On Santander, Take the Warren Buffett Approach

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

Part of the Warren Buffett philosophy is to look at troubled sectors in search of a diamond in the rough. He believes that you should buy companies whose stocks are depressed by factors other than their underlying business, because fundamentals will always win out in the end. This got me thinking about Banco Santander (NYSE: SAN) and whether or not Europe's current economic woes make it a buying opportunity. 

Banco Santander, S.A. is the parent bank of Grupo Santander, which has operations across the globe. Being an archetypical modern bank, their activities range from mere deposits to providing insurance or financing. Their core business, however, is to provide retail and commercial banking solutions to clients in Spain, Europe, and the United Kingdom, and to the Americas through their various subsidiaries. Aggressive expansion has catapulted them to the upper echelon of international finance in terms of market capitalization, and they even have several subsidiaries like Banco Santander Brasil, S.A. (NYSE: BSBR), Banco Santander (Mexico) (NYSE: BSMX), and Banco Santander-Chile (NYSE: BSAC), which are independently listed on the New York Stock Exchange.

Until now, the government and the banks had been locked in a "chicken and egg" insolvency conundrum. Spain's housing bubble had burst and the banks were quickly finding themselves overrun with toxic assets that were depreciating rapidly. To combat the threat of a banking crisis, government intervention is almost always required. Spain's government, however, was facing its own crisis as investors were repudiating them for their large budget deficits by raising their borrowing costs. This vicious circle was broken when Eurozone leaders developed a program to recapitalize banks on the brink of collapse.

Fortunately, Banco Santander has been very proactive in developing a strong enough balance sheet to cushion the impact of Spain's flailing economy. They netted EUR 1.029 billion from selling an insurance operation in Iberia and a subsidiary in Colombia, and tapped EUR 2.45 billion of profits from the last nine months, all to help provision against real estate risk and non-performing loans. At the end of the last quarter they had completed 90% of their provisioning and comfortably passed their stress tests. The "bottom up" stress tests were part of a strategy by lawmakers to identify and isolate weak spots in the banking system, in effect assuring that strong banks would not suffer disrepute by association. The fact that Santander cleared those hurdles basically removes the previous fear that if one Spanish bank failed, then the rest would follow in suit. 

I won't spend too much time on weaknesses, because they are so incredibly obvious. The rise in non-performing loans since 2009 has been a constant headache for Santander and that trend is not yet finished. At the end of Q3, the Spanish NPL ratio stood at 6.38%, but they expect it to hit a ceiling at 7% before it begins to drop.   


<img src="/media/images/user_14986/santander-npls_large.png" />

Another weakness plaguing Santander is the absurd austerity measures enacted by PM David Cameron in Britain. Over the last few years his party has followed an agenda drawn purely from ideological grounds in the face of overwhelming evidence that austerity is crippling their economy. And with the next British election set for 2015, David Cameron and the Conservatives are going to be here for a while.

While I applaud their efforts to manage the ongoing crisis in their European divisions, those regions will not be responsible for Santander's growth. The important thing has been for them to neutralize any downsides in Europe, so that their stock can be buoyed by emerging markets. Santander's long term prospects are heavily dependent on growth in Latin American countries, since 50% their profits derive from those areas. Here is a map showing the projected GDP growth rates (according to the IMF) of Santander's largest markets:

<img src="/media/images/user_14986/santander-distribution-of-attributable-profit-by-region_large.png" />

Growth in developed countries ranges from lackluster (light red) to contractionary (bright red), whereas Brazil, Chile, Argentina and Mexico will all see their economies expand by more than 3%. Also, management has been trying to expand the Group's financing activities in light of a pickup in global auto sales. They recently received regulatory approval to start a consumer finance unit in China, the world's largest market for automobiles. And they are currently hashing out an agreement with Chrysler Group LLC to set up an in house financing arm for the US manufacturer.

One of the reasons I began contemplating this stock was that its darkest hours are seemingly past. There were severe moments in the last two years where Spain's whole banking system faced a crisis of confidence. Depositors were cashing in their savings for fear that their bank wouldn't survive the mayhem; and very often the fear of a bank run is a self-fulfilling prophecy. But it didn't happen, and while the Spanish economy is not yet saved, the banking system is. 

However, when investing in banks you should always understand that they may have skeletons in the closet. It's what you don't know, rather than what you do know, that will hurt you in this business. Some examples of this: 1) Barclays and the LIBOR scandal, 2) UBS and the LIBOR scandal, 3) HSBC and money-laundering, 4) JP Morgan and the London whale trading loss. All those cases display an unanticipated shock brought on by a reckless culture that exists in financial institutions today. 

When the Oracle of Omaha took a stake in the Bank of America, he justified it by touting their retail banking side. Likewise, Santander's retail banking side is one the best in the world and has thousands of branches and ATMs in each of its operating areas. Their problems stemmed from macroeconomic troubles, not a terrible investment bank side like BofA's did, and that has since been mitigated. Once investors start looking beyond the fog of EU politics, threats of Catalonian secession, and Spanish unemployment numbers, they will see a company that has a strong underlying business and good prospects for growth. These are the fundamentals that define a good business, so you should ask yourself: What Would Buffett Do?

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