Stocks rose last week after the US central bank again indicated it was prepared to slow down the pace of interest rate increases.
We are invested in Value stocks, specifically European banks, because we feel the global economy has stabilised to such an extent that banks are again investable, while investors remain pessimistic. If the economy holds up, we see 50%+ upside for many of the positions in the portfolio.
Take the German banks $CBK.DE (Commerzbank AG) and $DBK.DE (Deutsche Bank Aktiengesellschaft) . German banks acquired a bad reputation over the past decade because there were too many players in the German banking market, leading to low industry profitability. The big German banks had to deal with their own unique problems, as they had overextended themselves before the 2008 Global Financial Crisis and had to retrench during the 2010s. Commerzbank and Deutsche Bank never earned adequate returns on their capital, and many investors gave up on the hope that they would ever improve.
This year, however, the environment has changed for the banks. Both Commerz and Deutsche benefit massively from higher interest rates, and as interest rates have moved higher, so have estimates of the banks’ future earnings. Commerzbank has seen its 2024 earnings estimate increase 40% since the beginning of the year. The shares have returned +20%, underperforming the increase in earnings estimates, because of the deteriorating economic situation.
If the economy does hold up in 2023, we could see a re-rating. The shares currently trade at 5x 2024E earnings, a distressed level: a normal bank trades at 10x earnings. Analysts who follow the company and have a bullish opinion on the stock think the shares could reach 12 euros next year. That would be a 50% return. We believe this is reasonable in a positive economic scenario.
A similar story could be told about many other European banks. The large French bank $BNP.PA (BNP Paribas SA), for example, trades at 6x 2024E earnings, while a normal valuation for this company since the Global Financial Crisis has been 9x. 50% upside is thus possible – provided, again, that the economy holds up.
What if it doesn’t? Banks typically fall 50% in recessions, so the downside if there is a 2023 recession leading to credit losses for the banks is also substantial. The idea of our strategy is to take higher risk for higher returns, so we accept this risk. To manage the risk (though it cannot be eliminated), we monitor the Germany-Italy interest rate spread, and have also not bought banks in countries where housing markets are at risk of a significant correction (Poland, Norway, Australia, Finland, Sweden, Canada).
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