EUFN: European financial stocks remain cheap (NASDAQ:EUFN)
iShares MSCI Europe Financials ETF (NASDAQ:EUFN) is an exchange-traded fund that provides exposure to financial companies in Europe. The fund’s benchmark is the MSCI Europe Financials Index and boasts an expense ratio of 0.48% (in line with many other niche funds offered by iShares, but not cheap by any means). The fund is popular, with $1.38 billion in assets under management as of March 11, 2022. This takes into account net inflows over the past year, although the EUFN has recently seen significant outflows.
As illustrated above, net inflows over the past year are approximately +377 million, however, in the two weeks beginning February 28 and March 7, net outflows were -222 million and -$211 million, respectively. These outings are not particularly special, however; the broader market sold off and the EUFN suffered similarly.
Yet EUFN is not expensive. The fund’s price-to-book ratio was 0.85x as of March 10, 2022, i.e. the average share price across EUFN’s portfolio was below the net asset value (1 .00x). Typically, discounts to net asset value arise from low returns on equity, and European banks are generally not expected to generate high returns on equity.
Yet if we look at the most recent factsheet for the EUFN benchmark, published as of February 28, 2022, the then price-to-book ratio of 0.88x compares to the forward price-to-earnings ratio. (estimated) of 9.43x. By dividing the former into the latter, we obtain an estimated return on equity of 9.33% at the portfolio level.
Professor Damodaran has published his latest estimate of the mature markets equity risk premium of 5.37% as of March 1, 2022. This is high relative to history and reflects recent risk aversion, as equities sold amid various risks that I have discussed in the past. These include inflationary pressures, a contraction in the fiscal impulse (government spending relative to GDP), a contraction in the credit impulse (bank lending to the non-financial private sector), and you can also add supply chain disruptions post COVID-19, as well as the recent major escalation of the Russian-Ukrainian war. Overall, the world looks risky at the moment, so it makes sense that the equity risk premium (or ERP for short) is high.
Nevertheless, 5.37% is still below EUFN’s return on equity forecast of 9.33%. Moreover, European bond yields are low. Using 5.37% as the ERP basis, I calculate the total cost of equity by finding the regionally weighted 10-year bond yield for EUFN’s portfolio, and adding it to our ERP basis. I also include country risk premiums when available, as provided by Damodaran.
I arrive here at an estimated cost of equity of 6.79%. This figure is still well below the estimated forward ROE of EUFN’s portfolio of 9.33%. Additionally, Morningstar analyst consensus estimates for three- to five-year earnings growth rates for EUFN are currently pegged at 18.03%. The ECB’s recent announcements to reduce stimulus measures could also be favorable to commercial interest rate margins, and therefore to European financial companies, as well as to the euro (in which more than 45% of the holdings of the EUFN are worded at the time of writing).
However, despite the recent earnings growth estimate, given inflationary risks and the escalating Russian-Ukrainian war, it would be better to base our short-term forecast (for valuation purposes) on a target ROE, say 9% after the first year. Additionally, we could assume portfolio-level dividend payouts (relative to portfolio earnings) of one-third, which is just under the actual 34.6% according to the company’s recent benchmark fact sheet. ‘EUFN. That is, if I divide the dividend yield by the trailing earnings yield.
Following this trajectory takes us to a smoothed earnings growth rate of 6%, after an initial drop in the first year that is implied from the data provided by MSCI (the benchmark provider, whose results I prefer because they tend to be less forgiving than Morningstar and other providers). Despite this “conservative” scenario (which may not be, but would seem less optimistic than the consensus), the suggested valuation would imply that EUFN is heavily discounted.
The uplift potential of more than 100% is probably unrealistic. However, based on this data, another way to express EUFN’s valuation is that the current share price would appear to lend at a cost of equity of 13.75%. It’s high; much higher than risk-free rates in Europe (EUFN’s weighted average risk-free rate on 10-years is just 0.93%). If I revise my ROE estimate to just 5% after the first year, the valuation only offers a 12% upside, with an implied cost of equity in this case of around 7.62%.
So it would seem to me that the EUFN is cheap, but that the market believes that long-term returns on equity for European banks should remain closer to 5% than 9% (or more). A firmer ECB and (even modestly) higher European interest rates could help support the stock prices of European financial companies.
Based on current valuations, it seems that investors have very little incentive to own European banks. But with central banks needing to ease inflation concerns, the banking sector (which tends to benefit from higher interest rates) could provide an interesting contrarian opportunity.