Thursday, 20 September 2018

Banking story turning the corner: stay long

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  • Keith Mullin
IFR Editor-in-chief Keith Mullin questions whether banks’ cost of equity is being overstating

MAJOR BANK STOCKS have been on a tear since the US election result, up on average around 25% – a whole lot more in many cases. It’s not just US banks but international players too. It’s probably safe to say equity prices have been caught by a wave of investor over-exuberance and the acceleration will settle down over time. But the appreciation does raise some vital questions.

Beyond short-run stock price volatility, is the banking story finally turning the corner and will the sector finally be subject to some buyside repositioning and rebalancing as fiscal stimulus, regulatory rollback, lower corporate and individual taxation, infrastructure spending, higher interest rates, (probably) over-engineered Brexit fears and other factors result in higher net interest margins over the cycle and an increased level of event-driven activity?

From a more technical perspective, has the recent stock-price spurt been driven purely by short-term opportunistic trading factors (principally the fear of missing out) or does it suggest one imponderable that has been bedevilling the sector for years – will return on equity now sustainably exceed cost of equity (CoE) – has been resolved in the minds of investors?

I’ve been uncomfortable for some considerable time that the analyst community has been paying too much attention at the micro level to top-line growth factors and their drivers/inhibitors and to broader macroeconomic factors, while paying too little attention to imputing a realistic CoE at the individual bank level, and therefore coming up with wonky valuations.

Many of the world’s largest banks are generating returns on equity in the high single digits to low double digits. It’s been widely accepted that those returns have undershot or barely covered their cost of equity, rendering the sector uninvestible and often resulting quite naturally in discounts to tangible book value in the stock market as the only way investors can justify purchasing decisions and generate target returns.

Those discounts reflect the apparent view among investors that the break-up value of assets in the event of liquidation is less than their stated accounting value.

That’s a damning indictment, but I would doubt frankly it’s a generally accepted fundamental sector view. If it were, it would bring into question why investors have continued to stay invested, given the opportunity costs.


A FUNDAMENTAL PILLAR of the house of relative value depends on your central base case for evaluating CoE. Ask anyone these days what that number is and they immediately spew out 10%. I’ve been listening to this globally accepted number for so long and it’s always bothered me.

The canon of academic literature on the topic is large but there’s no accepted methodology for determining a bank’s CoE. Now I’m no academic, but it strikes me that the capital asset pricing model that factors in the risk-free rate, the sensitivity of a given stock relative to the index plus an equity market premium has the right elements.

Bank CEOs have long moaned that the 10% rule of thumb for cost of equity is too high. The latest to do so was HSBC chief Stuart Gulliver in a dispatch from Davos. He said investors had not taken into account the much higher levels of capital held in the banking sector relative to 2006 and were still using the same CoE inputs.

Beyond the issue of capital quantum, I’d ask how the implosion of risk-free rates in the bond market and the move to negative yields in recent years can have failed to have influenced the outcome of expected return outputs one iota, even if you impute a higher equity risk premium.

Gulliver suggested investors’ refusal to lower CoE might be because regulators hadn’t finalised the rules on capital so investors hadn’t been able to get their heads around optimal capital levels. He added that once there is clarity around capital quantum, the cost of equity for banks would start to come down.

He pointed to a framework where banks like HSBC are generating returns on equity of 10% (he reckons 12%-13% isn’t achievable) with a cost of equity of 8%, a dividend yield of 4%-5% and shares trading at a multiple of 1.1x to 1.2x book.

In these days of low leverage and less risk, I would imagine that investors would consider that a reasonable framework. But I wonder if it might be erring on the conservative side.

I’m not going to take the Q4/FY2016 bank results we’ve seen to-date and make any specific sector-wide prognostications. It’s too early for that and we’ll need to see how the European banks fare relative to their US counterparts over the course of 2017.

But given valuations may have been off-beam to the downside for some time, and if you take an equation and gradually increase the numerator of bottom-line profits as operating conditions improve, while lowering the CoE denominator, you end up with a bigger number. Maybe I’ll challenge my own statement at the top and endorse any buy recommendations on the banking sector.

Not as a short-term trading play, but as a fundamental reflation story that rides any waves of volatility to capture longer-term upside potential.


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