Have Spanish Banks Fallen Enough?

05/30/2012 4:31 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The market seems to have discounted the shares more than enough, says MoneyShow’s Jim Jubak, also of Jubak’s Picks, but investors need to understand the very real risks that remain.

I can understand if you don’t own Banco Santander (STD) or Banco Bilbao Vizcaya (BBVA).

The Euro debt crisis just seems to drag on and on, getting scarier with each day. And Spain is the current center of that crisis. And Spanish banks are the focus of the Spanish crisis. So owning these two stocks, even if they’re the best banks in Spain, feels very risky on most days recently.

So why do I own them in my portfolios? Let me explain my reasoning on these two stocks right now. (I own Banco Bilbao Vizcaya in my Jubak’s Picks portfolio and Banco Santander in my Dividend Income portfolio.)

At current prices, I think both stocks have pretty much discounted all the risk of a meltdown in their portfolios—short of the very unlikely event of a Greek-style de facto default by Spain on its sovereign debt.

For example, Credit Suisse has run a scenario that looks at a full write-off of the property portfolios of Spain’s banks. For Banco Santander, that would result in a loss of €16 billion—no mean sum—and although the bank would take a big hit to earnings from a need to add about €8 billion to its provisions against losses, it would not need to raise additional capital. Neither would Banco Bilbao, where the loss would be €10.9 billion and the bank would need to add €6.5 billion to its provisions for losses.

How could these two banks take a 100% loss on their property portfolios and still come out so well? Because while each of these banks is headquartered in Spain, most of their assets aren’t in Spain. For example, only 25% of Banco Santander’s loan book is in Spain. About 50% of Banco Santander’s profits come from Latin America. Spain accounts for just 33% of Banco Bilbao’s income.

That geographical exposure has let these two banks build up comfortable capital cushions—Banco Santander showed a 9.1% core capital ratio at the end of 2011, for example, by the strict European Banking Authority standards—and to show relatively low ratios of non-performing assets (4% at Santander).

That doesn’t mean these two bank stocks aren’t without risk—it’s just that at this point in the trashing of their stocks—shares of Banco Santander are down 49% in 2012 through May 29 and shares of Banco Bilbao Vizcaya are down 46%—I think the big risks are political.

It’s the uncertainty of what the Spanish government might do—and especially the possibility that the government might force these two relatively healthy banks to acquire some of Spain’s worst banks—that links these banks to the Spanish banking crisis, and sends their share prices tumbling whenever there’s bad news about another Spanish bank (such as Bankia).

My read is that the odds of this kind of move by the Spanish government are very low. I don’t think the government of Prime Minister Mariano Rajoy is looking in that direction, and I think these two big banks have the political muscle to head off that alternative.

If you agree with that assessment then, your analysis should focus on

  • The prospects for Banco Santander and Banco Bilbao outside Spain. There I think Banco Bilbao has a slight edge, since its BBVA Bancomer unit in Mexico is the largest bank in an economy with some of the world’s best growth prospects in 2012. Banco Santander’s big Brazilian and UK units don’t have the same kind of macroeconomic tailwinds at the moment.
  • The likelihood that the banks will be able to maintain the current dividend payout that supports the 21% yield at Banco Santander and the 10.6% yield at Banco Bilbao. (That’s what happens to a stock’s yield when its price takes a beating.) To me, it looks like the dividends are sustainable. Banco Santander actually made €1.6 billion in the first quarter of 2012, for example.
  • Your forecast for when the Spanish and other Eurozone governments will come up with a convincing scheme to recapitalize Spain’s weakest banks. Even if that plan took quite a while to work, it would remove the political risk now hanging over Banco Santander and Banco Bilbao.

Spain’s economy continues to deteriorate, and growth isn’t exactly robust anywhere in the world. In addition, it’s hard for me to see a convincing solution to the Euro debt crisis that lets investors go back to worrying about a company’s earnings instead of the macroeconomic trends. For all those reasons, I find it difficult to put a target price on these shares.

Back in April, I suggested a range of $8.85 to $12 for Banco Santander. The Spanish economy looks worse now than it did then, and I get a one-year range of $7.25 to $9.50 for the stock now. At the lower end of that range, that works out to a 38% gain from the stock’s $5.25 price on May 30.

For Banco Bilbao Vizcaya, I get a higher top of the range at $10.25, and the bottom of the range sits at $8. The latter means a 42% potential gain from the May 30 share price of $5.66.

A word on those potential returns: Any time you see numbers like these, you need to realize that the potential upside is so large because the market judges the risk to be so high. If you buy these, you’re betting that the market is wrong—but you should only own these shares if your portfolio can withstand the risk that the market is right.

And a final word on the high dividends on these two stocks. The dividends are only attractive if you aren’t looking at a permanent impairment of capital. It would be great to collect a 21% yield on Santander, for example, but it’s only great if shares of Banco Santander don’t fall further and stay down there.

A drop that is wiped out by a recovery leaves the yield looking very attractive. A drop that leads to a permanently depressed stock price makes any yield, no matter how high, very unattractive.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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