A Proposed Portfolio of High-Quality European Banks

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

With clear signs of macroeconomic improvement in the Euro-zone, I think its time to start looking at its banking sector. European banks are not only the most sensitive sector in the economic cycle but also they trade very cheaply compared to their US peers (there is an average 42% price to tangible book discount to US banks.) On average, European banks sell for 80% of their tangible book value. In some cases, the discount is unfounded. This is the reason why I will propose to you a three-stock portfolio consisting of high-quality European banks.

High-quality and great expected performance

HSBC (NYSE: HBC) has a strong capital position that has now been made stronger through asset disposals such as the sale of Ping An for $7.4 billion. In HSBC's case, there is a huge potential for higher capital returns through dividends and share buy-backs as soon as the group achieves its targeted 10.5% Basel III capital ratio (which is now at 10.1%.) An ameliorated capital position added to more returns for shareholders and an even better profitability level (though cost cutting) make me think that HSBC has a lot to gain going forward. On top of the aforementioned facts, HSBC also offers huge exposure to the growing Asian markets.
 
Trading at 1.25 times its tangible book value and 9.8 times its price-to-earnings ratio, I like HSBC as an instrument to go long European banks. Generating a great return on tangible equity (ROTE) of 12.4% and paying a 4% cash dividend yield, I think HSBC should be 45% of the banking portfolio.

Finding value in France

Societe Generale (NASDAQOTH: SCGLY.PK) is cheap relative to its current fundamentals and looks like an opportunity when you take into account the very probable recovery of the French economy. The bank, which largely surpassed earnings per share consensus expectations in the first quarter, is taking the right measures to improve profitability. The key issues that are being taken care of are cost control and solvency. On the cost control side, Societe Generale has put in place a plan to cut costs by 8.5% (off of the 2011 base) with a self-imposed deadline set in 2015. On the solvency side, the bank is delivering above expectations. The current Basel III core ratio of 8.7% shall go up to 9.5% by the end of this year.

The most attractive feature of Societe Generale is its price. The bank trades at 58% its tangible book value and 5.8 times its price-to-earnings ratio. I also expect the bank to rise its dividend steadily. For 2013 I expect a 4% cash yield and for 2014 I would expect a 6% cash yield. I think Societe Generale should be 25% of this European banking portfolio.

A world-wide leader trading below book value

Deutsche Bank (NYSE: DB), the banking leader of Europe's biggest and strongest economy (Germany), is strangely cheap. Of course, Mr. Market has a point when it values Deutsche Bank so lowly. There are risks from litigation, regulation and a still tough macro environment; the bank is a strong international player, however, and has a strengthened capital position. After the equity increase, the bank has a 9.5% Basel III ratio, which is ahead of most of its peers (such as Barclays or JP Morgan.)

With underlying costs that are 9% better than consensus and with revenues and provisions also ahead of expectations, I expect investors to start focusing on the future and leaving behind the bank's 2012 dividend cut and recent capital increase. Deutsche Bank trades at 78% its tangible book value and 7.8 times its price-to-earnings ratio. I expect the bank's dividend to remain low at 2% until Basel III requirements are met. Given its low dividend, I would assign this high-quality banking institution "just" 30% out of this European banking portfolio.

Foolish conclusion

The performance of this high-potential portfolio will be tied to Europe's economic performance, which I think should ameliorate going forward. While you wait for the market to re-rate these stocks, you can enjoy a high-cash dividend yield. The weighted cash yield of this portfolio comes at a reasonable 3.4%. That said, I would expect this yield to grow fast from 2014 onwards.

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Federico Zaldua has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!

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