Lisa Haakman, PSG Asset Management*
Global developed market banks are unloved and consequently undervalued by investors. And for good reason; the profitability of global banks has reached multi-decade lows as a result of lower risk appetites and new regulation that sees them operating with much higher levels of capital than for many decades.
PSG Asset Management is invested in four global banking franchises that we believe will generate substantial returns for investors in the years ahead. These are J.P. Morgan, HSBC, Wells Fargo and Capital One. All four have a dominant market share in their respective niche areas and are run by management teams with a prudent approach to risk, as evidenced by their superior performance during the financial crisis.
It follows that banks with higher liquidity are lower risk investments and our portfolios hold some of the most liquid banks in the world, operating with loans-to-deposit ratios of approximately 70%.
Simplistically, a loans-to-deposit ratio of 70% means that 30% of the deposits the banks have taken in are not being lent out productively. In fact, these deposits are currently invested in cash, generating negative real returns and negative carry. In other words, the banks are making a loss by allowing consumers to place deposits with them. This means they are significantly less risky than they were before the crisis, and significantly less risky than many of their peers.
The market has not afforded them a lower cost of equity, instead it has punished them for their depressed levels of profitability, and they trade at similar (or lower) multiples to the banking universe. When the economy improves, the demand for lending will increase, allowing them to deploy some of these excess deposits. And when rates rise, the remainder that is still in cash will earn a higher yield, improving profitability.
Wells Fargo and Capital One enjoy low-level status as global systemic financial institutions. This allows them to operate with significantly less capital than HSBC and J.P. Morgan, and consequently they generate much higher returns on capital. Both 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 the 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 (which is ironic considering the stabilising role both HSBC and JP Morgan played in the crisis). This has resulted in very depressed valuations for these two shares.
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 some of their peers (primarily Standard Chartered, Citigroup and Deutsche Bank) exit many of these operations, JP Morgan and HSBC should be able to increase market share, which will allow them to generate higher returns on these depressed businesses.
In conclusion, our research suggests that there is significant re-rating potential in our portfolio. In addition, given the current surplus capital within these banks, they are delivering dividend yields well in excess of cash returns.
The global banks in our portfolio are quality businesses with difficult-to-replicate franchises. They represent some of the best risk-reward opportunities available in the global universe on a bottom- up investment basis and we have invested in them at a substantial margin of safety. 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 investors going forward.
* Lisa Haakman is an analyst at PSG Asset Management and a member of the PSG Asset Management Equity Team.