Barclays and Deutsche Bank Have Potential

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is hard to understand the upside opportunity in European banks, especially when there is almost nothing ever positive said about them. However, given enough time, I think the risk-to-reward on owning European banks will eventually improve.

What happened with these three European banks?

Source: Ycharts

Barclays (ADR) (NYSE: BCS), Credit Suisse, and Deutsche Bank (NYSE: DB) took a bit of a hit over the past month as investors have dumped the stocks over concerns of liquidity (banks have to hold onto a certain percentage of their capital and keep it on demand).

Source: Schlumberger

The whole premise to owning European banks is that they might be slightly undervalued relative to their future earnings potential. The weakness in the European economic zone has sent alarm signals to investors. Fortunately, the three banks (Barclays, Credit Suisse, Deutsche Bank) are globally diversified banking entities, helping to offset some of the risk to owning them.

Schlumberger projects that the Eurozone will eventually reach 0% GDP growth towards the end of 2013, and generate 1% GDP growth (year-over-year) by the end of 2014.

Barclays in a pinch

In a more recent article, I made the assumption that Barclays could be trading at a bit of a value. I still think there is a bit of a value proposition to owning the stock despite the new headwinds that are already coming from the company.

Barclays fell short of capital requirements based on a review made by the Prudential Regulation Authority. As a result, the bank has to increase the amount of capital on its balance sheet by $19.4 billion. Yes, that’s a “b” as in billion.

Barclays will be issuing a “rights issue” (think of it like a stock warrant) priced substantially lower than where the market is currently trading them at. The company’s rights issue will increase the share float by 3.2 billion shares, representing 25% of the existing ordinary shares. The added dilution will worsen the per-share performance of the company by around 25%.

Source: Barclays

In the past quarter, Barclays was able to grow revenue across every segment except the European residential and business segment. The difficulty in the segment will persist for the next couple of quarters. This is because the bank is expected to dilute its per-share figures as a result of not raising enough risk- adjusted capital (amount of capital held against liabilities on a bank’s balance sheet). The shortfall in capital will be addressed, and given enough time I think the bank will be able to recover. But for now, the sidelines would be the safest place to be until the euro zone economy recovers.

Deutsche Bank's risk exposure

Source: Deutsche Bank

Deutsche Bank, contrary to Barclays, will reduce the amount of assets on its balance sheet in order to meet common equity ratios. The effect on revenue has been largely minimal as the bank hasn’t reduced the size of its long-term loan portfolio by much. Reducing the amount of assets may mean reducing the amount of low-income, high-risk exposure activities that the bank undertakes.

Source: Deutsche Bank

The vast majority of the bank’s assets come from the corporate banking and securities business. It represents a pretty significant portion of the company’s total revenue, but can still be offset with growth from fee-based activities like asset management and transactions.

The company faces a vast majority of its liability and capital constraints from credit and clearing-house activities (corporate banking and securities segment). As a result, the amount of risk exposure can be reduced if it were to reduce its derivatives and clearing-house activities.

In theory, this sound pretty simple, but it actually took quite a while for US investment banks like Goldman Sachs (NYSE: GS) to report sizable gains in revenue and profits despite increasing tier-1 equity ratios.

Investment banking in the United States

I think that investors who feel that the risks of owning a European bank aren’t worth the hassle should consider looking at a homegrown brand instead.

Goldman Sachs reported fairly strong performance figures primarily due to growth in equity and bond underwriting. The investment banking segment grew revenue by around 29% year-over-year. The company’s fixed income, currency, and commodities execution segment reported 11% year-over-year revenue growth as the foreign exchange, bond, and commodities markets were volatile.

Goldman Sachs could surprise analysts going into the third quarter as the bank has exposure to the equity markets. If the stock market trends higher, then Goldman Sachs will earn larger fees from asset management. The company grew earnings by 114% year-over-year in the second quarter. Analysts are expecting the company’s growth to taper towards the second half of the year.

I don’t expect a repeat of second quarter performance, but I have reasonable suspicion that Goldman Sachs will easily jump over expectations in the second half of 2013.

Conclusion

The difficulties at Barclays and Deutsche Banks could continue, but given enough time, I think the stocks will trade at enough of a discount to make it worthwhile for long-term investors to buy.

Investors who can’t handle the uncertainty of owning European banks should focus their attention on Goldman Sachs even though expectations aren’t too high for the bank going into the third and fourth quarter of the year.

The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.


Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure