Four reasons banks aren’t cheap enough
Posted on April 24, 2008 by Richard Beddard
Filed Under Companies, Markets, Investing |
Weighing in on bank valuations again, here are four fundamental reasons why I ‘m not buying banks: Price, profits, cashflow, and deposits.
The long-term price earnings ratio is my preferred measure of value. I take the average of up to nine years of earnings and divide it into the current share price. Using the average of a large number of years ensures a very good, or very poor, year last year does not misguide us.
This is how the banks rank out of 1192 shares with more than five years of earnings (Long Term PE is in brackets):
Rank
155 (6) Bradford & Bingley (BB-)
201 (7) Alliance and Leicester (AL-)
221 (8) HBOS (HBOS)
256 (8) Royal Bank of Scotland (RBS)
294 (9) Allied Irish Banks (ALBK)
297 (10) Bank of Ireland (BKIR)
309 (10) Lloyds TSB (LLOY)
339 (11) Irish Life & Permanent (IPM)
345 (11) Barclays (BARC)
494 (15) HSBC (HSBA) (iBall)
566 (17) Anglo Irish Bank (ANGL)
784 (27) Standard Chartered (STAN)
For comparison, here are some companies*1 that are cheaper, by this measure.
73 (3) SCS Upholstery (SUY) (blog) (iBall)
113 (5) Johnston Press (JPR) (blog) (iBall)
148 (6) DSG International (DSGI)
The other reason I’m not keen on banks, is their accounting. Normally when I use a company’s earnings as a measure of value I like to check that, long-term, its cashflows - the actual money the company makes as opposed to its accounting profit - roughly equals or exceeds its profits.
But banks don’t report cashflow. And as we are discovering their accounting - off, and on balance sheet - is complex and not widely understood. Even by the banks themselves sometimes.
There might be a time when I’d consider banks, but they’d have to be dirt-cheap.
Soc Gen analyst and behavioural investing guru James Montier says:
A bargain basement way of valuing banks is to look at the ratio of market cap to deposits. In previous banking crises this has bottomed out around 3-4%. Outside of Japan, there are no banks priced in this range.
The quotes and table below are from a report he published on 10 April 2008.
Bringing us back from the blizzard of numbers, and into the real world of rights issues and bailouts, he says:
…it is worth noting that in Japan in the wake of the bubble bursting, the banks had to keep returning to the market time and time again to recapitalise, as wave after wave of corporate insolvency washed through the system, driven by ongoing deflation. Even if the US manages to avoid following the Japanese template, the current round of recapitalisations is unlikely to be the last. Investors may need deep pockets indeed!
Mind you, languishing at the top of my list, and the bottom of James’, is Bradford & Bingley*2. Of all the banks, it could be the one to watch, although it hasn’t ruled out a rights issue and trouble in the housing market could mean big trouble for the mortgage lender.
Other views:
Looking back at previous non-systemic tension in the banking sector they conclude that market indicators (share price slump, steeper yield curves and wider credit spreads) would suggest a buy, but real world measures (i.e defaults) suggest it is still to early. If you must go back in stick with the US concludes Citi, where recapitalisations have run further and the central bank has moved more aggressively.
Whitney Tilson, US Value Investor, on Bloomberg:
The fundamentals… indicate we’re in the third inning of a nine inning game here, and investors are pricing stocks as if we are in the ninth inning.
Video:
[Via Todd Sullivan’s Value Plays]
Footnotes:
- I own shares in SCS Upholstery
- Edmond Jackson made Bradford & Bingley a stock to watch last October.
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30 Responses to “Four reasons banks aren’t cheap enough”
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Don’t get me started on banks…
Right off the bat I’d say your first valuation method has to be tossed into the garbage for banks for other reasons than accounting.
The earnings were based on unsustainable practices. They took people’s deposits and loaned it to people who couldn’t afford to pay it back. The vast amounts they loaned is unsustainable. Going forward mortgage amounts will be smaller, so just this will make profits smaller. They were, in my mind, essentially taking profits on fraud and negligence, so historical data has no meaningful basis going forward for banks.
Hi Deborah,
I’m not sure about that, though I take the point that profits are going to be depressed, maybe for years. The reason for taking nine years of earnings is to encompass a full cycle (though that’s not guaranteed - cycles are difficult things to pin down!).
So using the long-term PE is more useful than using the normal historic PE because to take last year’s profits as your benchmark would surely be over-optimistic. How representative it is, is debatable, which is why I’d want to see banks trading at incredible low multiples, say two, three or four, before taking the risk.
That would imply even the cheaper ones would have to all but halve again in price.
I do not know the company, but I think they do a lot of buy to let business. There is also a comment in their statement on the 22nd that buy to let demand was strong, which means they might be doing even more business in a risky segment of the market.
Do they deserve to be cheap? I do not have a view, because I have not analysed it, but it seems to me to be a question that needs answering.
Hi Graeme,
Do you mean B&B? I agree! Difficult job though
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So we’re at innings 3 of 9, the banking crisis seemed to come to a head in June/July of last year, so that means another 20 or so months of the current credit crunch and we’ll be able to buy bank stocks with confidence at the start of 2010. Maybe that quote isn’t from this month and the maths could bring the safety zone to summer 2009.
Obviously I’m being ridiculous but I’m just trying to make the point that this crisis seems to be unfolding erratically and often at very high speed.
As regards the Alphaville quote, it looks as though the American banks have acted and re-acted faster to this crisis, but it also seems as though they had further to fall and had a much larger exposure to so-called toxic debt. Barclays and RBS have exposure to other markets in the Middle and Far East so seem to be more flexible than Northern Rock and they’re more liked than Bear Sterns. If the crisis deepens they’ll (hopefully) still have other sources of revenue.
Re: the Japanese issue, I don’t think anyone has really worked out why they’re still having problems but some theories have put it down to the culture there.
I don’t understand market cap to deposits, has this been influenced by the Tier 1 ratio and Basel? Thanks.
I find it astonishing that you feel comfortable buying shares a Sofa business (SUY) that is on the verge of seeing its earnings collapse into oblivion! Yes, I know that a lot of this is already priced in but SUY have a very real chance of going to the wall if the UK slips into a deep recession… Can you say the same about the likes of Barclays, RBS ?
Yes the Banks have big problems but if I had to choose between a bank like RBS and a sofa business like SUY during a recession, I know where I would put my money…
Your reasoning is flawed imho & your disclosure RE:SUY just serves to confirm this.
Good luck with SUY because I think you’ll need it!
I’ll stick to RBS i think…
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Hi Richard,
Your article reminds me of James Montier’s idea that investment performance is not based on what is true and not based on what you believe to be true but is based on what the majority of other people believe to be true (i.e. what is the story which most people believe).
I was thinking of the recent out-performance by banks and trying to work out why it is happening. Banks may be a good investment simply because people believe that they will not be allowed to fail by the governments.
In addition they are able to access a lot of extra liquidity in exchange for their safest assets. It is highly unlikely they will reduce the cost of mortgages using this liquidity (which is a good money spinner for them) and much more likely that they will use it to invest in the stock market in better performing assets.
The US job data is still quite strong and corporate earnings is still strong enough to support the jobs. This may reflect a similar situation in the UK. Jobs mean that people can continue to repay their mortgages.
Even if the Banks have to cut their dividends in half later in the year, they will still yield a reasonable amount.
If the number of write-downs turns out to be too high (because people can keep paying their mortgage) then the banks will be able to undo those write-downs later in the year.
All in all, it seems a fairly safe investment.
Finally, if you do not invest in equities now then you are going to be absolutely hammered by the massive global inflation which is going to hit us over the next few years with all these extra dollars and pounds in the system.
This is the story so now you have to try and pick it apart to see where it all goes wrong
Hi Justin, thanks for your comments. Regarding market cap to deposits, I think it’s just another way of relating price to something the banks have of value i.e. deposits. I suppose the advantage of using deposits is they’re unambiguously valuable - unlike some other bank assets (debt securities, for example :-))
More on capital adequacy.
Hi, the Wrexhamite.
Well, if you listen to some commentators (and I’m not one of them) bank earnings are about to collapse into oblivion. In SCS’ case this is recognised in the price of the shares (and then some, is my estimation) - as you say. Also I’m more confident that SCS can withstand a period of low earnings.
It’s not a popular style of investing, but I think in, say, 5 years time I will be richer because of it. That said, I hope you are too, with your RBS shares. Maybe the day will come when I join you as a shareholder.
[…] banks good investments? Robin Soole, posted a comment saying prospects for banks are not that bad, which explains why prices are going up. I’m […]
Hi Richard,
I see why you think SCS is a good long term bet, I had the same opinion too when I first looked over the figures. The one thing that turned me off them though was their durable competitive advantage (or lack of?).
One thing that I always look for (along with a margin of safety) is that the business has a durable competitive advantage & with SCS I am stuggling to see one… And this is what concerns me.
What advantage does SCS have over the competition? Aren’t they just another sofa company? What would stop another sofa company from entering the market with a better business model? Do they have any barriers to entry? Does SCS get plenty of repeat business? Isn’t the sofa business highly competitive? What if Tesco start selling the same sofa’s a lot cheaper with better QoS? Does SCS compete on price? If so, can they beat the competition? And further more, would you want to own a business that has to compete on price for market share? I know I wouldn’t.
They are all questions that returned a negative to me when doing my analysis - the figures look great during the boom years but how many Sofa companies can you compare against from the previous boom that ended in the late 80’s early 90’s? DFS? That’s about it I think, and even they went bust during the 1980’s and were bailed out by Baron Kirkham I believe…
RBS on the other hand have been around for over 200 years so they must be doing something right in the first place. How many competitors do they have? Not many, banking is a bit of an oligopoly. Repeat business? yes. Loyal customers? Yes. Compete on price? doesn’t need to. Market dominence? yes. Diversified? yes. Can you see where I am going with this…
This is what I mean by durable competitive advantage. As a long term investor this is what really matters to me because a few cracking years of business then bankrupcy is not going to make me rich, whereas a lifetime of consistantly above average years will.
This is not to say that your choice to invest in ScS is a bad one, I hope that it is a good investment for you, I just think that there is a lot bigger risk of ScS going to the wall than RBS. Who knows though. Thanks for listening.
Regards
Wrex
I agree that banks aren’t cheap enough.
Asking shareholders to invest more of their capital in your business in the hope that you can get back to profitability just doesn’t make sense.
RBS - issuing more shares, the company is still only worth as much, so the share price will drop.
Why reward banks for repeating the same mistakes that Loyds Insurance made - they didn’t sell appropriate products after anlysing the underlying risk.
RISK MANAGEMENT has been around in the insurance Industry for nearly 50years and the Banks still can’t get the hang of it?
Fast and loose with other peoples money.
Time for shareholders to make up 50% of all publicly quoted companies boards, that would certainly put a brake on some of the suicidal risk taking that has been going on.
Hi Robin, good to hear from you again.
>>This is the story so now you have to try and pick it apart to see where it all goes wrong
I’ve had a go!
Greetings Richard,
Happy belated Birthday.
I agree with you that bank stocks are going to get a lot cheaper.
I sold my Lloyds some time ago and I may buy back, just because of the income, but I am really waiting for RBS to go below £3.00 and then I think they will be worth considering.We will have to wait and see what skeletons they still have in the closet before that happens though.
I use them as a bank and they are certainly one of the best to deal with.
The dividend being paid in shares does not get me too excited but when they go back to paying us pensioners in cash or gold bullion, then will be the time to wake up and take notice.
JH
Hi John, thanks for the birthday greetings!
The Wrexhamite - I see exactly where you are going, and I agree SCS is in a competitive business - it’s much easier to set up shop as a sofa seller than a bank.
There are really two questions aren’t there; what are we buying, and how much are we paying for it.
The problem I have with assessing competitive advantage (i.e. the what we are buying side of the equation) is that it’s subjective, and it can often evaporate. Either because technology marches on (hence local newspapers are no longer the monopolies they were thought to be) or because the company itself overreaches. I think banks are paying for overreaching now (Northern Rock and its exposure to credit markets for example). Sometimes a businesses’ actions combine unexpectedly to damage the franchise (in the case of RBS that would be the meltdown of its subprime portfolio and its aggressive expansion).
As an investor I tend to focus more on the value side of the coin than quality. That’s not to say I’d buy any company so long as it’s cheap. I want a historical record of profitability, good cashflows and low, or no, debt. I want the company to be in a business that’s still relevant. I just don’t speculate so much about the more subjective qualities of the business.
Glen, I don’t think what the banks are doing is asking for more capital so they can make a profit, but they have to shore up their liquid balances (including deposits - thanks Richard) to the UK’s legal minimum. These unexpected losses came about because the AAA rated debt obligations turned out to be toxic with junk. Like if I bought a toy that turned out to be contaminated with lead for my child - it’s not my fault, although I could send every toy off for costly independent analysis.
What the share price now is taking into account is future earnings, losses and write-ups. Those figures will depend on the future needs of the emerging economies as well as our own. This is why I’m optimistic for the future. Short term movements seem to be just noise, in my humble opinion. Please feel free to correct me if I’ve got any of that ar$e about face.
Hi Justin,
The Banks in the UK use creative accounting practices to hide what their true asset value is.
The share price takes into account total asset value, profitability, debt and intangible assets.
Under intangible assets (assume air - how much is Northern Rocks Brand and Logo worth now?)
The reality is that what really determines share price is a combination of market sentiment and the aforementioned items.
They do not know the full extent of their sub-prime liabilities yet (they haven’t been able to unbundle the investment vehicles to get to the root of the issue)
To give a company more of your cash when they haven’t fully detailed the extent of their Risk Exposure is crazy.
This might be alright if you are a large institutional investor with millions invested, but if you are a small shareholder can you afford to absorb the loss if the price heads south?
I think that the bank share prices have more falling to do, and it doesn’t do much for market confidence to see companies coming around with begging bowls to shareholders and the treasury when for the last 10years they have made obscene profits.
They squandered their profits playing fast and loose in the takeover and aquisition game and the public in the UK will have to pay for it.
I blame the Bank of England, the FSA and the Labour Government who have allowed the Banking Industry in the UK to remain self-regulated for too long.
Time to follow the Swedish model and takeover the whole UK financial sector and make profit for the benefit of everyone in the UK and not just the Fat Cat Merchant Bankers.
Most of these guys and gals in the Banking Industry wouldn’t know how to spot a risk if it hit them on the back of the head with a 4 x 2 plank of wood.
Conclusion - don’t buy shares in Banks yet there is still a lot of unravelling to do yet 6 - 9 months worth.
“The Banks in the UK use creative accounting practices to hide what their true asset value is.”
Sorry you lost me right there.
Judging the value of any business by the quality of its average earnings going back five years, let alone nine doesn’t seem to me to be that good a basis for judging its likely performance in the future. While banks cannot be as easily challenged by smart newcomers as sofa companies, there are questions as to which ones are going to get their business models right for the next few years. These years are going to be very different to what has gone before both for trading and investment. As a result I fail to see how an informed judgement can be made until we know exactly what is the level of exposure to unsaleable securities to any particular bank and equally importantly; the quality of the people who will be making the crucial decisions on running its affairs from now on.
Banks need to be cheaper do they.
For me this is what brings the whole game into disrepute - generalisations about companies within any given sector.
People should have the brains to look at any company individually and establish facts before putting the razor to all.
Northern Rock happened because it was allowed by all & sundry to run riot. It could be argued the big five have also but I would suggest that list is only 2, maybe 3 long. One bank has definitely operated more conservatively and is seen as boring - I’d rather be boring, still around and paying my shareholders a handsome income rather than dishing out the corporate begging bowl for my mistakes.
Figurewizard, good to hear from you again.
I don’t think any value measure can be fool proof. Either you follow it slavishly in the expectation that its more often right than wrong, or you factor in a fair amount of judgement making stock-picks.
However the more years of earnings you use the more conservative the measure - especially as banks have apparently been on a debt fueled profit binge they might not be able to sustain (excuse the colourful language). Therefore the lower levels of earnings in earlier years tend to drag down the average - in effect your expectation of future earnings.
Michael, thanks for reply. I take your point, while standing by my article!
I think this is partly about expectations. I wrote the article with my bargain hunting goggles on which is why I ranked the shares and pointed out that there were other shares that were perhaps cheaper and less risky (also a controversial view).
It’s quite possible that there’s a bank languishing in the pack with a safe dividend, and if your objective is a steady income it’s a perfectly logical investment.
Please don’t tune out in disgust! I am planning to have a look at income shares at some point. In fact there’s a fair number of shares on extraordinary yields (Say 9% to 10%) at the moment. The traditional view would be those must be cut, but I do wonder if they all will be!
What an astonishing set of statements.
No one yet knows the full extent of the banking exposure to bad debts or sophistated (but flawed) methods of packaging debt.
I agree with some other colleagues that your credibility does bear scrutiny when referencing SCS as a potential investment. Buying shares (which does not constitute investment per se) in companies with no competitive advantage, operating on profit margins of 3.4% and ROCE less than 20,no dividend going forward and no historic dividend cover to speak of, you would have to be a pure risk taker.
In fact these are close to derby winner odds.
This is not a plug, but compare this to a quality company like Glaxo, with strong branding, 34% operating margins, 50% ROCE and a strong consistent 4-5% yield, plus the detailed eye; financial analysis; management scrutiny of Warren Buffet and Charlie Munger as investors.
I think you are looking at the wrong end of the market for your returns - IMHO of course
Hi Richard,
I was reviewing some of your ‘value’ posts it struck me that most value investors say ‘their method is 80% mechanical’ (or whatever number they pick out the air).
The actual ‘clever’ bit is making a forecast on the future earnings of the company (e.g. has it been irrevocably damaged by the credit crunch, is the last legal scandal going to bring it down, have the criminals at the top taken too much out of the company etc).
LR points out that you did not correctly correct account for ROCE, however is this not just another ‘value’ filter. At what point do you throw out historical data and use your own judgement?
Another question. If this was a new company (with no historic earnings) would you invest in it? How would you go about making a judgement on its viability? Presumably no value investor would touch a new company.
Hi LR. Thanks for your comment. I don’t have much to add to my reply to the Wrexhamite above. Basically you are describing a set of criteria for what makes a good company and applying it to SCS which is clearly distressed right now. So obviously it comes out wanting.
Yet it is patently obvious that investors can, and do, profit from recovery situations.
Here’s an example. I bought Inchcape (a motor vehicle dealership) for about 50p adjusted for splits in 2000 - today it’s nearly 450p. The share price had been in free-fall for years. Operating margins are about 4% now, but I think they were even lower then! If I’d bought Glaxo then, when I think margins etc. may have looked even better than they do now, I’d have lost money - lots of it. I think very few people thought motor dealerships were good businesses to be in, in 2000, but they were.
That’s not to say Glaxo’s a bad company, or that it’s not a good investment, but I don’t accept your premise that only a sub-section of the market is worthy of consideration for investment.
Hi Robin
Re: I didn’t account for ROCE at all. It’s not a criteria I use when I’m looking at ‘deep value’ - the kind of distressed stocks on very low long-term price earnings ratios that I talked about in this post. Since banks are currently in a pretty distressed state I chose to compare them to similarly troubled companies and establish whether relatively speaking they were cheap.
Your point about forecasting the future earnings of companies is an interesting one. I wouldn’t put such emphasis on forecasting. The evidence is we’re very bad at it.
I’m no Buffett expert, but he may be an example of a value investor who sometimes forecasts future cashflows, but when he does I think the sticks to businesses which are very predictable. Otherwise it’s just guesswork.
The other way of looking at value is that, with the exception of a few growth stocks (Microsoft in the 90s or Starbucks until about last year) profits fluctuate. Generally speaking when profits fall, investors sell. But value investors assume that profits will recover and take the opportunity to buy at lower prices.
There’s plenty of evidence that if you do it purely mechanically (i.e. no forecasting at all) you win. Strategies that buy shares on a low pe ratio, or price to book value, or cashflows, or dividend yield tend to win. It’s the Dogs of the Dow theory.
Personally, I prefer to establish a couple of other things. That the business isn’t redundant (hence discussions about ‘buggy whip’ businesses elsewhere on this blog. And that it isn’t going to go bust. Hence my interest in debt. If the business has a future, and it’s not got the banks bearing down it, then I think it’s probably got time to recover.
The fact that other investors find such companies abhorrent is my opportunity - because it explains why the price is so low!
Sorry Robin - forgot about part 2 of your comment! Regarding ‘new’ companies. Well it depends what you use as your measure of value but if its earnings then you are looking for companies with a profitable history. So in that context value tends to mean buying businesses in established ‘dull’ industries.
New issues are a bit different because a company can come to the market with an established record of earnings.
Incidentally ROCE isn’t a value filter it’s a quality filter. Just a technical point! Companies with high Return on Capital use capital very efficiently. You can relate it to value though. Mechanical strategies that involve buying companies with high ROCE and low PEs (good companies that are cheap) have been shown to work - the most famous example is Joel Greenblatt’s ‘magic formula’ - which I wrote about here: http://www.iii.co.uk/articles/articledisplay.jsp?article_id=2071225§ion=Planning&catEnforce=YourStories
Thanks Richard,
Those are three good answers.