Download Are European banks a buy?

Are European banks a buy?
August 2015
Sector profitability
The best way of demonstrating the above statement is to conduct
a DuPont decomposition on the banking sector. A DuPont
decomposition is simply a breakdown of return on equity into its
constituent parts. For the banking sector the simplest and most
relevant breakdown is between return on assets and leverage,
noting that Return on Equity = Return on Assets x Leverage. Before
doing so, it is worth considering the chart below, which shows the
market capitalisation (in billions of euros) for 57 European banks
covered by Autonomous Research. [In the analysis that follows I am
indebted to the excellent data provided by Autonomous Research
and Redburn Partners].
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Another reason is that we strongly believe that many investors are
not paying attention to some of the fundamental changes that
have occurred in the sector and in the behaviour of regulators.
In particular, banks in Europe are now required to hold far higher
levels of capital than before and we see capital requirements
going up, not down, as the ECB becomes an increasingly assertive
regulator along the lines of the US Federal Reserve. Also, contrary
to the belief of many investors, the sector has recovered a far higher
level of pre-crises profits than is commonly recognised. The current
low return on equity versus history is a function of much lower
levels of leverage and not of lower levels of profitability. The
last statement is absolutely critical in considering the sector in the
context of what has happened over the last eight years and where
we go from here.
Chart 1: ‘Mega bank’ sector capitalisation
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There are numerous reasons why we don’t like banks. The most
important one is that banks are highly leveraged, low return on
equity businesses that are value-destructive through time. The very
high level of share issuance and frequent recapitalisations over
the past decade are testament to this. As a team that likes to own
businesses that create value for shareholders over the long term,
many of the banks are simply not worth owning. Ever.
20
Niall Gallagher
Investment Director, GAM
Received wisdom in equity markets is that banks
are a leveraged play on the real economy. As a
team that is positive on the European economic
environment, and in particular certain peripheral
eurozone economies, we are constantly asked:
Why do you hold so few banks in your portfolios?
Or in the words of what James Montier of Bostonbased asset manager GMO calls the “relative
performance derby”: Why are you so underweight
the sector? [For the avoidance of all doubt, we do
not manage our portfolios with respect to index
construction].
Sector
Source: Autonomous Research.
Date: 31 December 2000 – 31 July 2015
The above chart may surprise many as it shows that a wide proxy
for the European bank sector is now trading back at peak levels
of market value, despite the fact that many share prices remain
at a fraction of their pre-crisis level. What connects these two
contrasting elements is share issuance. Many banks are back at
peak market capitalisations, but given the huge share issuance of
the last few years the value per share is not.
The data below for the same peer group of 57 banks shows a complete DuPont decomposition for the banks with three years of
Autonomous forecasts.
DuPont analysis
Dupont analysis
As % adjusted avge. assets
Net interest income
Fee income
Trading income
Other income
Revenues
Costs
Pre-provision profits
Provisions
Pre-tax profits
Tax, prefs & minorities
Net profits
Leverage
Net RoTBV
2005
1.22%
0.82%
0.51%
0.11%
2.65%
-1.59%
1.07%
-0.16%
0.93%
-0.28%
0.65%
36.7
23.9%
2006
1.25%
0.90%
0.59%
0.18%
2.92%
-1.67%
1.25%
-0.20%
1.09%
-0.34%
0.75%
36.7
27.5%
2007
1.24%
0.88%
0.41%
0.20%
2.72%
-1.62%
1.10%
-0.25%
0.87%
-0.25%
0.62%
37.2
23.1%
2008
1.48%
0.77%
-0.21%
0.22%
2.26%
-1.56%
0.69%
-0.50%
0.22%
-0.06%
0.16%
37.3
5.9%
2009
1.61%
0.75%
0.43%
0.05%
2.83%
-1.64%
1.20%
-0.90%
0.34%
-0.08%
0.25%
31.3
8.0%
2010
1.59%
0.76%
0.43%
0.09%
2.88%
-1.67%
1.21%
-0.60%
0.63%
-0.22%
0.42%
26.2
10.9%
2011
1.53%
0.71%
0.21%
0.17%
2.61%
-1.61%
1.00%
-0.68%
0.50%
-0.21%
0.29%
25.0
7.3%
2012
1.45%
0.67%
0.34%
0.08%
2.54%
-1.56%
0.99%
-0.61%
0.43%
-0.22%
0.21%
24.2
5.1%
2013
1.42%
0.68%
0.37%
0.05%
2.53%
-1.55%
0.98%
-0.55%
0.47%
-0.19%
0.28%
22.3
6.2%
2014
1.46%
0.70%
0.31%
0.08%
2.56%
-1.54%
1.01%
-0.43%
0.61%
-0.21%
0.40%
20.5
8.2%
2015E
1.47%
0.71%
0.26%
0.16%
2.60%
-1.55%
1.05%
-0.35%
0.75%
-0.28%
0.47%
19.6
9.2%
2016E
1.46%
0.71%
0.24%
0.14%
2.55%
-1.46%
1.09%
-0.31%
0.83%
-0.31%
0.52%
18.8
9.8%
2017E
1.50%
0.72%
0.24%
0.13%
2.59%
-1.44%
1.15%
-0.29%
0.91%
-0.33%
0.57%
18.1
10.3%
Source: Autonomous Research.
25.0%
20.0%
15.0%
15.0%
10.0%
10.0%
5.0%
5.0%
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E
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0.0%
05
0.0%
RoTBV (LHS
Leverage (RHS)
Source: Autonomous Research
Dates: 31 December 2005 – 31 December 2017 (expected)
It is worth using a second data source to cross-check these insights.
The chart below is taken from Redburn Ideas and uses an industrial
DuPont decomposition for an aggregation of 40 European banks,
breaking down return on equity into ‘Business Operating Profit
Margin’ and ‘Capital Turnover’ (leverage). The advantage of this series
is that it takes consensus estimates from Factset and it is also a
longer time series. The conclusion, though, is identical: profit margins
have fully recovered, while leverage is at far lower levels. It is lower
leverage that explains the lower return on equity.
Chart 3: Business operating profit margin and capital turnover
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5%
0.2
0%
0.0
Capital Turnover
Source: Redburn Ideas
Dates: 31 December 1995 – 31 December 2015 (forecasted)
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BOP Margin
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10%
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15%
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20%
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1.0
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25%
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Leverage is the key variable to focus on, and what is quite
extraordinary is how much this has come down (it has halved).
On the positive, we have spoken a lot in our conversations with
clients on how the higher levels of capital in the banking sector
are a positive for European equities as this implies a sector that
is capable of supporting the real economy through a pick-up in
loan growth. The negative is that the return on equity (or return
on tangible book value) is far lower than previous cycle levels,
so bank investors are not getting remunerated as well on their
capital as in prior cycles.
30.0%
20.0%
De
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•
Pre-tax profits as a percentage of assets (profitability) as
a whole are forecast to get within a hair’s breadth of prior
peak levels. The fact that the sector has recovered almost
all of its lost profitability is far outside the consciousness of
most investors who focus on earnings per share and return
on equity only.
35.0%
25.0%
97
•
Loan loss provision costs have already come down
substantially and are forecast (and thus priced) to come
down further. A provision rate of 29 bps on assets is most
likely a below cycle sector average (certainly it is in an
historical context). Evidence from prior sector ‘explosions’
demonstrates that in the aftermath of a banking sector
clean-up, provisions remain ‘lower for longer’ than average
with the Nordic banking sector perhaps the best example.
So this might be a profit variable to extrapolate for some
time. But be clear that this is not sustainable in the long
term, in our view.
40.0%
30.0%
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•
Costs have already come down a lot and are forecast (and thus
priced) to come down further. No doubt many who are positive
on the sector will see this as a source of further profitability
gains but may ignore the extent to which banks have put off
required IT investments and have benefited from a period of
very restrained wage growth in Europe. We believe it would be
a mistake to extrapolate on costs.
Chart 2: Return on tangible book value versus leverage levels
De
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Revenues per unit of asset are not quite back to the peak
levels of the last decade but are not far off. Net interest income
in particular is forecast (and thus priced) to be at the high
end-of-decade levels by 2017. Fee and trading income are
forecast to be a little way below peak but the extent to which
this reflects an opportunity, or perhaps a permanent loss of
wholesale and investment banking activity, given regulatory
changes remains to be seen.
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•
The key insight that comes out of this analysis is that while the
banking sector has a return on equity (or return on tangible book
value) that is far lower than the previous cyclical peak. This has
nothing to do with lower levels of profitability, but is in fact down
to far lower levels of leverage.
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There are a number of really interesting facets of the above data:
To what extent is this priced into the sector’s trading valuation?
The banking sector is forecast to generate an ROE of 8.4% in 2016
and is currently trading at 1x market capitalisation to equity. A 1x
book value multiple implies that the banking sector has a cost of
equity of 8.4%, which seems more than full to us as we use a 9%
hurdle for our investments. Put another way, 1x book value seems
fairly rich for a sector generating an 8.4% return on equity, unless
return on equity is set to rise.
The chart below shows the equity-to-assets ratio for the US
banking sector since 1880. [US data is far more comprehensive].
This includes all banks, including small local banks that are highly
capitalised, and uses a wider definition of equity than the common
equity we refer to. But nonetheless, the data makes a powerful point:
bank capital ratios were far higher in history than they are today, even
with the recent increases and using a broader definition of equity.
The trend is clear and it is higher.
Chart 4: Return on equity versus market cap to equity
Chart 5: Equity to assets
10%
1.0
5%
0.5
0%
0.0
Return on Equity % (LHS)
Market cap to Equity x (RHS)
20.0%
15.0%
10.0%
5.0%
0.0%
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15%
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25.0%
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2.0
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20%
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30.0%
03
2.5
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25%
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35.0%
97
3.0
95
30%
Equity to Assets
Source: Redburn Ideas
Dates: 31 December 1995 – 31 December 2015 (forecasted)
Source: Redburn Ideas
Dates: 31 December 1880 – 31 December 2014
Is leverage itself cyclical?
Where could we be wrong?
An interesting thought is whether leverage itself is cyclical, and
that perhaps the next stage of the cycle is for leverage to rise. Our
response to this is an emphatic ‘no’. Banking supervision for
the large and systemic eurozone banking groups has now passed
over to the ECB, which is showing ever increasing evidence of
being a much tougher regulator than the prior national regulators
it has replaced. We expect the ECB to continue to twist the ratchet
further and that leverage will continue to fall. Indeed, some former
policymakers (Alan Greenspan, Robert Jenkins) have called for
equity-to-assets for the sector to rise to as much as 20%, although
this includes ‘near equity’ as well as common equity, so the
leverage implications are not as extreme as they might appear.
The above analysis suggests that profitability in the banking sector
has fully recovered and that leverage is unlikely to increase. We are
very confident in the second assertion, but what about the first? Could
sector profitability expand beyond previous peaks to new levels?
At a global level, Basel 3 is already set to replace the discredited
Basel 2 with far higher levels of capital required for many forms
of market and operational risk. This has had a significant impact
on the wholesale and investment banks, which have found
that many activities are not profitable when allocated a proper
level of capital. Basel 4 is currently under consideration and is
set to address the discredited Risk-Weighted Asset regime that
underpins the ‘Tier 1’ capital approach to prudential regulation.
[Under the Basel regime: Tier 1 Capital = Equity / Risk-Weighted
Assets]. Under Basel 2 & 3 banks are allowed to set their own
risk weights, and thus their own capital levels, for many forms of
lending based on internal models – a bit like allowing my 8-year
old daughter to set her own bed time. Basel 4, which is aiming to
put in place floors to risk weights, is likely to bite European banks
to a far greater extent than banks elsewhere as the use of internal
models is more ingrained in Europe and risk weights are much
lower. This can be seen in the ratio of risk-weighted assets to
total assets, which is typically less than 50% for many European
banks and typically over 50% for non-European banks. More
fundamentally, we think that regulation is implicitly heading in the
direction of leverage ratios supplanting Tier 1 ratios, suggesting a
regulatory focus on equity to total assets rather than equity to riskweighted assets. This is a big change.
A strong justification for a higher level of banking sector profitability
is that all this new capital has to be somehow remunerated. That is,
capital providers (shareholders) will require higher compensation to
be paid for by bank customers in the form of higher costs of financial
intermediation, and that the additional return on this additional capital
will drive the sector higher. There is some merit to this argument – in
the US the banking sector has had an average return on equity of
8.7% since 1880 through periods when capital levels were far higher.
There are a number of ways that profitability could increase:
1. Net interest margins (net interest income / assets) may not be
bounded at the previous cyclical highs. Although asset spreads
(interest rates on loans minus ‘official’ interest rates) have expanded
significantly from previous cycles, when official interest rates
(ECB, Bank of England) eventually rise, banks may be able to
add a liability margin (official interest rates minus deposit costs)
to the asset spread, producing a higher net interest margin (asset
spread plus liability spread). Indeed, it might be added that the
current zero interest rate regime is biasing bank profits to the
downside given the lack of liability margins. The problem we have
with this view is that asset spreads are already at very high levels
and are showing signs of decreasing in the context of higher levels
of capital and liquidity (more funds chasing whatever loan growth
exists). We would be surprised if these trends did not continue
given the still large size of the asset spread versus history.
Moreover, without pontificating on when interest rates will rise, we
know that banks tend to balance the overall net interest margin
between asset spreads and liability spreads over the course of
the interest cycle. So it is perhaps unrealistic to expect asset
spreads to stay high and liability spreads to rebuild when interest
rates eventually rise. And as the table above from Autonomous
Research shows, net interest margins are already quite high in
an historical context. Hence, we are sceptical that net interest
margins will rise further.
Investment and wholesale banking profit streams could also
see a cyclical rebound, to the extent that they are cyclically
depressed rather than structurally impaired due to changes
in prudential regulation (Basel 3) that have destroyed the
profit rationale for warehousing assets required to support
trading businesses. But it must also be borne in mind that the
LTRO, TLTRO and zero interest rate policies of central banks
and followed by the OMT have ‘gifted’ many banks in Europe
extraordinary profits from buying sovereign bonds in recent
years and riding the yield compression over Bunds. These
profits will not recur.
There are also significant threats to much of the ‘core’ fee and
commission income for European retail banks from technology
and regulation. Payment fees, credit and debit card interchange
fees, foreign exchange fees are all areas that are being attacked
by a combination of new and innovative technology – some
of which we have exposure to in the portfolios – and EU
regulations, such as Payment Services Directive 2, that will cap
interchange fees on credit and debit cards in the EU.
3. Costs and provisions. Costs are an area of European bank
profitability that we do not believe will provide much further
room for expansion in sector profitability, given that banks have
already gained from an environment of low wage growth. Banks
are also likely to have to invest heavily in digital technology and
core IT processes to keep up with the broader evolution of
technology and consumer behaviour as well as to counter the
threat to many revenue streams from technology companies
themselves. Provisions may well stay ‘lower for longer’ as
discussed above, but this is to an extent already factored into
the estimates and we believe that expectations.
One area of cost that seems to show no signs of attenuating
are charges for prior misconduct. This does not just impact
investment and wholesale banks, but also retail banks in the UK
for products such as Payment Protection Insurance, where the
costs have already risen to tens of billions of pounds and are
showing no signs of abating.
Perhaps the biggest critique of our analysis is through considering
valuation. Could the sector be trading on a low valuation versus
history, with our analysis missing the wood for the trees? Our analysis
hopefully shows this is not the case, but it is worth looking at some of
the traditional valuation metrics to see what they imply.
Chart 6: Price-to-earnings ratios of European banks relative to
European market
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2. Fee and trading income may rise further. There are numerous
ways in which fee and trading income could increase. In a low
interest rate environment banks might manage to increase sales
of (non-capital bearing) savings products to customers, thus
boosting profitability without a corresponding need for more
incremental capital. Some Italian banks have proved particularly
successful at this. However, Italy is somewhat of a unique case
given the stock of embedded wealth, a high savings culture
and the position of the banks in that society. It also needs to be
remembered that many investment products in Italy have high
front-end fees, so the ‘switching’ of customers from interest
revenue profits to fee revenue profits may prove a one-off. The
materiality of fee income revenues in the context of total revenues
is also not large enough in most European countries to ‘move the
dial’ on overall revenue growth. If net interest revenues remain
under pressure, switching customers to fee-bearing products will
not compensate to a sufficient degree.
Valuation
‘0
2
Perhaps a bigger critique of our view is that – in the context of the
positive credit impulse we have written about so much – shouldn’t
the eventual rise in loan growth increase both net interest
revenues and profits? The answer to this is: yes, of course, but
every incremental unit of new lending requires an incremental
unit of new capital given prudential regulation (capital ratios). So it
is only if the price of lending per unit volume increases above the
rate of funding per unit volume that there is an incremental return
on new capital (rising return on equity).
‘0
1
Price to Earnings – FY2 – Relative to Europe
Source: Factset
Dates: 29 December 2000 – 19 August 2015
The chart above shows the price / earnings ratio (PER) of European
banks to the broader European market, illustrating a current PER of
0.7x versus a long-term average of 0.8x. As the sector is forecast to
provide the same earnings growth as the market for the next two years,
this PER analysis suggests a 12% upside to current valuations should
the sector trend back to an average PER. However, the period from
2002 to 2008 was a very unusual period for the sector, with earnings
growing far above the market due to the extraordinary leveraging of the
sector equity base, which of coursed helped fuel the ‘debt super cycle’.
We do not expect these conditions to recur and are thus not sure that
last cycle represents a good comparator for the present time.
A further critique based on analysis with longer-term data is that the
US banking sector has averaged an ROE of 8.7% since 1880 and an
average price to book over that time period of 1.35x. This suggests
that there is room for the European bank sector with a current
ROE of circa 8% to see a rise in price to book from the current 1x,
particularly if falling levels of leverage imply safer balance sheets
and thus a lower cost of equity. This is a point that has been made
by both Alan Greenspan and Mervyn King. However, there are two
problems with this argument: First, the implied cost of equity derived
from a price to book multiple of 1.35x for a sector with an 8% ROE
and a 3% terminal growth rate (‘g’) is 6.7%. This is both low and
is a level that we feel very uncomfortable with. If we were to use a
6.7% cost of equity assumption for our investments, rather than our
customary 9%, many of our shareholdings would have target prices
of well over 100% above current market prices. Second, the current
leverage ratio of the sector is 18.1x, implying a common equity-toassets of only 5.5%. This is hardly a low level of leverage / high level
of equity, and is worth considering in the context of many of our
non-financial holdings that run with net cash balance sheets. This
argument may well work in the future but there is a long way to go on
capital solidity and, of course, financial services will need to be repriced upwards quite significantly to prevent ROE collapsing.
Longer-term data for the European bank sector is harder to source,
but Autonomous Research has done some ground-breaking analysis
for the UK, showing that the average ROE of the UK sector since
1893 has been 9.9% with the sector trading at an average price to
book of 1.5x versus 1.0x at the current time. Given the UK’s track
record with inflation, we would be cautious with using a lot of the
older historic data, but nonetheless the chart below using data back
to 1970 illustrates that the current valuation is not high versus history.
Of course, return on equity is also low versus history and leverage is
still high versus history, so in order to generate a higher re-rating the
sector will have to generate higher profitability and lower leverage.
Chart 7: Price-to-book ratio of UK banks.
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3.00
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2.00
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1.00
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Despite a negative overall view
on the bank sector, we recognise
that it is a very large sector with
some degree of heterogeneity.
Consequently, there will likely
be some banks that are in the
process of making changes to
their operating models and return
structures that may create value for
shareholders. There is a case to be
made that many of the wholesale
and investment banks in Europe
(that trade at typically less than 1x
statutory book value fall into this
category). Some of these banks
have new management teams with
excellent track records who speak to
a greater commitment to generating
shareholder value, the shrinking of low-return businesses and
the right-sizing of balance sheets. If successful, this may prove
a positive spur to share prices in the medium term. The problem
we have with this is that wholesale and investment banks are both
the most leveraged, the most complex and also the most opaque
of the banks. Prudential regulation has forced these banks into
a fundamental reappraisal of their business models, and the
challenges of shrinking a multi-trillion euro balance sheet without
damaging earnings should not be underestimated.
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Are there any banks we like?
Source: Autonomous Research
Dates: 31 December 1970 – 31 December 2014
The final metric often pointed to is dividend yield, with many
European banks now paying attractive dividends versus both
interest rates and bond yields. While we accept that making
a high dividend pay-out is very sensible in a low-growth
environment for those banks that are well capitalised, dividend
is a capital allocation decision and not a valuation metric.
Investors should be focused on total shareholder return, which is
a combination of dividends and capital growth. Capital growth is
a function of book value per share growth, which in turn is driven
by return on equity multiplied by proportion of capital generation
retained. A company that pays out 100% of its earnings in
dividends will not grow its book value or capital, which brings the
analysis back to the fact that true compound wealth creation is
driven by return on equity and reinvestment opportunities. Banks
do not score well on this front.
Elsewhere, the three banks that are currently held in our portfolios
represent what we judge to be an attractive combination of
valuations, returns, growth and restructuring possibilities. We will
continue to look for money-making bank investments, and if the
facts change we will of course change our views. But for now we
think the sector is over-loved and mispriced.
Nothing contained herein constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of
any investment or to engage in any other transaction. The statements and opinions are those of the author at the time of publication and may not reflect his/her views thereafter.
The companies listed were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any
portfolio and do not represent any recommendations by the author. Past performance is not indicative of future performance. No liability shall be accepted for the accuracy and
completeness of the information. Within the UK, this material has been issued and approved by GAM London Ltd, 20 King Street, London SW1Y 6QY, authorised and regulated
by the Financial Conduct Authority. JN6526 – August 2015