EUFN is an exchange-traded fund (ETF) that tracks the MSCI European Financials Index, an index consisting of developed market equities in the European financial sector. With $374 million in assets and a 3-month average daily volume of 275,000 shares, EUFN has significant liquidity and provides a cost-effective way to gain exposure to financial companies in the European developed markets. Over the last 12 months, EUFN is down 8.2% due to the banks’ balance sheet concerns, a slowing European economy, and the threat of a Greek exit from the Euro Zone. For comparison, U.S. financial stocks (S&P 500 financials) are up 18%, while the MSCI Europe returned -0.5% and the MSCI World returned 10.7% over the last 12 months.

We believe these concerns are overblown and European financial stocks are poised to outperform over the next 12 months. Specifically, we believe there are three major reasons why EUFN provides a good buying opportunity right now.

  1. 1.      European banks’ balance sheet concerns are behind us

Late last year, both the Bank of England and the European Central Bank (ECB) completed their comprehensive assessment of their respective banking systems. The UK stress test covered 8 major UK banks (including three of the top ten components of EUFN, i.e. HSBC, Lloyds, and Barclays) while the ECB’s asset quality review covered 130 banks in the euro area with over 80% of total bank assets. Both stress tests are highly robust. The UK’s stress scenario assumes a sharp rise of 4% in the Bank of England’s policy rate. Unemployment is assumed to rise to 12% with a corresponding drop in asset prices, including a severe 35% drop in UK housing prices. Meanwhile, the ECB’s asset quality review assumes a general spike in the Euro Zone’s government bond yields, with the German 10-year yield rising to 3%, stock prices declining by 20%, and housing prices down by 10%.

Only one UK bank, Co-operative Bank, did not pass. Co-operative does not pose any systemic risk as it had anticipated the results in advance and is in the process of selling assets to de-risk its balance sheet. Co-operative is also not publicly traded and thus is not a component of EUFN. Meanwhile, only 13 out of the 130 banks under the ECB’s asset quality review will need to raise capital; only three of them have a capital raising requirement of more than 1-billion euros. Perhaps most importantly, none of EUFN’s top 10 components have significant exposure to Greece. Confidence surrounding European financial institutions has grown since the publication of the stress test results late last year. European regulators—who have become stricter on capital requirements over time—are sufficiently confident to allow higher dividend payouts. EUFN is sporting a 3.4% dividend, a highly attractive yield for income investors.

  1. 2.      Lending activity picking up in the Euro area while bank valuations remain decent

According to the just-released 4Q 2014 Euro area banking lending survey, bank credit standards for all loan categories in the euro area continued to ease in 4Q 2014. Moreover, the survey reported a continuing rise in net loan demand in all categories—especially for loans to non-financial corporations and for consumer credit. Going forward, Euro area banks continue to expect an increase in net demand across all loan categories for 1Q 2015.

Meanwhile, access to funding improved again for all market instruments and for short-term retail deposits. Banks expect more easing in terms of access to both retail and wholesale funding. The survey, along with the results of both the UK and the ECB’s stress tests, suggests that deleveraging in the European financial sector is effectively over. Banks report that recent regulatory and supervisory actions had a positive impact, as they increased confidence in the banks’ financial conditions, allowing banks better access to lower-cost funds.

From a valuation standpoint, the top ten components of EUFN are trading at near their 3-year valuation range on a price-to-book basis. More importantly, the return on equity (ROE) of most of the components have picked up as European financials continued to focus on the most profitable business areas and on cutting costs.

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  1. 3.      The ECB’s 60 billion euro quantitative easing policy will further support banks’ balance sheets

Banks in the Euro Zone typically hold a disproportionately high amount of the assets of the country where they are domiciled. For example, 25% of Banco Santander’s assets lie in Spain, with much of it in Spanish government bonds, even though the bank’s Spanish division only contributes 7% of its total global profits. The 60-billion euro of the ECB’s monthly purchases beginning next month will comprise of 45-billion euros of sovereign debt, 5-billion euros of bonds issued by agencies, and 10-billion euros for asset-backed securities and covered bonds. We believe the ECB’s monthly purchases of 45-billion euros of sovereign debt will support government bond prices of the “core” peripheral countries, such as Italy, Spain, and Portugal. This will provide a boost to the balance sheets of European financial institutions that are holding these bonds. While banks such as HSBC may not directly benefit, we believe sovereign QE will further boost general lending and economic activity in the region. Since European financials are high beta plays to the European economy, EUFN should benefit significantly as well.

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*** Disclosure: My firm, CB Capital Partners, holds shares in EUFN as of February 9, 2015.