Funds begin to back European banks Let us take a trip into the heart of darkness. Fund managers have discovered the nerve to invest in European stocks once more. The latest survey by Bank of America Merrill Lynch suggests allocations to the continent are now the highest since May 2007, and 36 per cent of portfolio managers consider themselves overweight in the area. But if they are comfortable about going back to the eurozone, will they venture into the heart of Europe's crisis, and buy banks? To be clear, this does not mean using bank stocks as a basis for a macro bet that the eurozone crisis will pan out satisfactorily. Rather, people on both the buy- and sell-sides are arguing that it is time to buy European banks on their own merits, because they are good value. Smart Money Several issues arise. First, the experience of the last decade makes it hard to discern the return on equity banks should aspire to. ROEs averaged more than 20 per cent before Lehman, which was plainly unsustainable, and then went negative. Without an obvious "old normal" it is hard to alight on a "new normal" for banks" profitability. Second, dispersion in the sector is wide. Over the past 12 months, performance for the 47 banks in the Stoxx 600 banks index varies from a 90 per cent gain for Bankinter to an 84 per cent loss for Bankia, both of Spain. Some banks have shot up thanks to Mario Draghi's promise. The best-performing bank in the Stoxx 600 index since the pre-Draghi bottom last year has been Crédit Agricole, with a gain of 183 per cent. But even after that gain, CA only trades for slightly more than half its book value - the most popular measure for bank valuation - and it suffers a return on equity of minus 14 per cent. This does not yet look like a safe and secure value investment - but equally it is plenty possible that the stock could rise far more if the eurozone crisis continues to abate. But some banks do look more like an "investment" than a "bet." Mark Hargraves, who manages the Europe equity fund for Axa Investment Management, argues that eurozone banks are discounted because of three separate risks - of a renewed sovereign debt crisis; of a protracted eurozone recession; and of re-regulation. All these risks are reducing. Not only this, but the crisis and re-regulation could lead to a "new normal" for profitability that could put ROEs into double digits. Regulators have refused to split up banks directly. Meanwhile, the cheap funding that allowed the likes of Northern Rock to compete is no longer available. Thus, Mr Hargraves argues, Europe's banking system will be more concentrated than it was before. However, banks have been forced to dispose of assets as they delever and attempt to meet new capital targets. This has often meant disposing of businesses in which they were not a dominant or profitable player. UBS, and its gradual exit from fixed income and currencies trading, in which it never achieved dominance, gives an example. So, even if banks face a more regulated future in a sluggish economy, they will be more streamlined, focus on what they do best and have less competition to worry about. Great for shareholders, if not customers. They may well pay out more in dividends. This supports them as truly "investable" businesses, rather than vehicles for a macro punt. To see what might lie ahead, Mr Hargraves points to the Scandinavian banks, outside the euro, who shared in the full pain of the Lehman crisis (in part because of their exposure to the Baltics), but were not so directly involved in the eurozone crisis. Since the post-Lehman trough in March 2009, Swedbank leads all European peers with a return slightly in excess of 800 per cent, and now generates a return of 13 per cent on equity. It trades at 66 per cent more than book value (having once traded at a discount of more than 80 per cent), so it is no longer cheap, but it shows the possibilities that are luring portfolio managers. The trick is to find banks penalised for their links to the eurozone, but with the strong franchise needed to exploit future conditions. Popular candidates include the big French banks - BNP Paribas and Société Générale - and Benelux banks, such as KBC. Appetite for banks in the periphery, cheaper because the risks are greater, remains more limited. Does this mean that European banks can be treated as a value investment? They lack the necessary margin of safety, and there are too many risks. The forthcoming asset quality review under the European Central Bank may reveal more problems, and force banks to raise more capital. And the lurking risk that political discord forces a new sovereign crisis remains. Buying stock in a European bank might still go very wrong. But the move towards Europe and its banks by fund managers is not delusional. For the long term, on a risk-adjusted basis, well chosen European banks begin to look like decent investments.