Banking stocks are one of the most complex and economically sensitive investments any stock picker has in their portfolio, and ever since the global recession, “bank bashing” is a favourite pastime.
However, with Donald Trump now the most powerful man in the world, inflation expectations are rising and bank stocks are a new flavour of the month. This is welcome news to many, but no more-so than those who were burnt in the 2007-2016 period of share-holder value destruction. This is especially true for European bank holders who are still down 67% since the peak of the financial crisis.
As advocates of value investing, the key question is whether bank stocks are a value opportunity or a value trap. We have already begun to see early signs of this sentiment shift, with European banks up 24% since June 30, and 8% alone since the Trump victory.
The link between a bank’s stock price and its return-on-equity is also incredibly important. If bank stocks have any chance of rising sustainably, we need to see stability and/or growth in both forms of profitability. Unfortunately, this has not happened in recent years, with the average return-on-equity of a European bank falling from a healthy 20-year average of 10.5% to a value destructing 5.3%.
One of the greatest challenges for banks is regulatory constraint, creating an inability to earn healthy profits against the significant headwinds of high debt, low interest rates, geopolitical risks, open competition and an ageing population. This is exacerbated among the banks in Europe because they have traditionally earned more than 60% of their revenue from standard lending practices, which rely on leverage and durable economic conditions. Therefore, the reality is that profit margins need to be considered using four key questions:
Can banks sustainably increase lending despite a regulatory and economic headwind?
Current lending growth is only 1.8% and while there may be scope for this to expand over shorter periods, it appears very difficult to structurally sustain for two reasons. First, post-crisis scrutiny has led to increased capital requirements and it is wishful thinking for the Trump ‘deregulation’ movement to spread into European financial services in a meaningful manner.
Furthermore, demand for higher loan growth is arguably unlikely under a backdrop of low economic growth, high existing debt levels and an emphasis on consumer deleveraging. This impediment is being labelled as “Japanisation” for logical reasons.
Can banks increase their margins on traditional lending?
Another challenge to profitability is that ‘net interest margins’ are at an all-time low of below 1.2%. This can only increase under one of two scenarios: a reduction in competitive pressure or a rise and steepening in the yield curve. The former is incredibly difficult in Europe due to a lack economic moats among the major banks, although the latter could improve if inflation returns.
Can banks transform from within?
If banks are unable to transform the global conditions that drive their profitability, they must transform from within. One strategy being contemplated is a shift in the corporate vision to earn more revenue from non-traditional ‘fee and commission’ activities – investment banking, M&A, trading and asset management, although this appears difficult to sustain as it is already elevated. Alternatively, management could put the knife on bottom-line expenses or consider consolidation opportunities within the industry. This could build on the Scandinavian model, which is perceived as the industry leader.
Are there any other X-factors that could play on the bank sectors fate?
One of the biggest headaches for banks in a post-crisis world has been the enormous rise in litigation expenses. These remain extraordinarily high by historical standards and an optimist could see scope for an eventual unwinding of these impairments; the pessimist could also cite a snowball effect if a European bank defaults. Further to the downside, a bad-debt cycle could easily create havoc, which is especially relevant in Europe given some of the geopolitical and country-specific risks such those being experienced in Italy.
The Good News and The Bad News
Notwithstanding the profitability issues outlined above, there is good and bad news on an investment front.
Starting with the good news, banks are still cheap on most valuation metrics. They are trading at very low prices relative to book value, have a very healthy dividend yield of approximately 4.7% and are trading at a level that implies an ROE closer to 4.4% rather than the actual current return-on-equity of 5.3%. These arguably act as a defensive mechanism to overall returns and potentially increase upside potential.
The bigger and harder question is whether European banks are a value trap. To answer this, it requires an investor to contemplate whether they should buy an asset that has a potentially poor profit outlook and is thereby destroying shareholder value. There are two trains of thought in this regard:
The Warren Buffett and Charlie Munger style of value investing would say that an investor should prefer to buy a high-quality business at a fair value than a fair business at a bargain. This makes sense if your holding period is forever, but will thereby miss the opportunity to obtain value capture in these types of opportunities.
The Benjamin Graham or Howard Marks style of value investing would say that every asset has its price, and if a large enough margin of safety exists then the value capture can still provide a tremendous return. This ‘distressed asset’ camp is also suited to long-term holdings, allowing value capture time to occur but with the risk of a value trap.
On balance, European banks look cheap, but investors must acknowledge the enormous complexity in the industry and structural headwinds that could keep profitability low for a long time. Only time will tell whether European banks are turning Japanese or set for a rebound under a Donald Trump presidency.
