These last few weeks have been marred by extremely significant volatility as we prepare for the Brexit vote on June 23rd.
While most of the impact of any Brexit wouldn’t likely be felt for several years at the minimum, the uncertainty that more countries would leave the Eurozone could mean more volatility for the market in these already uncertain times.
I believe the significant declines that stocks saw last week, particularly in Europe, were indicative of the market pricing in reasonably high odds that the results of the Brexit vote will be for Britain to leave the EU. Betting odds are highly in favor that the Britain will remain part of the EU, while polls are much more indecisive. I’m not smart enough to know which way it will go but if I had to bet I’d say cooler heads will prevail and Britain would remain part of the EU. In my opinion, the benefits outweigh the negatives and it would be more productive to try to leverage the EU for changes that might make staying in the EU a little more palatable for some of the countries that are showing less enthusiasm for the EU. Banks across the globe have sold off as they are often a proxy for investor confidence, which is at very low levels.
The fear is that with economic growth already very slow, a Brexit could put Britain and possibly the United States closer to a recession.
I do not believe that the economic data shows that a recession is very likely this year, but I would argue that the big U.S. banks are already pricing in a very severe recession as current valuations make no sense. To me there is far more upside and very little downside for long-term investors and in this article I’ll explain some of the main reasons that have led me to believe this.
It is important to understand that the big banks have a far different business model than they did prior to the Financial Crisis:
- They have double the capital and double the liquidity. This is an absolutely massive difference that probably would have allowed all of them to survive the Financial Crisis without taking on additional equity. That is quite a statement being that this was the greatest recession since the Great Depression of the 1930s.
- These banks are no longer aggressively engaging in areas such as proprietary trading where they were using their balance sheets to speculate on securities.
- Loan quality has never been higher and it has become increasingly difficult for consumers without pristine credit to get access to mortgages. While bad for consumers, it makes the banks far more resilient to credit quality degradation than they were when anybody with a pulse could get a mortgage.
- The banks don’t just buy mortgages originated by unscrupulous mortgage lenders like they used to. Instead they focus on organically growing their balance sheets, which is much lower risk as proven by far lower default rates during the Great Recession, than purchased mortgages.
- Banks are catering to their clients and providing needed services as opposed to focusing on growth at all costs.
- Real estate prices have continued higher and we have a supply shortage problem in many communities, meaning that barring a major recession, home prices should be a continued tailwind, especially with interest rates so low.
- Lastly, the big banks are finally past the massive tens of billions of dollars of litigation costs stemming from the Financial Crisis, which greatly hurt profits over the last 5 years.
The headwinds for the banks are record low interest rates, which compress net interest margins.
This is certainly a problem and reduces the overall earnings power of all banks. Global growth is slow, which leads to lower revenues in investment banking. This was very apparent in the first quarter, but the 2nd quarter looks to be quite solid. Energy and mining credit has caused some trouble, forcing banks to increase reserves. Prices have risen quite a bit since the 1st quarter for energy and metals and overall exposure is not too bad, so I don’t believe the situation is likely to get much worse. These are definitely negatives, but they aren’t too difficult for the banks to deal with and still generate solid profits. Solid profits might mean a goal of a 10% return on tangible equity for the likes of Citigroup and Bank of America. While MS and JPM should be able to generate those returns on total equity since they don’t have the burden of the deferred tax assets. That would have a negative impact on ROE since they tie up capital. In better times, I believe C and BAC can generate returns on tangible equity of 13-15%, while MS and JPM should be able to do about 12% on equity. Wells Fargo is even better but the valuation is much harder to justify in my estimation so I didn’t show it.
Looking at the table above, I will define a few things and then talk about what they mean.
- Tangible book value (TBV) per share is basically the most conservative estimate of the runoff value of a bank as it excludes goodwill and intangible assets.
- Book value (BV) per share is assets minus liabilities equals shareholder equity. Most banks have historically traded at a premium to book value and certainly to tangible book value.
- Return on equity (ROE) is the after-tax profit generated per dollar of shareholder equity in 2015. Before the Financial Crisis, ROE’s were in the mid to high-teens but now with double the capital, they will assuredly be lower, but the banks are much safer also.
- Earnings yield is calculated by dividing 2015 earnings per share by the current share price. It shows you what these banks would pay out in dividends if they paid 100% of their after-tax earnings to shareholders. It is a good comparison to other investments such as bonds and equities.
- To calculate normalized EPS, I took very conservative assumptions for what each bank could earn in a slightly better economic environment. By slightly better, I’m talking about maybe 25-50 basis points of interest rate increases and a similar economy to what we have now.
As you can see; C, BAC and MS all trade at very sizeable discounts to tangible book value despite being profitable and overly-capitalized. These companies are likely to be approved for large stock buybacks in the upcoming CCAR process, which should allow tangible book value per share to grow at an accelerated rate over the next several years.
I believe 10-13% per annum is a very realistic goal and I’d also expect the valuations to converge so that these banks are at least trading at their tangible book value once again.
That can lead to returns in excess of 20% per annum, and the banks would still be very inexpensive relative to the overall market. These 3 banks would have to lose many tens of billions of dollars for the liquidation values to be close to the current stock prices. Even if there was a Brexit and even a minor recession in the U.S., I don’t believe we would see the big banks take losses, but instead we would see reduced profits. That is hardly a case for these current distressed valuations. It is highly likely that dividend increases will be announced over the next month as we get the CCAR results. This could lead to a revaluing of the sector, which not only would be the cheapest in the market, but it also will have the best dividend growth potential.
This investment opportunity should be compared to others. Citigroup’s earnings yield is 12.66% on last year’s trough earnings. This compares to 10-year Treasuries which have an earnings yield of 1.6%. Junk bonds yield 7.3%, which is very low when you consider that a large percentage of the junk bond index is in troubled energy companies that are either defaulting or are darn close to it. Triple-B rated bonds are only yielding 3.49%. An attractive earnings yield wouldn’t be that enticing if these were risky investments, but the fact is that these banks have never been safer. It is simply an issue that market participants have never been so negative towards banks as they are right now. This is a situation that simply can’t last forever.
While no one can predict what will happen over the short-term, (expect volatility these next few weeks on Brexit possibility), there is virtually no scenario where I can see us taking permanent losses of capital. It would take a recession far worse than the Great Recession, which I believe is highly unlikely. I know it can be frustrating at times when stock prices get disconnected from fundamentals. The good news is that the fundamentals are very measurable and we just need the absence of a disaster to make a good deal of money on these positions.
This is an absolutely phenomenal opportunity, especially when I believe that many investments such as bonds and many ETFs and mutual funds will likely have negative returns over the next 3-5 years.