By Helen Reid and Julien Ponthus
LONDON (Reuters) - Europe's most shunned stock market sector, banking, is starting to tempt some investors as a string of solid earnings updates persuade them there are cut-price deals to be had.
Euro zone banks <.SX7E> are the worst performing stocks so far this year, down 13 percent as investors shed assets seen as most vulnerable to political upheaval.
At the same time, a boost for the sector in the form of an interest rate hike by the European Central Bank (ECB) still seems far away.
Yet banks have generally delivered strong second-quarter results, and their low valuations and growing dividend payouts are attracting investors despite the political uncertainty over, for example, Italy's new government and U.S. trade policy.
Banking shares have still not recovered from the financial crisis: the euro zone bank stocks index is down 75 percent from its 2007 peak, while the broader euro zone stocks index <.STOXXE> is just 10 percent away.
So there is still a long way to go. But that is precisely what is attracting value investors keen to find a bargain before the rest of the market catches on.
"We have been adding to European banks particularly as we've seen U.S. banks get closer to fair value whereas there's a big disparity in valuations in Europe," said Chris Dyer, head of global equity at investment manager Eaton Vance.
Euro zone bank stocks trade at 0.7 times their book value per share (BPS), half that of the U.S. S&P 500 banks sector.
And banks' earnings overall have comforted investors.
Some 74 percent of financial sector firms have beaten earnings forecasts this quarterly reporting season, one of the strongest ratios in Europe, Thomson Reuters data shows.
Profitability is up 22 percent year-on-year, Goldman Sachs analysts say, while credit quality is rising along with loan volumes, despite slowing economic growth in the euro zone.
The bank recommends buying the shares of France's BNP Paribas
"Valuations are saying people don't have a lot of confidence in European economic growth and have lost patience with the idea that rates will ever go up," said Steve Sherman, senior portfolio manager at BNP Paribas Asset Management (BNPPAM).
But bank stock buyers say they're being paid to wait. The sector offers good dividend yields, with even Britain's state-owned RBS
"We see a 15 percent upside in the next 12 months for the banking stocks we cover, against an 8.8 percent upside for our broader European coverage," said Farhad Moshiri, an analyst covering the sector at researchers Alphavalue.
Perceived "value" stocks such as banks are coming back into vogue as sharp falls in tech giants Facebook
But even if this marks a turning point in the decade-long dominance of growth over value stocks, risks remain.
VALUE STOCK OR VALUE TRAP?
Between tougher regulations, hefty fines for financial crisis misdemeanours, sluggish growth and political volatility, the euro zone's banks face an uphill struggle to convince many investors.
"There are still a lot of people who see the sector as a value trap," said Jerome Legras, head of research at Axiom Alternative Investments, which invests in bank equity and debt.
Political upheaval in Italy in May spooked some investors still concerned about the euro zone's resilience after the sovereign debt crisis, leading them to worry that apparently good value stocks could be a trap leading to further losses.
"Banks are caught at the crux of that push and pull between earnings and political/trade concerns because banks are levered to future economic growth and political stability," said BNPPAM's Sherman.
And while the ECB is expected to start raising rates in about a year, a global crisis - say sparked by a trade war - could further delay a normalisation of monetary policy.
"Valuations are cheap, true, but the counter argument is that bank stocks will move only when rates rise," said Kairos Partners portfolio manager Federico Trabucco.
"Mr Market discounts events in advance but probably it’s too early now. We’ve already seen some false banking rallies," he added.
The banking sector has attempted - and failed at - a convincing earnings recovery several times over the past decade, and many remain sceptical this time could be different.
Even bullish investors, like Eaton Vance's Dyer, are exercising caution. He has taken a larger number of smaller positions than normal in order to avoid taking too big a bet on a particular region or lender.
"A lot of those catalysts are binary so we try to spread the risk," he said.
With Italian budget talks also looming in September, some are still waiting for the risks to diminish before wading in.
"I will buy when things get clearer" is how a lot of investors currently see it, said Axiom's Legras.
(Reporting by Helen Reid and Julien Ponthus, additional reporting by Danilo Masoni, Editing by Mark Potter)