The aftermath of the global financial crisis continues to cast its formidable shadow and international investors are still shunning developed market banks. As a result, some US banks are currently trading at 70-year valuation lows relative to the S&P 500 Index.
In the eight years since the financial meltdown, regulators have attempted to compensate for poor judgement and excessive risk taking by codifying a number of rules and principles relating to capital and market values. These rules should, in theory, prevent a repeat of the crisis.
Bloated headcount (to deal with the raft of new regulations), ongoing litigation settlements, reduced risk appetite and historically low-interest rates have combined to generate multi-decade lows in profitability by inflating costs and depressing revenue. The consequence of higher levels of capital and lower levels of profitability, is severely depressed returns on equity. This, in turn, has resulted in decade-low price-to-book (P/B) valuations for the banks.
There do exist, however, excellent banks which have a dominant market share in their respective niche areas and are run by management teams with a prudent approach to risk. To us, they represent some of the best risk-reward opportunities available in the global universe on a bottom-up basis and we own four such banks in our portfolios. They are significantly less risky investments than they were before the crisis, and significantly less risky investments than many of their banking peers.
However, the market has not yet afforded them a lower cost of equity, and they trade at similar (or lower) multiples to the banking universe.
Two of the banks in which we have invested have a predominantly US presence and consequently enjoy low-level status as global systemic financial institutions. This allows them to operate with significantly less capital than many of their peers and, as a result of less onerous capital requirements, they can consequently generate significantly higher returns on capital. These two banks are very well positioned to benefit from a stronger US consumer in an improving US economy. As inflation fears are virtually non-existent, economists are expecting only modest increases in rates. This produces something of a goldilocks scenario for banks, as they generate higher margins on their lending without significantly higher credit losses.
The merits of being a globally connected bank are currently being hotly debated, given the punitive capital treatment they now receive. This has resulted in very depressed valuations for some of these companies. Building common IT systems and cultivating a common culture proved to be very difficult when these large multi-national banks were growing so rapidly. It is also evident from the number of litigation settlements that these giant firms proved very hard to manage. However, there is undoubtedly a need for global multi-national banks to offer trade finance, currency funding, hedging and cash management to global multi-national companies. As the global economy improves, they should generate higher revenue from increased cross-border flows.
Furthermore, given the current surplus capital within these banks, they are delivering dividend yields well in excess of cash returns, and we are invested in two such banks.
We have invested in high-quality businesses with difficult-to-replicate franchises at a substantial margin of safety, in a market where such opportunities are not plentiful. We believe that the combination of robust tangible net asset value growth, high dividend yields and a return to normalised price-to-book valuations will generate substantial returns for shareholders of these stocks and for our investors in the years ahead.
