The FIG Idea: Five ways equity analysts could do better
Bank stocks are up 50% from their 2009 lows, but down 30% since a year ago and down 70% from their all-time highs in early 2007. Many equity investors from a decade ago lost their shirt in the banks sector. They can blame macroeconomic shifts for some of this price volatility. But a lot of it is because "the market" doesn't do a great job valuing bank stocks.
Analysts and investors could certainly do better.
At present, a lot of their decision-making is technical (share price movements) and relative (prefer Bank A to Bank B). If it’s oversold, maybe it’s becoming a Buy; if it trades higher than peers, maybe it’s a Sell.
If and when they look at the fundamentals, it generally boils down to looking at a few key indicators from banks' statutory accounts: primarily, earnings per share (EPS) and book value (BV) projections. Adjust for any known oddities, like a regulatory capital deficit, throw in some gut-feel valuation multiples and — presto — a price target!
These methods are generic across all industrial sectors. In benign periods, they may appear to work for banks. But not in more troubled times. Banks are hugely leveraged investments, meaning risk is the key valuation factor, rather than base case accounting earnings.
Here are five ways analysts and investors could improve their assessments.
1. Don't rely on the accounts.
Statutory financial statements are, at best, a weak indication of value creation. They tell us little about the risk that a bank is running.
A sharp rise in quarterly profits, for example, does not mean necessarily that the business is doing better. Likewise, a return-on-equity of 30%-40% doesn't imply that the shares should be worth a fortune, as investors in UBS and Northern Rock discovered in 2008.
For industrials, we are taught that “cash is king”. Sadly, for banks, cash flow is close to meaningless. The accounts give some useful information, it is true, but they need to be carefully interpreted and supplemented.
2. Read the regulations and the politics
In case you haven’t noticed, banks are regulated by the state. They don’t have full control over their own earnings streams and capital bases. That’s the quid pro quo for being licensed to take deposits and having the support of the central bank in tough times.
Politicians feel empowered to impose windfall taxes, bank levies and sector-specific corporate tax rates.
Regulators, acting in the interests of financial stability, impose ever-increasing capital and liquidity requirements, while constraining many aspects of business operations.
An investor's view has to include an informed and insightful view on potential political and regulatory developments. After all, profitability is no use if it gets sucked up by taxes and solvency buffers.
3. Think about the risk of the bank (top down)
The equity market needs a sophisticated view on risk.
Equity investors need to be looking at scenarios not projections, a range of outcomes rather than the most likely "base case" outcome, sensitivities as well as trends. They may want to borrow tools from their colleagues in credit markets and options traders.
A better grip on the cost of capital is also essential.
At present, the market mostly relies upon the so-called capital asset pricing model (CAPM), which is the wrong tool and leads to wrong decisions. Instead, investors should be looking at modelled volatility in economic value to derive an appropriate cost-of-capital. The results would be surprising.
With a better view on risk, the equity market could drop the antiquated notions of "Buy/Sell" and "price target", looking instead at portfolio analytics and risk appetite matching.
4. Think about the risk in the bank (bottom up)
Equity investors need to know what they're buying. When something goes wrong, the shareholder always loses money.
In effect, they own the "first loss" tranche of a highly leveraged loan portfolio. So, they should look at the loans that the bank has in some detail. CLO investors do this diligently; equity investors are more superficial.
It's far more than NPL ratios and provision levels. A look at the loan book needs to consider things like current origination standards and trends in collateral.
The analysis can be done quite efficiently: it's not as scary as it sounds. Where is the bank growing? What types of loans does it specialise in? How does it justify its revenue margins?
Any investor not willing to do a proper assessment is "flying blind" and should stay away from investing in banks.
Equity investors need the same approach for other risk areas, such as operational risk, where again equity investors provide the "first loss" capital. What would need to happen for my investment to lose value? And how likely is that?
5. Capex and obsolescence
The equity market focuses on near term earnings and dividend projections. But as cost-of-capital falls, the terminal value of an investment becomes ever more important. For some banks, it could be as much as 80% of their value.
The long term is not a perpetual steady state — far from it. Strategic changes in the banking industry mean that massive capex needs to be factored in, as well as the threat to franchise value from new entrants with modern business models.
A longer term view would highlight several banks that are over- or under-valued. There are defensive banks being treated as perennial cash cows, but are facing decline, if not oblivion. Others are better at strategic adaptation, and have more chance of defending their franchise value successfully.
These five elements seem obvious, but they are not the way the market works today. The market works in the same way that it always did. Analysts talk in the language that investment managers understand. Investment managers jump to their masters' (overly short term) investment objectives.
There must be value in better understanding the risks, regulations and strategic developments in the banking sector. Banks can be attractive investments but it's not easy to value their shares.
A risk-adjusted and radically modern — yet ultimately grounded — investment view makes sense. If only investors would learn from their recent losses and face with confidence the new realities of owning banks.
The FIG Idea is written by a FIG market professional with more than 20 years of experience