Do you Buy, Sell, or Hold the Banks?

Richard Hemming

Valuation theory first

In order to answer this question we need to draw upon valuation theory, which asserts that there is a strong relationship between an asset’s price to book, which is reflective of its valuation, and its return on equity, which determines its profitability. Guess what? Banks are no different.

If a bank has high profitability, all things being equal, it should have a relatively high valuation, or price to book (its assets minus its liabilities) relative to other assets. A rough determinant of valuation is also the earnings multiple, such as the Price to Earnings (PE). But for banks the price to book is more relevant because they’re cyclical. Their earnings move around a great deal, creating a volatile PE over time.

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Charts don't lie

The two charts below clearly show that there is a relationship between profitability (ROE) and valuation (price to book). If ROE is a causal factor, it peaks in 2007/8 pre-financial crisis of 2008-2011 at close to 20%. It’s no surprise that the price to book multiple also peaks at that time at around 3 times.
Should-you-buy,-hold-or-sell-the-banks.png

Subsequent to the financial crisis there was a fall in the ROE to 10%, after which it partially recovered. Since that time it has had some bumps due to increasing capital requirements from Australia’s prudential regulator, APRA.

Then, prior to pandemic ROE hovered at 10% and this year has subsequently dipped to around 7%, its lowest level since the mid-1990s. Today we are getting to historically low levels.

What happened during the pandemic?

Initially, you can see that because bank earnings are so cyclical, being heavily reliant on economic activity, en masse they deferred paying dividends and their price to book fell to discount levels, trading at below book value. Since then, there has been a partial recovery, driving their stock prices and now trade at 1.1-1.2 times book value. This is the lowest book multiple banks have traded on since 1993, which is similar to the ROE story.

Summing up so far (but wait there's more)

Whether you Buy, Sell or Hold the banks depends upon where you think the sector’s profitability will end up, which in turn determines their valuation, or book multiple.

As you would expect, the equation is not quite this simple. There is one important wrinkle in the profit/valuation connection, which relates to capital requirements. Over the past decade banks have had to increase the amount of equity finance, otherwise known as loss absorbing capital. This has been a global phenomenon, although Australia has been at the forefront of protecting its banks. Overall, because of this, banks around the world went into this pandemic with balance sheets as strong as ever. Unlike the financial crisis, there has not been finance system concerns. With the benefit of hindsight, this is a key reason that within 6 to 7 months many bank stocks are close to being back at pre-COVID peaks. Whereas in the wake of the financial crisis it took years for them to get back to pre-GCF peaks.

It is true, however, that the ROE has come down for the sector. But this reflects, in no small part, stronger balance sheets. Backtracking for a second: ROE is at its lowest level since the mid-1990s and price to book is at its lowest levels for 25 years. You would think that the banks are fairly valued. What’s the big deal?

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The big deal

Looking through the volatility to bank profitability caused by the pandemic, ROE is comparable to the early 1990s because the balance sheets are stronger than they’ve been in decades. The banks have record amounts of loss absorbing capital buffers. The banks have become less cyclical! They have a greater ability to absorb shocks like the pandemic.

The key takeout: Keep banks in your portfolio

Notwithstanding the lower level of profitability, banks should be trading at a bigger premium to their book value because they’ve become safer. They’re less risky and less cyclical and more defensive.

Relative value in the big four

In a relative sense, Commonwealth Bank (CBA) continues to look expensive on our valuation, which is why we’ve loaded up our exposure to the remaining three. Westpac Bank (WBC) is by far the best value, which reflects the big hits that bank has sustained to sentiment and the associated regulatory fines. At this stage despite their good performance we are maintaining our overweight exposure, which is about 1.5 times the level they represent in the benchmark S&P/ASX 200 Index. Buying the banks still makes sense! 

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About the Author

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (AFSL: 409518). The author does not own shares in any of the stocks mentioned.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.

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