Dr. Michael Burry earned himself a reputation as one of the best value investors in recent history thanks to the returns his Scion Capital produced before and during the financial crisis.
One of the reasons why Burry was so successful was that he wasn't afraid to invest in companies the rest of the market was avoiding. These stocks Burry called his "ick investments," because most other investors would go "ick" when looking at them.
Value investing is all about investing where other investors are afraid to tread, as this is usually where the best deals are to be found. And this brings me onto the top of European banks.
I'm almost sure most readers will have said "ick" when reading the paragraph above. Who wants to invest in European banks right? The whole sector and region's economy seems to be gripped by a perpetual cycle of bad news. But this is precisely what creates the best environment for value investors.
The ick sector
There's no denying that European banks have been a disappointing investment over the past decade.
According to some reports, investors have stumped up half a trillion euros in equity to recapitalize European lenders since the start of 2008, equivalent to half the total market value of the Stoxx 600 banks index in euros while the Stoxx 600 banks index has lost 48% since the beginning of 2008.
With so much money flowing into the sector, you could be forgiven for thinking European banks are now well-capitalized. Unfortunately, that is not true.
There were still €880 billion of non-performing loans held by European banks at the end of last year according to the European Central Bank. Although this figure is heading in the right direction (down from 1 trillion in 2016), it is clear that European lenders face an uphill struggle to get their balance sheets in order.
Deutsche Bank (DB, Financial) is by far the most significant casualty of the European banking crisis. Since 2008 the lender has tapped investors for €30 billion, which is a third more than its current market value of just under €20 billion.
That being said, there have been some success stories. Shares in Italy's UniCredit (UCG, Financial) have gained 75% from the price it set for its €13 billion rights issue in early 2017. Shares in Credit Suisse are up more than 50% since the 2016 low.
Improving outlook
Bad loans are just one part of the European bank puzzle. These institutions have also been hobbled by the ECB's interest rate policy, which has starved them of income at a time when they need it most.
There are now signs that this dovish monetary policy stance is set to come to an end over the next 12 to 24 months. The ECB recently announced that it would stop quantitative easing bond purchases by the end of this year and will consider interest rate increases from mid-2019. Higher rates would be a fantastic development for banks, but whether the Eurozone economy could stomach them is a different matter.
Still, trying to time the moves of central banks is always a tricky sport, so it's best to look at the banks themselves.
Here you can find some deeply undervalued companies.
UniCredit for example currently trades at a price to tangible book ratio of 0.6 and a forward price-earnings ratio of 8.1. The bank is profitable and generating a return on equity, so it's arguable the stock deserves to trade at least book value.
In fact, according to a recent broker report from Citibank (C, Financial), price-book ratios across the sector are still near 20-year lows, and rising return on equity figures justify higher multiples for many banks.
Another possible opportunity is France's Credit Agricole. Once again, this bank looks cheap on both a price-earnings ratio (8.8) and price to tangible book ratio (0.9) (price-book is 0.6). What's more, it is estimated the stock will support a dividend yield of 5.7% next year.
This might not be a trade for the faint-hearted, but it is difficult to deny that there's value to be found in the European banks' sector. The question is whether or not the risk is worth the reward.
Disclosure: The author owns no stock mentioned.
