. This means that while returns on equity are no longer possible as in the El Dorado years, investors only pay less than 40 cents per euro of equity. In other words, the return on equity for the shareholder is 2.5 times the return on equity of the bank. With a return on equity (RoE) of 8, this means a return of 20 percent or a P/E ratio of 5. That is certainly not expensive!

It is no longer justified that bank share prices suffer from the crisis

And from a European perspective, the outlook for banks has also improved considerably. Shares in European banks, as measured by the STOXX 600 Banks index, have risen by around 18 percent since the beginning of the year – ten percentage points more than the broad market. Rising interest rates, the unexpectedly robust economy and the reporting season provided a tailwind here. Driven by bubbling interest income, average pre-tax profits rose by around 20 percent – ten percent more than analysts had recently expected. Banks also built up provisions, while loan losses remained at a low level. The common equity tier 1 ratio rose 0.2 percentage points to 13.4 percent, almost three percentage points above the European Central Bank’s minimum requirement.

Favorable valuations

On the other hand, costs rose, particularly as a result of wage increases, and credit growth slowed from around seven percent since mid-2022 to just under five percent last December due to more expensive funding conditions. Despite the recent rally, European banks are relatively cheaply valued, with an expected price-to-earnings ratio of 7.5.

Translation for convenience only!

The author: Hans Peter Schupp is a board member of FIDECUM AG and portfolio manager of the Contrarian Value Euroland fund.