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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]. € 1,800 € 1,600 € 1,400 € 1,200 € 1,000 € 800 € 600 € 400 € 200 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 1 Cu 4 rre nt 02 20 20 01 €0 00 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 20 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% E E 20 17 E 16 15 20 20 14 13 20 12 20 10 11 20 20 09 20 08 20 07 20 20 20 20 06 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 0.4 5% 0.2 0% 0.0 Capital Turnover Source: Redburn Ideas Dates: 31 December 1995 – 31 December 2015 (forecasted) c De De c De c De c De c De c De c BOP Margin 15 f 10% 13 0.6 11 0.8 15% 09 20% 07 1.0 05 1.2 25% 03 30% 01 1.4 99 35% De c 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 c • 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% 95 • 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 c • 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. c • 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. De 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% 18 8 18 0 8 18 6 9 18 2 9 19 8 0 19 4 1 19 0 16 19 2 19 2 2 19 8 3 19 4 4 19 6 5 19 2 5 19 8 6 19 4 7 19 0 7 19 6 8 19 2 8 19 8 9 20 4 0 20 0 0 20 6 12 15 c De c De c De c De c De c De c De c De c De c De c De f 1.5 13 15% 11 25.0% 09 2.0 07 20% 05 30.0% 03 2.5 01 25% 99 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 1.4 1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 ‘1 5 ‘1 4 ‘1 3 ‘1 2 ‘1 1 ‘1 0 ‘0 9 ‘0 8 ‘0 7 ‘0 6 0.5 ‘0 5 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. 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 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. 19 7 19 0 7 19 2 7 19 4 7 19 6 7 19 8 8 19 0 8 19 2 8 19 4 8 19 6 8 19 8 9 19 0 9 19 2 9 19 4 9 19 6 9 20 8 0 20 0 0 20 2 0 20 4 0 20 6 0 20 8 1 20 0 1 20 2 14 0.0 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