Bank stress tests

The tests, in 2010, 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 Dexia, a Belgian bank, was given the all clear, only to be bailed out a short time afterwards. It is perhaps with these catastrophic failures in mind that the European regulators were so eager for this new set of stress tests, the results of which came out on October 27th, to be up to the job.

 The basic premise is that the tests are an asset-quality review, with the hope of finding out if there are any more skeletons lurking in the closet and whether the banks are sufficiently capitalised to withstand a deterioration in the macroeconomic environment.

The good news is that the banks have been in the business of rebuilding their balance sheets for some time. However, the importance of passing these tests has meant that banks have resisted lending to SMEs, which has harmed both the banks profitability and the eurozone’s growth prospects. This in turn has led to many banks', and the European stock market in general, looking very cheap. In fact, Europe hasn't been as cheap, relative to the US, since 1978.

So why are the banks so cheap? Well, it’s a combination of overbearing regulation, which limits their profitability (perhaps terminally) and a weak economy in the eurozone. This, combined with authorities on both sides of the Atlantic levying huge fines on several institutions, which seems to be more about what the respective bank can pay, rather than the seriousness of the infringement, leaves many banks trading below book value. However, if you take a step back and imagine what the banking sector will look like in 20 years, I suspect, given the huge barriers to entry, it would look much like it does today.

Value investing
This brings us onto the concept of value investing. Value investing, or buying stocks that are cheap in relation to their intrinsic value, is broadly accepted as the most consistently successful investment strategy. Perhaps its best known practitioner is Warren Buffett, whose ‘margin of safety’ investment style has seen him deliver compound returns of around 22%* per annum and become one of the richest men in the world.

So, if it is as simple as buying cheap stocks, why isn’t everyone doing it? Well, it could be as simple a reason as 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. Take the example of the banks in middle of the financial crisis. Lehman had gone under, RBS and Lloyds had been partially nationalised, and those that were left were suffering huge losses as their loans, related to the US subprime mortgages, turned sour. Anyone advocating buying banks then would have been branded a lunatic, which means buying these shares requires nerves of steel. As Nick Kirrage of the FundCalibre Elite-rated, and highly successful Schroder Income and Recovery funds, both of which have a distinct value bias, says “we buys stocks others can’t, won’t or don’t or simply find too unpalatable”.

In summary, I don’t know if the results of the bank stress tests will have a huge long-term market impact but, that said, I don’t think it is 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 ECB adopting quantitative easing further down the line, make European equities, and banks in particular, an interesting place for a value investor to be.

*Source: http://www.forbes.com/lists/2006/10/C0R3.html, 6th November 2014