Chicago-based Perkins managers explain why they are avoiding Europe
Managers and analysts at Perkins Investment Management, Chicago-based subsidiary of US investment manager Janus Capital Group, have explained why they are avoiding European assets.
Gregory Kolb is Portfolio Manager of the Perkins Global Value strategy. Tom Reynolds is a research analyst covering the financial services sector, a position he has held since joining Perkins in August 2009. Together, they have answered questions about their firm’s views of Europe.
Q: Is Perkins finding opportunities with European banks today, given that the segment is down more than 50% and significantly underperforming other sectors?
Greg Kolb: It’s true that many European banks, including some attractive, higher-quality franchises, have fallen below long-term average P/E and price-to-tangible-book value (P/TBV) ratios. However, just because a stock is down in price does not mean it’s attractive from a risk/reward perspective.
US bank stocks, as a group, bottomed at approximately 55% of tangible book value in 2008, but three of the 10 largest US depository institutions also failed or were taken over for almost nothing. Three major U.S. investment banks suffered the same fate.
The average P/TBV in European financials is currently around 0.9x, with several of the larger money centre banks trading between 60% and 110% of tangible book value. This is well above the trough levels experienced in the US crisis.
At this point, we don’t believe the market is focused enough on potential downside exposure, based on the significant unresolved and, in many ways, unquantifiable systemic risks across Europe.
These include: 1) the size of the banking system relative to gross domestic product (GDP) and the resultant ability for European governments to bail out their banks, since sovereign governments are already strained themselves; 2) overall leverage and funding model risks, including ongoing deposit flight from the periphery; and 3) euro-zone political union and common euro currency risks, which present ramifications for capital flows and contract law in the event of a disorderly disintegration.
Each of these issues raises significant questions and presents tremendous downside risk, leading us to avoid European financials in general.
It is easier to grasp the sovereign government and bank linkage problem by understanding bank size relative to each country. In the US, there’s the concept of “too big to fail.” For context, JPMorgan’s total assets are currently 15% of US GDP. That seems pretty big until considering that total assets for BNP Paribas are roughly 70% of French GDP.
While total US banking assets to GDP are about 82%, in France the ratio is around 400% according to some estimates, though probably closer to 300% after normalizing accounting approaches between the two countries. This sheer size difference creates significant problems.
The US government bailed out its financial system in 2008 with the TARP program, which represented about 5% of overall banking assets, and other programs that provided significant asset guarantees and liquidity provisions. Markets trusted these actions in part because the US government’s debt burden was not oversized at the time. In contrast, if France needs to bail out its banks, a 5% TARP-like bailout would equal 15% of French GDP, and if funded with government debt would take France’s debt-to-GDP ratio from the current 90% level to 105%.
At that point, it is questionable whether markets would deem the French government stable enough to backstop liquidity in its system or whether a 5% capital infusion would even be enough to plug balance sheet holes in a wholesale-funded model. In short, it is not clear whether all the European countries have the strength to support their relatively large banking sectors.