Quantitative easing is rampant; asset prices are driving higher; interest rates are near zero in many developed nations and have been for several years; government debt levels are high and growing; inflation is low and fears of deflation persist.
The activities of Central Banks, exhibited by the ballooning in their balance sheets, have focused upon promoting economic recovery. As we will discuss in this report, economic recovery is good for the financial sector generally and banks in particular. But which banks offer the most potential?
Investment in banks is akin to investing in economic growth. Reviewing Australia’s history of long term growth we see a sustained period of credit growth, low bad debt levels and steady profit growth for our major banks. The compounding effects of growth, over 24 years since our last recession, have supported Australian banks’ position as some of the largest in the world.
Across the rest of the developed world economy, banks have performed indifferently as recessions and property bubbles have taken their toll. Fortunately for EU banks (ex-Greece), credit growth is now reappearing after several negative years. In the US a recovery has been underway for some five years although credit growth has been mild.
When to invest in a bank
The purchasing and/or the holding of bank shares involves a positive forward call on the economy where operations are undertaken. This is because banks are remarkably leveraged entities. They are “confidence machines” that lend long (assets) but borrow short (liabilities) and harvest returns from activity in the economy. Occasionally they get into distress when consumer or business confidence is shaken (credit squeeze) and/or the operating economy encounters a recession (bad debts increase and profits fall).
Australian banks really haven’t been tested in a downturn for 24 years; US banks had their challenge during the GFC whilst European banks have been through a tough period in the last few years and several have failed.
Arguably the best time to buy a bank is during a cyclical economic downturn when share prices are under pressure. The purchase of bank shares during this time is counter-cyclical and requires strong conviction that the operating economy is fundamentally sound and will structurally recover. During a recession bad debts will be elevated, earnings will be poor and discounted capital raisings are likely. Low share prices against value (in particular “book value”) present significant leverage to recovery. It is observable from history that bank shares can move from a discount to book value to a multiple of book value as return on equity (ROE) recovers with an economy.
Over the last decade, the major US banks have shown the process of multiple contraction and recovery in action. Prior to 2007 the US enjoyed sound economic progress and rapid credit growth. This was followed by the deep recession in the 2008-2009 period that featured massive bad debts, capital raisings and bail-outs. The early part of recovery exhibited subpar economic activity in 2009 – 2013. A feature of this period was low ROEs on large capital bases supported by US Treasury support, and this has transitioned into improving economic outcomes through 2013 to the present period.
Figure 1. US Major Banks – Price to Book
Thomson Reuters Datastream
Bank profits increase strongly in economic recovery because of the leverage within their structures. Whilst observing this is relatively easy, acting on this observation is much harder in practice. It requires a contrarian view and a medium term time horizon. It also requires a historical perspective on ROE. Banks cannot justify their value if their ROE sits below 10% for a sustained period.
Given the above, where should international bank investors focus their attention?
A starting point can be developed from the following questions:
- Where is the growth in global economies?
- Which regions are at the early stages of economic expansion?
- Which regions may be late in their economic cycles?
The recent IMF World Economic Outlook provides some good direction.
“Global growth remains moderate, with uneven prospects across the main countries and regions. It is projected to be 3.5% in 2015, in line with forecasts in the January 2015 World Economic Outlook (WEO) Update. Relative to last year, the outlook for advanced economies is improving, while growth in emerging market and developing economies is projected to be lower, primarily reflecting weaker prospects for some large emerging market economies and oil-exporting countries.”
While there are always differing opinions, it looks most likely that developed economies in general are strengthening (from a low base) and emerging markets will continue to grow but at a slower pace. Perhaps a good example of how banks adapt to changing times is HSBC, which is Europe’s largest bank by capitalisation. It is coming to the end of a three year program of becoming ‘simpler and smaller’ primarily by reducing its assets in emerging markets.
The world’s investment grade banks
From our deep dive on the commercial bank sector, we have identified the following 15 banks as banks of interest.
|Wells Fargo||United States|
|JPMorgan Chase||United States|
|HSBC Holdings||United Kingdom|
|Bank of America||United States|
|Bank of China||China|
|Westpac Banking Group||Australia|
|Royal Bank of Canada||Canada|
|ANZ Banking Group||Australia|
|Mitsubishi UFJ Financial||Japan|
|National Australia Bank||Australia|
|Standard Chartered||United Kingdom|
The key metrics to judge a bank’s performance are:
- Profitability or ROE;
- Net interest margin (NIM);
- Loan growth; and
- Bad debt expense.
On the profitability front, the large Australian banks are clear leaders with between 16 to 20% ROEs. They are closely followed by Royal Bank of Canada, ICBC and Bank of China. These banks have enjoyed relatively stable and growing economies and in China in particular credit expansion has been very significant.
The banks that display subdued ROE are typically from regions that have experienced more challenging economic conditions, such as the US with Wells Fargo recording 13% ROE and Citi expected to record circa 8% ROE this year.
Banks in Japan and Europe have had the toughest time with expectations for Standard Chartered and HSBC in the 7-9% range. Of course one needs to look forward. We generally expect the Japanese ageing demographics to continue to hamper credit growth in Japan for the foreseeable future. We have expectations for a moderate recovery in Europe and this will bode well for increasing ROE for Standard Chartered and HSBC over the next few years.
Consensus expectations for Australian banks’ ROE is for more of the same, however it would be prudent to be a little cautious given the challenges that face the local economy, as has been flagged by the RBA.
The Australian banks are expensive relative to their international peers. This observation is based on their high multiples of price to book value. Australian banks are well held by Australian investors and super funds that are attracted by high franked dividends. This attraction to yield has arguably blinded the market’s perception of risk, which becomes more acute when bank multiples are high.
The US banks are trading around fair value and offer moderate mid-single digit returns from these price points. The key for them is to grow returns from a lacklustre consumer sector. Generally US banks’ ROE are well below historic norms and those ratios recorded prior to the GFC. Tighter capital regulations are also an inhibitor to lifting returns, but the quality of US bank balance sheets looks good.
Japanese banks look mildly expensive and the macroeconomic picture remains sufficiently cloudy. The recent rally in Japanese share prices is an example of the full force of QE. We doubt that the profit growth of Japanese banks is truly reflective of normal banking activities.
The Chinese banks on the surface look cheap and sound, however the rapid expansion of credit in recent years followed by last year’s rapid decline paints a confusing picture. We note the recent announcement to reduce bank capital deposits with the Central Bank, and whilst this should help expand credit growth, we would like to see more go into consumption or investment rather than speculation.
The Canadian banks are trading around valuations and, similar to the US banks, offer moderate returns. However with commodity price softness, there are some economic headwinds brewing.
European banks look very interesting. If the QE policy succeeds in stabilising European economies, then a positive investment thesis can be developed for the likes of HSBC Holdings and Standard Chartered. Both are trading at discounts to value with improving ROE profiles.
Ownership Disclosure: Clime Asset Management (Clime) owns Wells Fargo, Citigroup, WBC, NAB, ANZ on behalf of various mandates where it acts as an investment manager.