The stress tests imposed on the banking system by the European regulators have not covered them in glory.
In 2010, the tests gave a clean bill of health to Ireland’s two biggest banks, just months before the Irish banking system disintegrated. History repeated itself in 2011 when Belgian bank Dexia was given the all-clear, only to be bailed out a short time afterwards.
It is perhaps these catastrophic failures that have made the regulators so eager for the new set of stress tests, the results for which are due on October 27, to be up to the job and truly analyse how banks would cope in another financial downturn.
The good news is banks have been rebuilding their balance sheets for some time. Consequently, most of the fund managers I have met recently expect there to be few surprises.
However, the importance of passing these tests has meant banks have resisted lending to small- and medium-sized enterprises, which has harmed both the banks’ profitability and the eurozone’s growth prospects.
This has led to many banks, and the European stock market in general, looking very cheap. In fact, the price-to-earnings ratio differential between Europe and the US is as wide as it has been since 1978.
So, why are the banks so cheap? It is a combination of overbearing regulation, which limits their profitability – perhaps terminally – a weak economy in the eurozone and authorities levying huge fines.
Admittedly, the picture is not as bad as it was in the depths of the crisis in 2008, but, aside from valuations, there is little reason for optimism. However, if you take a step back and imagine what the banking sector will look like in 20 years’ time, I suspect, given the huge barriers to entry, it will look much like it does today.
This brings me onto the concept of value investing. Value investing – buying stocks that are cheap in relation to their intrinsic value – is broadly accepted as the most consistently successful investment strategy.
So, if it is as simple as buying cheap stocks, why isn’t everyone doing it? The primary reason is human emotion – or the fear of being wrong and leaving the relative safety of the herd.
When shares are trading on low valuations, the sentiment around them can be extremely negative.
Anyone who advocated buying banks during the depths of the financial crisis would have been branded a lunatic, which means buying such shares requires nerves of steel.
As Nick Kirrage of the highly successful, FundCalibre Elite-rated Schroder Income and Recovery funds, both of which have a distinct value bias, says: “We buy stocks others can’t, won’t or don’t.”
I do not know what the results of the bank stress tests will be or if they will have a market impact. That said, it is not implausible for a credible test to lead to a re-rating of the banking sector.
This, coupled with the potential for increased lending – which may spur growth – and the European Central Bank’s adoption of quantitative easing further down the line, makes European equities, and banks in particular, an interesting place for a value investor to be.
Darius McDermott is managing director of FundCalibre
