Banking Baedeker

The deal party has just begun. In the wake of UniCredit Banca's $23.4 billion bid for HVB Group, announced in June, investors are confident that more cross-border European banking mergers are on the way. Although that proposed Italian-German bank union is not the first major transnational banking alliance lately -- last November, Spain's Grupo Santander acquired the U.K.'s Abbey National for $16.2 billion -- it is the biggest, and it has taken deal making in the sector to a new level.

As Davide Serra, Morgan Stanley's London-based European banking analyst, puts it, "With information technology, risk controls and other fixed expenses representing one quarter of banks' operating costs, economies of scale will become increasingly critical, forging more cross-border mergers."

Even without the M&A lure, a contingent of international money managers find European bank stocks quite attractive. "Banks are tremendous cash generators," notes Merrill Lynch & Co. European banking strategist Stuart Graham, who sees top-line growth and restructuring, along with merger deals, as drivers of earnings and stock prices.

True, the rally in European bank stocks has been going on for a while. The group has outperformed its U.S. counterparts for the past three years, returning, in dollar terms, an average annual 14 percent, versus 8.7 percent for U.S. banks. (Over five years, however, U.S. banks outperformed 8.9 percent to 7.8 percent.)

Mindful of the rally's longevity, many portfolio managers are expanding their stock-picking horizons to invest in banks in fast-growing Eastern Europe and in the more robust Western European economies, notably Greece, Ireland and Spain.

Yet multiples remain attractive for the entire European banking sector: a trailing 12-month price-to-earnings ratio of 12, well below U.S. banks' trailing multiple of 13.8. For the 12 months ended June 30, the MSCI European banking index climbed 20 percent in dollar terms. During the same period U.S. bank stocks gained 7.72 percent and the Standard & Poor's 500 index rose 6.32 percent.

An especially strong endorsement of the European banking sector comes from Rudolph-Riad Younes, who co-manages the Julius Baer International Equity Funds I and II, which have more than $22 billion in assets. Free to invest in any region or industry in the world, Younes keeps nearly 25 percent of his funds' assets in European banks. (He is also keen on major oil companies, large cement manufacturers, European utilities and privatized airports and toll roads across the Continent.) Younes has delivered 15 percent annualized returns over the past decade, well ahead of the 5.41 percent return for the MSCI EAFE index in the same period.

He believes European banks will continue to outperform because the consumption of financial services in Europe lags far behind British and U.S. levels. At the same time, banks are becoming increasingly efficient through better risk controls, improved technology and effective consolidation.

At the moment, Younes says, he is "most concerned about overextended consumers in the U.S. and the U.K., where interest rate payments as a percent of disposable income are running between 23 and 25 percent." The ratio in Eastern Europe is in the low single digits. That's one reason why the funds' top ten holdings (as of second-quarter 2005) include the Czech Republic's Komercní banka, Hungary's OTP Bank and Poland's PKO Bank Polski and Bank Pekao.

Younes explains, "These are regional banking leaders -- transparent, well run and more often than not led by Western European management." He adds that the banks are expanding through internal growth and acquisitions and may become takeover targets themselves.

European bank stocks have helped the £500 million ($870 million), London-based Jupiter Financial Opportunities Fund, managed by Philip Gibbs, return 24.1 percent over the past year and an average annualized 15.9 percent per year over the past five years.

Like Younes, Gibbs is bullish on Eastern Europe. Recently, he cut his 8.7 percent stake in UBS in half, seeing more-attractive growth opportunities in Eastern Europe. Gibbs now has 12.6 percent of his fund's assets in Bank Austria Creditanstalt and Erste Bank. Both generate half their earnings from Eastern Europe -- a proportion that Gibbs expects to rise.

Meanwhile, he has started rotating out of Ireland, cutting his positions in Allied Irish Banks and Bank of Ireland from 4.3 percent to 1.5 percent of his assets. He believes that Ireland's growth will start to slow as its economy begins to converge with continental Europe's.

Guy de Blonay, manager of the U.K.-based New Star Global Financials fund, keeps 40 percent of the fund's £17 million in assets in European Union banks. That ratio has held steady since the fund debuted, under de Blonay's leadership, in December 2001. For the 12 months through June 5, New Star Global Financials returned 30.8 percent; over three years it's up an annualized 13.07 percent in sterling terms.

Though Gibbs has slashed his UBS holding, de Blonay remains optimistic about the stock, which represents 7 percent of his portfolio. He established his position in June 2003, when the shares were selling for Sf70 ($92); he was bullish on the firm's highly profitable investment and private banking divisions. "UBS is a growth story in a rising market," de Blonay says. He has watched the shares soar 40 percent over the past two years.

His next-largest position is Dublin-based Anglo Irish Bank Corp., which accounts for 5 percent of his fund's assets. "The company focuses on clients that large banks have overlooked," says de Blonay. "It has excelled because of its due diligence and credit discipline, which have produced a loan-loss ratio of just 0.55 percent."

As a result, over the past five years, the bank has enjoyed average annual earnings growth of 25 percent and an annualized return on equity of 30 percent. De Blonay purchased shares at E2.20 ($1.96) when his fund started up in December 2001. At the time, the stock was sporting a trailing P/E of just 8. By early June 2005 the shares were up 350 percent, trading at E9.90 with a P/E of 14.5.

Since the second half of 2004, New Star Global Financials has been building a position in Greek banks, which currently represent 5 percent of its portfolio. Holdings in Alpha Bank, National Bank of Greece and Piraeus Bank Group have appreciated by more than 50 percent over the past year as Greece continues its financial convergence with Western Europe.

David Loggia, manager of the Paris-based E110 million-in-assets Carmignac Grande Europe fund, part of asset management firm Carmignac-Gestion, has generated, in euro terms, one-year returns of 24.2 percent through June 5 and three-year annualized returns of 8.56 percent. He has invested 17 percent of his portfolio in EU banks and is especially enthusiastic about the growth prospects for Eastern Europe, Greece, Ireland and Spain. These economies, he asserts, offer greater opportunities for credit expansion than do those of other countries in the region.

Bank loans as a share of GDP are 30 percent in Poland, 95 percent in Spain and 143 percent in Germany. Credit card usage per 100 inhabitants is a mere 2.1 in Poland, compared with 26 in Spain and 39 in Germany.

Recent and prospective growth rates across Europe, moreover, are a tale of two continents. Among the so-called core countries, Germany, the Netherlands and Switzerland all had GDP growth of less than 2 percent in 2004. And the Economist Intelligence Unit forecasts that this year growth for all three nations will be 1.2 percent or less. In contrast, the Czech Republic, Greece and Hungary each grew 4 percent or better in 2004, and the Economist unit sees continued, albeit slower, expansion for all three this year: 4.3 percent for the Czech Republic, 2.7 percent for Greece and 3.4 percent for Hungary.

"Banks are effective proxies for playing strong growth economies," says the Carmignac Grande Europe fund's Loggia. Low penetration of banking products leaves room for considerable credit growth with limited competition.

As a play on Eastern Europe, Loggia owns a stake in Belgium's KBC Bank, which earns approximately one third of its profits from the region and sells for just 11 times estimated 2005 earnings. He established his position in the stock, 3 percent of fund assets, in August 2003 at E35; in early June it was trading at E66.

Although Loggia is not specifically looking for takeover candidates, he wouldn't be surprised if he found them. According to Thomson Financial, European banking deals have been on an upswing since 2003, when 228 acquisitions, worth a total $26.7 billion, were announced. Last year the number of deals fell to 218, but their value more than doubled, to $54.8 billion. Between January and July of this year, banks announced 90 M&A deals, valued at a combined $48.6 billion. Richard Peterson, a senior analyst at Thomson in New York, projects a year-end total of 220 deals, worth more than $100 billion, making 2005 the largest deal-making year for European banks since 1999. That makes those low P/Es all the more alluring.