Buy in may and go away

According to Mandarine Gestion, current valuation levels in the banking sector constitute opportunities rarely seen over a medium-term horizon. However, over the short term, investors are preferring to focus on two factors while at the same time exaggerating in our view their consequences and therefore provoking excesses: sovereign debt and liquidity levels.

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We will first focus on the greatest market fear, i.e. sovereign debt, and examine the consequences of a restructuring of the debt of risky countries on the balance sheets of French banks. Is the market just making up stories to scare itself? We take this logic to its conclusion and consider first a catastrophic scenario with a 50% loss on the Greek, Irish and Portuguese debt and then a 100% loss on all these exposures (and even adding a 50% loss for Spain) as reported by the banks at the end of 2010. We then examine the impact of such losses on share prices (table)

Obviously, such a scenario would imply collateral damage (increase in the cost of risk) whose consequences would be felt directly on bank balance sheets. Nevertheless, at this point and assuming the worst case scenario (unlikely in our view), the impact on individual share prices is not only limited, but additionally has already been taken into account since the revival of these fears in mid- April.

We now will consider liquidity levels. The Basel III commission is requiring that banks set aside equity funds in order to meet possible needs for liquidity in case of economic upheavals. The required level will be 7% (core Tier 1 ratio) in 2019. However, local regulators can impose more drastic standards if they deem them necessary. In this case, must we transpose the standards imposed by a local regulator to the entire sector and draw conclusions from such transpositions in terms of potential needs for capital increases?

We do not think so, as the capital needs of each bank depend on their individual strategy. A good way to evaluate this need is to examine the loan to deposit ratio. The higher this ratio, the greater the bank’s need for liquidity in case of non-repayment of loans (a bank that lends more than it has in deposits has a riskier profile). This ratio varies substantially from one country to another. We believe that this is an argument in favour of a specific approach that is not transposable to all banks.

It is always easier to give in to crowd psychology by condemning the banks on the pretext that conditions are too dangerous. One of the safeguards that enable us to avoid succumbing to the madness of crowds and to take advantage of these temporary excesses is called the valuation. In this case, we will let investors come to their senses and, just for once, “BUY IN MAY AND GO AWAY”!

Mandarine Gestion , May 2011

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