By Luc Plouvier, manager of the Kempen Global High Dividend fund at Van Lanschot Kempen
European banks are seen as a doomsday device to many, but they have been remarkably resilient in recent years. After a lost decade recovering from the financial crisis, they were again hit between in 2020 by the fallout of the covid pandemic, an energy crisis and spiking inflation.
During this series of mini crises, they have shown that something has finally changed. The slow but steady improvements in capital strength, risk costs and efficiency have led to a vastly improved investment proposition.
Those who invested in European banks over the past 15 years have mostly been disappointed. In the US the recapitalisation was done much more forcefully in 2008 with a large amount of new equity being put in by the US government.
The same process in Europe was much slower, more painful, and was paid for by shareholders over the past decade and a half. The starting point was worse and the process was slowed down by the Eurozone government debt crisis in the early 2010s.
Many investors have since avoided the sector entirely because of what were perceived as structural issues and that negative sentiment is still strong to this day.
However, we feel that the long, slow march towards a well-capitalized, profitable sector has mostly ended in recent years. That fact is still underappreciated by the market.
Capital strength
European banks have made big strides in bolstering their balance sheet thanks to multiple rounds of new regulation which have led them to constantly reinvest their profits in the business to further bolster their capital buffers.
During that process they also held on to capital well in excess of minimum requirements in anticipation of even stricter regulation.
However, further regulatory changes should have a less pronounced impact as we have reached the end of this cycle. Because of that, management is getting increasingly confident about their long-term capital requirements. This finally allows them to allocate excess capital towards increased shareholder returns.
Cost of risk and efficiency
Another consequence of the financial crisis was that regulators reigned in bank’s risky lending structures. Their businesses became simpler, which has led to lower volumes of non-performing loans and reduced loan losses. A more defensive business generally should command a higher valuation.
However, a simplified, less risky business also means lower margins. This has put structural pressure on the profitability of European banks. To compensate, banks have become more efficient and less complex. Branches have closed, and banking have digitalized at a rapid pace.
Many have refocused on their simple core offering, taking deposits and lending. As a result, an increased number of banks have become more stable cash-generative businesses. In our view this is the core requirement for an attractive investment.
Still undervalued despite the rising rate environment
The relentless pressure of the multitude of headwinds faced by the sector meant that valuations were pushed to extreme lows. Additionally, efforts to improve profitability were not able to materialise until interest rates started to rise.
The recent strong improvement in profitability has led to a strong rally with banks being the best performing sub-sector in Europe since May 2022.
Yet even after this rally, on the back of normalising interest rates the sector remains attractively valued, trading at seven times forward earnings, with a dividend yield of around 7%.
Some may argue that the rise in rates is just a short-term benefit that lifts all boats, which will fade once interest rates start to decline and hence these earnings are unsustainable.
Although the rising rates of late may mask that some banks are still low quality, on aggregate the trends for the sector are positive.
It can also be argued that the previous decade of zero- or negative interest rates were the anomaly. Forward markets certainly agree, with expectations for interest rates equal to the current 10-year rates.
Focus on shareholder returns
Many banks have shown commitment to refocus on shareholder returns. Dividend yields are already attractive and are increasingly being complemented by share buybacks. There are few sectors which match the European banks in terms of total shareholder yield currently.
Banks will always be a cyclical business, and not all banks in Europe are a sound investment. However, there are enough that tick the boxes of strong cash generation, sound capital allocation at an attractive valuation.
Although many investors still find it easy to come up with reasons to ignore European banks, we believe that they, at the very least, merit a closer look.
