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Friday, May 10, 2013 - 09:54
Dispelling myths

The South African banking sector is not as compelling from a valuation stand point as the large US banks. This is according to Paul Whitburn, portfolio manager at value based asset manager, RE:CM, who says that although South African banks are well-capitalised and avoided the great financial crisis, this is reflected in their current pricing. Additionally, they will have to adhere to new regulations that will increase costs and perhaps reduce longer-term returns.


He says an additional tail wind for South African banks has been the continual growth of credit extension as a percentage of GDP from 50% in the 1960s to the current 70%. “The secular increase in credit extension has slowed considerably over the last few years causing earnings growth to slow. With local banks priced at a slight premium to their long-term average, any further slowdown could result in a de-rating of local banking stocks.”
In contrast, Whitburn believes that many of the negative views on US banks are founded on commonly-held myths, with a number of deposit-taking institutions offering good value for patient investors with a conservative long-term investment strategy. In accordance with his views, Whitburn dispels some myths about the US banking sector.
Myth 1 – US banks are over-geared and more risky today than ever before. Whitburn says that to assume all banks are similar in nature and capital structure is in fact incorrect.
“The largest distinction that needs to be made regarding US financial institutions is between the banks that have banking licences (i.e. deposit-taking institutions) and the investment banks that until recently weren't considered as deposit-taking institutions. Yes, the investment banks were highly leveraged – up to 30 and 40 times total assets to equity and predominantly funded by the wholesale market, which costs more and is less sticky than deposit funding.
“In contrast, we view geographically dominant deposit-taking banks that have scale as being good quality businesses. These include Wells Fargo, JP Morgan and Bank of America.”
He adds that it is also interesting to note that gearing for the US banking sector was higher in 1940 and the late 1970s at 16 to 18 times equity compared to the current leverage of 9 times. “After our meetings with the large US banks last year, we are confident that current leverage isn't a risk and that it will remain at these levels even with the new Basel 3 regulations.”
Myth 2 – US banks are bad businesses. Many investors believe that, due to the collapse of the financial and housing bubble, banks are awful businesses and should be avoided at all costs.
However, Whitburn says that given their essential role in the economy, it is no coincidence that the long-term growth of the US banking industry is in line with nominal GDP growth of 7.4% over the last 80 years. The long-term median return on assets (ROA) for the entire industry is 0.7%, but the returns generated by the larger banks with cheap deposit funding and scale are considerably better. Long term return on equity (ROE) is 10% for the industry. These earnings are cyclical – the US banking industry has experienced 13 banking crises over the last 200 years, compared to the five in South Africa over the same period.
“We believe that the larger banks in the US have significant barriers to entry due to economies of scale, and even more importantly, sticky customers. This allows most large retail banks to sustainably generate returns above their cost of capital.”
Myth 3 – Regulation and capital requirements will be negative for US banks. Due to the irrational behaviour of the banks, and especially the investment banks, leading up to 2008, regulation has increased tremendously. This has resulted in a significant increase in regulatory equity held by the banks to levels last seen in the 1930s after the Great Depression.
However, Whitburn says all the regulation has done is make banks less risky and increase costs to such an extent that the smaller banks are unable to compete due to their lack of economies of scale, thereby strengthening the competitive edge of the large, geographically dominant incumbents.
“There has been a decline in banks operating in the US from a peak of 14 000 in 1934 to the current 6 200. This number will continue to decline as the US banking industry becomes more concentrated. The six largest banks control 75% of the national banking assets, from 20% in the early 1980s. This increasing concentration means even more economies of scale and pricing power for the banks that remain. So, while we agree that average returns will be lower in future, we believe that many investors are overstating their decline, or underestimating the ability of large well-run banks to generate high returns.”
Myth 4 – US banks will turn out to be poor investments. “The long term average price to book ratio (‘P/B’) for the US banking industry is 1.5 times and it peaked at 4 times in the late 1990s, at which point we believe these banks were trading at a substantial premium to their intrinsic value.
“US banks are currently trading at 0.9 times P/B, a substantial discount to both their actual book value, as well as their long term average P/B. This pessimism is justified by investors due to the low level of economic activity, interest rates at all-time lows and regulatory costs reducing returns in the future."
He says many investors are assuming these 'costs' of regulation and additional capital requirements can't be passed on in the form of more expensive credit. “However, in an industry that has become more concentrated with fewer irrational competitors, we believe banks will more than likely be able to pass on substantial elements of these costs to their clients.
“In summary, US banks have de-risked their balance sheets and increased the collateral underlying their business but are trading at lows in term of valuations. Together with economic and housing cycles at lows, we believe the US banking industry is an interesting investment opportunity.”
Whitburn says currently RE:CM favours Bank of America and Wells Fargo, two of the largest banks in the US.
 

Copyright © Insurance Times and Investments® Vol:26.5 1st May, 2013
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