Though junior analysts cheating on internal exams at Goldman Sachs (GS) and JP Morgan (JPM) has probably garnered more headlines than the results of the two entities themselves, one thing remains clear: the US financial system remains on very healthy ground. While robust capital ratios speak to this, not all banks are doing great, and volatile economic and market conditions are posing challenges for many, even if such conditions are an inescapable characteristic of the financial system itself.
Morgan Stanley’s (MS) third-quarter results, for one, left much to be desired. Reported net revenue dropped to $7.8 billion from $8.9 billion in the year-ago period, while net income fell to $0.48 per share from $0.83 in the September quarter-end last year; the measures include debt valuation adjustments (DVA). The bank’s annualized return on average common equity was 5.6%, less than the minimum high-single-digit hurdle rate we’d look for in a bank in order to say its quarter was a value-creating proposition for shareholders. Morgan Stanley’s ‘Fixed Income’ business and its ‘Asia Merchant Banking’ business faced considerable pressure as a result of the volatility in global markets.
Morgan Stanley’s ‘Wealth Management’ operations, however, remain a lucrative, high-margin division of the investment bank, but such resilience hasn’t been able to stem the sell-off in shares, which are hovering near 52-week lows. The company’s capital position remains top-notch, with a Basel III common equity Tier I ratio of 13.9% at the end of September, but with tangible book value per common just shy of $30 per share and the bank failing to generate an annualized ROE greater than our estimate of its cost of capital, we admit there still remains downside risk to the price of shares from today’s levels. Banks that are destroying economic value typically trade at a discount to tangible book value, or they should, meaning a trip to the high-$20s for Morgan Stanley’s shares cannot be ruled out, even as we say our long-term fair value estimate of Morgan Stanley is $33 per share.
JP Morgan’s performance in its third quarter wasn’t blockbuster either, as the company missed consensus expectations on both the top and bottom lines. Chairman and CEO Jamie Dimon noted that the challenging global economic environment and continued low rates hurt its wholesale business, but despite the headwinds, the bank still generated a return on tangible common equity (ROTCE) of 15% during the period, much better than the mark at Morgan Stanley and better than what we had been expecting. Favorable trends in consumer credit quality in part helped to push JP Morgan’s tangible book value 8% higher to $47.36 per share by the end of the quarter.
Though not as robust as Morgan Stanley’s, JP Morgan’s capital position remains solid. The bank boasted a Basel III common equity Tier I capital ratio of 11.4% at the end of the third quarter, even as it returned $2.7 billion to shareholders in the third quarter. Though economic returns are strong at JP Morgan, we note the bank’s premium price-to-tangible book value already reflects a continuation of strong ROTCE performance. Our fair value estimate of JP Morgan is $64 per share, about in line with where shares are trading, but its near-3% dividend yield is starting to attract income investors, perhaps offering its price an added boost in coming periods. Management downplaying performance in the current quarter shouldn’t be ignored, however.
Goldman Sachs’ performance during the third quarter also came in below expectations on both the top and bottom lines. Echoing some of the party lines at Morgan Stanley and JP Morgan, CEO Lloyd Blankfein noted the bank “experienced lower levels of activity and declining asset prices during the quarter, reflecting renewed concerns about global economic growth.” We generally weren’t blown away by Goldman’s annualized return on average common shareholders’ equity (ROE) of 7% during the third quarter, particularly compared to the mid-teens mark at JP Morgan and the near-9% level generated during the first nine months of the year.
But there’s a lot to like about Goldman Sachs. The bank garnered the top ranking in worldwide completed M&A and equity and equity-related offerings, and its year-to-date net revenues of $5.48 billion in its ‘Investment Banking’ operations turned out to be the highest performance over a similar nine-month period since 2007. ‘Investment Management’ revenues also set an all-time record year-to-date, as assets under supervision stood at $1.19 trillion at the end of the quarter. Though Goldman didn’t live up to our ROE forecasts during the third quarter, we continue to expect strong economic returns on a go-forward basis. Our fair value estimate of $186 per share for Goldman stands at a modest premium to the bank’s tangible book value per common share mark of $162.11 registered at the end of the third quarter, but in-line with where shares are currently trading at the time of this writing.
Bank of America’s (BAC) performance during the third quarter was solid, in our view, with the bank generating a return on average tangible common equity of 10%, besting Morgan Stanley’s and Goldman’s marks during the period. Revenue and earnings came in better than consensus expectations thanks to strength in mortgage and home equity originations, credit card issuance, and improved investment banking performance. Net charge offs fell 11%, and management noted ongoing progress with expense management initiatives. Total deposits advanced 4%, to $1.16 trillion, at the end of the quarter, as the firm returned $3.1 billion to common shareholders via repurchases and dividends. Bank of America’s common equity Tier 1 capital stood at ~11% at the end of the third quarter, and tangible book value per share of $15.50 is roughly in line with our fair value estimate of $16 and where shares are currently trading hands.
Citigroup’s (C) third-quarter performance wasn’t bad either. Though the bank is most exposed to contagion dynamics should weakness in China infect the global financial system, year-to-date return on tangible common equity (ROTCE) stood at 10%, excluding CVA/DVA; we view such performance as an economic value-creating achievement for the executive team. Citigroup’s capital position remains sound, with the bank boasting a common equity Tier I capital ratio of 11.6%, better than that of JP Morgan and BofA. Tangible book value of $60.07 and value-generation performance speak to an underpriced equity in the low $50s, where Citigroup’s shares are currently trading. Our fair value estimate of the bank stands at $58 per share, and we would not be surprised to see shares of Citigroup breach the $60 level to the upside if it continues to put up solid 10% ROTCE marks.
We’ve always been risk-averse when it comes to the financials sector, and that approach won’t be changing anytime soon. We continue to prefer the Financial Select Sector SPDR (XLF) and SPDR S&P Bank ETF (KBE) as our exposure to financials in the Best Ideas Newsletter portfolio, and our risk-aversion may never facilitate the addition of a banking entity in the Dividend Growth Newsletter portfolio. For traders looking to bet on rapid price-to-tangible book conversion in the context of a value-creating entity, Citigroup offers a unique arbitrage opportunity at the moment. We’re sticking with diversified exposure to the financials sector in the Best Ideas Newsletter portfolio, in any case, however.