By Jesús Aguado

MADRID (Reuters) - BBVA's share price has more than trebled since late 2020, narrowing its valuation gap to Santander and highlighting a divergence in fortunes between the Spanish banks that may be short-lived.

Both trace their roots to 1857 and neighbouring northern Spanish cities, but Santander emerged as the dominant bank in Spain with more than twice the assets of BBVA and, until very recently, a far larger market capitalisation.

But the gap has narrowed from 20 billion euros ($22 billion) three years ago to around 5.5 billion euros, raising questions about which has got their strategy right.

The shift reflects how investors are rewarding banks which share more of their resurgent profits than those prioritising investment in future growth, as well as those that made the right bets outside slower-growing Europe.

Shares in BBVA, which is worth some 64 billion euros compared with Santander's market value of 69.5 billion euros, have been buoyed by its Mexico subsidiary, which has around a quarter of the retail market.

"BBVA has in Mexico one of the best retail bank franchises in any emerging market and it is faring even better for BBVA than Brazil for Santander," said Enrique Quemada, chairman of investment bank ONEtoONE Corporate Finance Group.

Investors have also rewarded BBVA for deciding to quit the United States in November 2020 to focus on handing more cash to shareholders, analysts and investors told Reuters.

"For growth, profitability ... growing dividends, and share buybacks, the market continues to reward us," BBVA Chairman Carlos Torres told shareholders this month.

Torres has been chairman since the end of 2018, when Onur Genç became BBVA CEO.

Since 2021, BBVA has distributed 13.19 billion euros to shareholders, including extraordinary buybacks of 4.16 billion euros. This equates to 20.6% of its current market valuation, Reuters calculations show.

A more cautious approach to handouts under Santander Executive Chair Ana Botin, falling profitability in Brazil and mixed fortunes in some of its 10 main markets have hobbled the larger bank's shares, analysts and investors added.

Botin, whose father Emilio previously ran Santander, has been in the role since his death in September of 2014.

Santander, which unlike BBVA does not make extraordinary buybacks, has paid out 12.8 billion euros, 18.4% of its market capitalisation, Reuters calculations show.

A focus on distributing capital has lifted shares of other European banks such as Italy's UniCredit, while stocks with less generous payout policies including Santander and BNP Paribas have been left lagging.

Santander's Chief Financial Officer Jose Garcia Cantera told Reuters that an investor preference for payments today during a period of high interest rates rather than heavily discounted future profits will not last as rates fall.

"Future growth will be more valued ...We are starting to see the first signs of that," Cantera said.

BBVA declined to comment.

MORE DIVERSIFIED

Although BBVA cannot compete with Santander for reach and scale, its shares trade at more than 1.2 times book value thanks to a 32.5% jump so far in 2024.

Santander's shares are up 15.5% over the same period but trade at just over 0.7 times book value, in the bottom third of large European banks, LSEG data shows.

"For Santander you have so many moving parts ... you need a lot of stars to align," said London-based Berenberg analyst Michael Christodoulou, who expects it to benefit as falling rates ease asset quality concerns, including in Brazil.

Christodoulou has a 'hold' recommendation on both banks.

Whether BBVA shares maintain their momentum will depend as much on capital returns as on whether it can meet its financial targets in its core Mexican and Spanish markets, given its bigger exposure to fewer countries than Santander.

BBVA makes more than two-thirds of its profit in emerging markets and is re-investing in fewer businesses than Santander.

BBVA expects a return on tangible equity (ROTE), a measure of profitability, of between 17% to 20% in 2024 from 17% in 2023, while Santander is targeting a ROTE of 16% in 2024, up from 15.06% last year.

Analysts at broker Alantra expect Santander to benefit in the medium to long-term from cost-savings with the roll-out of global units and to deliver faster profit growth.

Improving performance at Santander's autos lending business in Europe and the U.S. should help too, they predict.

Yet Santander must improve profitability in Brazil, other analysts say, adding that its U.S. expansion plans need to pay off following a 48% fall in 2023 net profit there.

To keep BBVA at bay, Santander should become more aggressive on buybacks, said Caixabank analyst Carlos Peixoto, adding: "but at this stage they are not in a position to do so."

Santander's core Tier 1 fully loaded capital ratio, the strictest measure of solvency, stood at 12.26% at the end of last year, compared with BBVA's 12.67%.

On March 22 Santander said it expects to pay more than 6 billion euros in dividends and ordinary share buybacks against 2024 results under its policy of distributing half of its earnings to shareholders.

Santander's strategy of investing in a more diversified range of businesses will be rewarded over time, Cantera said.

"As things turn around and the market starts valuing growth more, those banks that didn't invest for the future are going to be at a disadvantage," he added.

($1 = 0.9245 euros)