Well managed US banks have managed to grow shareholder value over the past 10 years at a compound 12%+ despite the terrible 2008 to 2012 years (the average of the universe we cover is about 9%). Can the next 10 years be as bad as the past 11 (Dec 2004 to Dec 2015)? We think not. Recent bank results confirm that they’ve been cleaned up, are better capitalised and reserved, nobody seems to own them and best of all, are trading at much lower valuations than they did end 2004. If they generate the same growth in shareholder value as they did in the past, from the current low valuations investments may prove to be rewarding.
How to ensure a long-lasting marriage
My favourite Buffet story when I do client presentations is to tell his story that the most important ingredient to ensure a long-lasting marriage is that both partners must have low expectations at the beginning.
Figure 1 is one of many examples that illustrate how under-owned financial shares are and how low expectations currently are (this graph shows only North America but similar graphs/tables (or the data) show European financials to be even more under-owned).
Figure 1: Hedge funds net exposure to North American financials shows largest underweight relative to the S&P 500 Index
Source: Bloomberg, Morgan Stanley Prime Brokerage, “Global Reflections”, 2 Sep 2016, data as at 16 Aug 2016
The graph shows low expectations, are they low enough?
In contrast to the market’s large underweight, the recent (June 2016) results and the past 11 years growth in shareholder value show that banks came through the crisis well and have adjusted to the additional burdens placed on them. The results show that they are well placed to deliver 10% shareholder value growth per annum, and higher if the Fed does raise interest rates.
Figure 2: Denker Capital US Banks sample
Source: Company financials, Denker Capital
Note: The data is derived from US banks covered in Denker Capital research. The message would be the same if entire US bank universe were used.
I could write a few chapters on the messages that can be derived from the table in Figure 2, but the main thoughts are:
- The Capital-to-Asset ratio (a very rough but simple ratio that reflects the amount of capital that backs banks’ assets) has almost doubled since the pre-2008 crisis. Whilst this has resulted in lower ROE’s (Return-on-Equity/Capital) and hence a lower shareholder value growth rate, the growth is now achieved at significantly lower risk.
- Despite the lower interest rate environment, banks’ lending spreads have been remarkably resilient thanks to significantly lower funding costs. Looking forward: Higher interest rates will widen the lending spreads plus generate higher yields on the non-lending assets and increase ROE’s. A future bonus waits should the Fed hike rates. At her most recent talk (September) Janet Yellen (Chair of the Federal Reserve) presented the chart below (Figure 3) showing that rates could be anywhere from just above zero to 4.5% by the end of 2018.
Figure 3: Median federal funds rate forecast (with upper and lower range included)
Source: US Federal Reserve, RMB Morgan Stanley, 19 Aug 2016, “Charts that made a different today”
- The higher cost-to-income ratio reflects lower business volumes, but also the significant regulatory reporting burden placed on banks. The focus now is on reducing costs and lowering the cost-to-income ratio via automation of the reporting burden and increasing efficiency of branches and head office. Obviously increased lending or other volumes will also push up income and improve the ratio. Comparing the USA banks cost-to-income of 60 (amongst highest in the world) to e.g. Swedish banks (low 40’s) shows how much room for improvement exists.
- The NPLs-to-Loan ratio (non-performing loans as a % of the total loan book) and the Reserves as % of NPLs reflect the effectiveness of the Fed’s action post 2008 forcing banks to clean up their bad debts
- (via the TARP program banks were forced to take capital from the government which they had to hold until they could prove that they’d cleaned up their books and recapitalised).
- The high Reserves as % of loans show how banks have rebuilt reserves.
The recent June 2016 results reflect further how well the banks have adjusted:
- Average loan growth of 5.1% (6 months to Jun 2016 over 6 months to Jun 2015),
- Reduction in operational costs (All banks in the universe we cover reported lower operational costs),
- Marginal NIM compression and falling fee income (2016 over 2015),
- Increased NPL provisions.
The mix of good and bad included in the above allowed them to:
- Increase dividend payments by 9%,
- Grow tangible shareholder value by 11% year-on-year.
Few investors realise that during the 11 years from Dec 2004 to Dec 2015 these banks on average have grown shareholder value at a compound rate of 9% (the well managed ones exceeded this). This despite all the write-offs, penalties and capital raises during the 2008 to 2012 crisis.
Figure 4: US banks – strong compound growth in shareholder value despite 10 very difficult years
Source: Denker Capital, Company financials
Figure 4 shows the disparity in returns between e.g. US Bancorp and Citigroup over the previous 11 years (yes, stock picking does make a difference). But it also shows that the growth in shareholder value (i.e. Net Asset Value per Share plus dividends) did not translate into similar investment returns. Why? Because in Dec 2004 optimism (and hence valuations) was excessively high.
Now, in September 2016, the banks have been cleaned, recapitalised, are well reserved and geared for normalisation, but are trading at low valuations reflecting the current pessimism.
What are the risks?
There are always risks – currently some of the risks include a) the US entering a recession (which will mean no further interest rate hikes, a lower loan growth rate and the possibility of higher impairment levels), b) the uncertainty regarding the next US president’s view on banks as well as c) increased competition from Fintech.
Obviously we’ve got opinions on the downside associated with each of the three, but I don’t want to waste your time. Important is that the next 10 years are unlikely to be as bad for banks as the previous 11, yet in those years they still grew shareholder value at a compound rate exceeding 9%.
What about the insurers and what about the Sanlam Global Financial Fund?
The insurers have also seen a significant de-rating and are also poised to do well, especially if investment returns increase on the back of higher interest rates, but there are a number of other factors that impact their ROE’s as well which I don’t want to go into now.
Especially the EU insurers are attractive on a yield basis but we plan to discuss this in our next article on European financials.
Our Sanlam Global Financial Fund (managed by Denker Capital) reflects its global nature: 27% invested in US financials, 20% Europe/UK insurers and banks and 45% EM financials. This does highlight that whilst we like the certainty of the compounding of US financials, we think the 20% compounding of EM banks is even more attractive in the current low growth world. As said, UK/European insurers and banks are very undervalued, but the economic and political risks keep us from increasing our investment there. But more about that over the next few weeks.
Expectations are too low
Figure 5 & 6 highlight this: Despite narrowing the ROE differential to the S&P 500 Index over the past 4 years, the banks have de-rated relative to the S&P. 500 Index This doesn’t make sense. Not only is the high degree of certainty of a ~10% shareholder value growth not reflected, any upside from higher interest rates, continued focus on costs and the possibility of a regulatory mind-set change is being ignored.
Figure 5: Price-to-Book: next 12 months consensus
Figure 6: ROE last 12 months