European banks back in favour despite analyst gloom, says Old Mutual AM
Analysts upgrading their expectations for European companies in 2012, after deep pessimism in the third quarter led to widespread downgrades, should boost European shares even though the current reporting season is the worst since early 2009, according to Old Mutual Asset Management.
Kevin Lilley, manager of Old Mutual AM’s European Equity fund, said European shares could jump further than their two month rises so far, as management prognoses are so much more positive than downgrading analysts had been in the depths of 2011.
Since June, average expectations for 2012 earnings per share growth has almost halved, to 7%, whereas for 2011 the decline is down to 3%, according to a research note from Bank of America Merrill Lynch.
In one sense, analysts’ gloom was justified – only 43% of the 300-plus European companies that have reported fourth quarter earnings so far have beaten expectations – the lowest proportion since early 2009.
Excluding financials a modestly-better 46% beat expectations.
Only one third of financials beat consensus EPS predictions, below industrials (35%) and consumer goods (37%).
But Lilley said prices have fallen too far in the face of such gloom.
“In the third quarter economists were conducting ‘competitive downgrading’, seeing who could come out with the worst number for the Eurozone.”
In addition, he says, the earnings season that followed was “the worst we have had for years, partly driven by the climate we had in the fourth quarter, at the height of the negative political news. Things have improved since that period.”
If prices have not yet improved, they will, Lilley predicts.
He singles out the least-loved sector – banks – as the one with the greatest potential – “the sector can go up 30% to 40% from here just to get back to some of the multiples it was on in the early part of last year.”
The 200-day trend line for the sector’s share price performance is painfully close to – but still just below – the sector’s daily performance, at which point the shares would trigger a classic ‘buy’ signal.
Bank shares trade on price to book of about 0.67 times, compared to 0.8 to 1 times a year ago.
However it has been a roller coaster ride for the sector. It traded on around 0.55 times in early 2009 as the global crisis deepened, and “plummeted” back towards that level earlier this year. Before the whole crisis they traded on more than 2 times.
Lilley says the two tranches of the European Central Bank’s cheap loan program (abbreviated as LTRO) mean “banks, which have to finance significant debt this year, at a time the bond market was closed to them, do not now need to refinance. They can let debt mature.”
When ECB head Mario Draghi first announced LTRO, Lilley began overweighting banks – they are now the largest overweight in his fund – and he continues to add to them. Deutsche Bank, BNP Paribas and BBVA are among larger holdings.
Banks have recently been able to access bond markets – only for secured credit, but even Italian banks – and Lilley says the sector’s capital ratios are “significantly better than they were this time last year.
“The ECB has taken away the tail risk with almost-free money, the banks are better capitalised, and because of the stress tests the level of disclosure is much better than it has been for years.”
His portfolio is generally overweight mega-caps because, he explains, “the valuation levels are so cheap I do not need to look for the small cap companies.”
Lilley also favours cyclicals over defensives as the economic climate improves.
He is underweight defensives – telecoms, utilities and food – “because I do not see where the relative valuation potential is”.
Lilley adds much of the gloom around the economic outlook has focused on the eurozone – although this is only two thirds of Europe ex-UK, and even less of ‘pan-Europe’.
He notes Switzerland, Norway, Sweden and Denmark – none of which use the euro – have growing economies, “but the headlines are about the eurozone”.
European companies can build earnings exposure to such nations, or to robust Germany, or to developing economies.
He adds the shocks coming from Greece (as well as Italy, Spain and Portugal) have become quieter, even though the sovereign debt problems are not yet solved.
“The volatility on markets is calming down, which is good. It is what is needed for equity investors to come back.”