Image Source: Mike Cohen
By Brian Nelson, CFA
In March, during the depths of the COVID-19 meltdown, we trimmed our fair value estimates for many financials and money center banks. The reasoning was rather straightforward. Our base-case projections for the group were lowered as a result of our expectations of a global economic recession. We factored in higher credit losses due to our anticipation of slowing economic activity that would be triggered by consumers staying at home to avoid COVID-19.
We also considered the impact of net interest margin (“NIM”) compression that would result from expectations of a sustained ominous inverted yield curve, and in light of heightened uncertainty regarding the fatality rate of the virus itself (at the time), we included a meaningful (10%) probability of a very bad tail-risk scenario that would cause permanent capital impairment generated by broad-based systematic stress across the financial system. In aggregate, this resulted in ~30% fair value estimate reductions across our money center bank coverage.
To a large extent, we have been correct on the basis of banking share-price relative weakness compared to other sectors. During the period February 19, 2020 through March 23, 2020, the financials sector fell a whopping 43%, with only the energy sector performing worse over this time period. In the subsequent immediate bounce back in the markets (March 23, 2020 through May 14, 2020), the financials sector only advanced 19%, again a return that was second worst in the sector rankings–performing slightly better than only the consumer staples sector. Year-to-date, an ETF tracking the financials sector (XLF) is down over 11%, while the S&P 500 has advanced nearly 11%–representing more than 20 percentage points of underperformance.
During the past few weeks, positive news surrounding the Pfizer (PFE)/BioNTech (BNTX) and Moderna (MRNA) vaccines means that, while times will still be tough for banks as bad loans pile up, losses and defaults perhaps won’t be as bad as we had originally predicted at the onset of the outbreak of COVID-19. The unemployment rate has steadily crept lower from the 14.7% rate it hit in April 2020 (it stands at 6.9% as of October), and businesses have been battling hard through the worst of times with help from the Paycheck Protection Program, among other stimulus efforts. There have still been many business failures, however.
Several banks’ net interest margins have faced pressure, too, but 30-year rates have managed to ease a bit higher from the sub-1% mark on March 9, 2020, to 1.62% at the time of this writing (November 18). The widely-watched 10-year/3-month Treasury yield spread has also advanced to 79 basis points, representing a meaningful improvement from most of February and early March when the 10-year/3-month Treasury yield spread was negative. The probability of an adverse tail-event is also substantially reduced (if not, eliminated), given the laser-focus of the Fed/Treasury to do whatever it takes to get to the other side the COVID-19 crisis. With all of this in mind, we expect to raise our fair value estimates for the money center banks upon their next update, effective November 21.
That said, we’re not changing our general views on the banking and financials sector. Banks are being used more and more these days as extensions of government fiscal intervention/policy via myriad stimulus programs (which makes them more like “utilities”), while regulatory oversight has put a limit on just how much capital they can return to shareholders. This adds a degree of unnecessary complexity for dividend growth and income investors. Returns on equity remain relatively unattractive for many banks when compared to some of the strongest Economic Castles on the market that put up ROICs north of 100%, for example, some even higher. Systemic risk remains present, too, with most lending books opaque and intertwined within a global financial system that remains far from healthy due to COVID-19.
Let’s talk a bit about bank valuation. From an enterprise free cash flow basis (FCFF), cash flows for many banks and financials are largely arbitrary to model given the Fed/Treasury backstop (read Value Trap on this topic), and most remain leveraged by the very nature of their business models. We don’t like the free-cash-flow-to-equity valuation method (FCFE) that many use to value banking entities either, and we generally use a residual income model to value most banking entities, a process that grosses book value up or down based on the trajectory of economic value creation. However, even this approach doesn’t instill much confidence in an intrinsic value estimate, given the often-arbitrary nature of accounting book value. Even Warren Buffett, who owns insurers and banks in his vast Berkshire portfolio–and has used book value as a yardstick for years–has since abandoned the measure. From Berkshire’s 2018 annual letter to shareholders:
Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice.
The fact is that the annual change in Berkshire’s book value…is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.
Concluding Thoughts
In light of better-than-feared developments across the economic environment and the financials and banking system, more generally, we’re raising our fair value estimates for many financials and money center banks. We still don’t see much reason to own the group, however, as we generally prefer indirect exposure to the global financial system via PayPal (PYPL) and credit card processor Visa (V), both of which have noteworthy competitive advantages, strong business models and are tied to long-term secular growth trends. Square (SQ) and Mastercard (MA) are two more of our favorites, and we cannot overlook many security research providers with strong fundamental momentum, including Morningstar (MORN). Our updated fair value estimates for the money center banks will be published November 21.
To download our comprehensive banking sector report (pdf) >>
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Related: KBE, KRE, KBWR, KBWB
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Brian Nelson owns shares in SPY, SCHG, DIA, VOT, and QQQ. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.