The Valuentum analyst team talks about why we don’t like the business models of banking entities, why they are currently destroying economic value, but also why the team includes exposure in the Best Ideas Newsletter portfolio. What gives? Find out in this ~9 minute podcast.
If you cannot view the video, please view the transcript that follows.
Tickerized for holdings in the exchange traded funds, XLF and KBE, and for various financials-oriented ETFs.
Kris Rosemann:
Hello and welcome to the Valuentum Securities podcast. My name is Kris Rosemann Associate Investment Analyst at Valuentum. With me is Chris Araos and Brian Nelson President of Equity Research and ETF Analysis at Valuentum. Today, we are going to have a quick discussion over the global banking sector. I would like to begin with a broad question for you Brian — what in your mind makes the banking sector more risky than your traditional operating company?
Brian Nelson, CFA
I think that’s a great question Kris and thank you for having me. I think a lot of times investors want to view banks on an equal footing as a general operating company, and that’s just the wrong way of looking at things. The banking industry should be viewed in a very unique light.
One of the riskier things about the banks is their loan books. Even some of the top executives of the banks themselves can’t know exactly what’s going on in their operations. I’ll give you two specific examples. JP Morgan’s (JPM) “London Whale” incident of 2012 and then Credit Suisse’s (CS) $1 billion write down more recently were two post Dodd-Frank legislation events that showed that, even with increased regulations and oversight, that bad things can happen and still spiral out of control.
Kris Rosemann:
So how do we at Valuentum look at the valuation of banks, more specifically what is your opinion of their economic value creation potential? The top ten banks recently – it was reported that they posted a combined return on equity of just seven percent. How does that explain the (difficulty) of banks (being able) to generate economic profit?
Brian Nelson, CFA
Well, you know that the reality is that with increased regulation and oversight, it’s demanding banks to hold larger capital bases. So these excess capital bases–when you think about the returns, if you have to hold more capital, your return on capital–just by the simple definition is going to be lower. So what happens with the modern banking business model is that, because of all this regulation and this need to guard against the next potential calamity is that returns are depressed.
Typically speaking, most investors are going to demand, or at least the hurdle rate for most banking investors in terms of the cost of equity is about ten percent. So what we’ve seen over the past, in at least 2015 is value destruction. Economic value destruction, seven years after the panic bottom in 2009, you’re seeing banking companies that are destroying economic value.
A lot of the banking models are challenged due to these excess regulations, and as this factors into the valuation framework, the economic value construct faces pressure in terms of reduction in tangible book value in the face of any entity that is expected to destroy economic profit (ROE < COE). Because of the excess regulations and the need for having to hold a lot of capital, this has really hurt the returns, the economic returns that banks (have been able to generate).
Kris Rosemann:
Is there a lot of other things you are seeing in today’s global financial environment that is impacting the ability of these banks to generate an economic value for their shareholders? We’re seeing lots of monetary easing across the globe from central banks and federal governments, and as we know in the United States, interest rates are at very low levels, what impact does that have on the banking sector?
Brian Nelson, CFA
Sure, I think you know it’s not so much the level of interest rates, per se, but the spread of the net interest margin, and the net interest income that banks can generate. It’s really comparing short and long end of the curve.
For the most part though, lower interest rates tend to limit the flexibility that banks have in terms of charging higher interest rates. So that’s one limitation that we’ve seen in the ultra-low interest rate environment. That being said, I think this ominous (cautious) outlook–this need to hold excess capital–has brewed cultures within at least one more-recent bank’s example, where they were stretching to add more fee income to meet performance targets.
We have seen the Wells Fargo (WFC) account opening scandal as one specific example of a culture gone wrong. Where they were pushing growth, and the need to generate new areas of fee income to meet certain performance targets.
Christopher Araos:
Brexit has created considerable instability throughout economies in general. How has this also affected the British pound instability affected banking in general?
Brian Nelson, CFA
Sure, I think where we’ve seen through most of the financial crisis in ’08 and ’09 were a lot of dividend cuts, and the US banks and really just the bailout package. What we’ve seen over the past few years is a resurgence of dividend cuts from Santander (SAN) to Deutche Bank (DB).
In the Brexit situation, in particular, we are most concerned about Lloyds Group (LYG) a company, a bank, for example, that has a higher assets-equity ratio then even some of the banks in the U.S. heading into–some of the global money centers that really took it on the chin–prior to the financial crisis. In terms of the UK banks, some actually have higher leverage in some cases than some of the US banks, Bank of America (BAC) being one in particular, Citigroup (C) being the other (prior to the Financial Crisis in 2008).
We’re also seeing that the pound being at 30-year low is obviously going to complicate situations in the hedge fund market, which could cause asset flight. We also saw that the property market in the UK froze where many property funds weren’t allowing redemptions. We’re still waiting to see what that fallout might be, but with some forecasts suggesting that the London property market and commercial real estate in the UK, in general, could fall ten to twenty percent, that’s a pretty hefty wipeout to the asset basis of many banks.
I don’t think that anybody is anticipating growth by UK’s Brexit. Many economic forecasters are anticipating either slowing growth or potentially entering into recession for the UK.
Kris Rosemann:
Obviously, we’re well aware of the risks of the banking sector here at Valuentum, but we do include both the Financial Select Sector SPDR (XLF) and SPDR S&P Bank ETF (KBE) ETFs in the Best Ideas Newsletter portfolio. Though they make up small percentages of the portfolio at both under two percent, can you speak to the added qualities that we gain in a portfolio context from the ETFs as opposed to holding an individual bank? Why are we so keen on holding that diversified exposure?
Brian Nelson, CFA
That’s a great question, and it goes into some of the things we talked about: the arbitrary nature of a bank holding cash to generate cash; it is very hard to value the opaqueness of their individual books; the idea that things can still spiral out of control with JP Morgan and Credit Suisse being examples, but when we look at the banking sector, they are trading at twelve times forward earnings, the most underpriced sector according to forward P/E ratio relative to any other sector out there.
On a tangible book basis, they are not trading at too much premium, 1.1 in a market that’s very frothy. They’re not too ridiculously overpriced, but the reason why we don’t necessarily hold an individual bank is due to that firm-specific risk–whether it be the Wells Fargo instance more recently, JP Morgan a few years ago. We prefer the diversified exposure to gain broader sector diversity in the Financial Select Sector SPDR as well as the SPDR Bank ETF have acted as two important components in a whole portfolio context to really help us drive performance in the Best Ideas Newsletter portfolio.
Kris Rosemann:
Great, yeah thank you very much for your time Brian.
Brian Nelson, CFA
Thank you guys so much for having me.