Banking stocks back on the menu

Bank stocks are, for many high net worth individuals, the final frontier.

Until recently, the banks have remained an unforgiven sector among private clients. Investors remember the dramatic 2008 collapse in share price values of a sector seen up until then as a defensive play. Many banks are also still hobbled by the credit crunch legacy of high levels of non-performing loans, and by low economic growth in their home
countries. The poor state of underlying economies has made it difficult for banks both to win profitable new business and to lift existing borrowers out of non-performance.

Over the past few months, however, wealthy investors have boldly started by investing again in bank stocks – but this investment remains extremely selective.

Private clients have been gradually increasing the proportion of risk assets in their portfolios in response to the improving economic and capital market outlook – and this has largely taken the form of greater exposure to equities.

Opposite sides of the pond

“The sector is really a mixed bag, with a clear difference between the US and Europe,” says Didier Duret, chief investment officer for ABN Amro Private Banking. “In Europe the banks are heavily constrained by the double bind of the economy and regulation.”

By contrast, in the US the banks have a bigger margin of freedom, and the macro story is more compelling. “The US economy and housing market are both starting to do well,” says Cesar Perez, chief investment strategist for Europe, the Middle East and Africa at JP Morgan Private Bank.

As a result, 55 percent of JP Morgan’s equity allocation is through US stocks. “One of the ways we’re playing this is through the banks,” says Mr Perez, pointing to the importance of the housing recovery, which reduces the amount of non-performing loans.

This optimistic US story is contrasted with the “really sluggish market in the eurozone” according to Henrik Lundin, chief investment strategist for Nordea and head of asset allocation for Nordea Private Banking, who sees US gross domestic product growth reaching 3 per cent next year, increasing profitability by boosting loan volumes.

Even in this relatively sunny environment, private bankers and their analysts tend to favour US banks with diversified businesses. Diversified banks have a lower risk profile, says Mr Duret at ABN Amro. “They are investing in different states, with
different product lines, and with a very broad operating base.”

In common with Nordea and with several bank analysts, ABN Amro favours Citigroup, largely because of its highly diversified business.

Citigroup is appealing because of its attractive valuation – about 0.8 times book value – and progress in restructuring its business since the credit crunch, says Patrik Lang, bank analyst at Julius Baer.

“JP Morgan is a bank with a very strong balance sheet – this is the main driver for growing its market share in several businesses,” says Javier Lodeiro, US banking analyst at Credit Suisse. The firm is expanding in several areas such as corporate banking, private banking and European corporate finance.

One problem with US banks is that although many wealth managers now see their appeal, so, too, do other investors – bidding up prices to the point where they are no longer at bargain levels.

There is still “some juice” left in the US banks, says Nordea’s Mr Lundin – with an average price to book for US financials as a whole, including banks, of about 1.25, compared with a long-term average of 1.9. Even after pricing in a discount to allow for the continued risks they face, he sees many as “slightly below fair value”.

The price of European banks has also risen rapidly, with some big names putting in rises over the past year of as much as 50 percent. Nevertheless, perceptions of banks’ current investment appeal can differ starkly. As a result of the sharp rises, even the minority of investors quite bullish on European banks are starting to question whether they still offer value.

In the camp of sceptical bulls sits Paul Vrouwes, senior portfolio manager specialising in financials at ING Investment Management, who describes investment in European banks as “a bit late”.

“I think the easy money has been made in the last six to eight months,” says Mr Vrouwes, adding that the average price to book ratios of 1.0 or slightly lower – up from 0.7 or 0.8 last autumn, before the big rise in bank shares – suggest banks are no longer bargains. He bases this on a long-term historical price to book value of 1.2, plus a necessary discount to allow for banks’ continued need to recapitalise themselves.

This is in response to the legacy of bad loans caused by the credit crunch, which “put a hole in their capital”, and to the demands of Basel III for higher capital levels. Most of the big US banks, by contrast, are already in compliance with the forthcoming Basel III capital requirements.

Regulation hangs like a pall over European banks – with analysts and wealth managers particularly gloomy about the regulatory outlook for those with large investment banking arms.

“Investment banks have a lot of headwinds,” says Julius Baer’s Mr Lang. As well as stricter capital requirements, he cites the new EU cap on bonuses, which restricts variable pay to 100 percent of fixed salary, or 200 percent with explicit shareholder approval. The bonus cap is likely to push up fixed salaries, he thinks, hitting shareholders.

In addition, he believes that in response to this and to a more general crackdown by governments on investment banking rewards, many successful investment bankers will leave established banks to set up their own businesses. Mr Lang is, for this reason, sceptical about investing in Deutsche Bank. “It is not a well-diversified bank, but is very dependent on investment banking,” he explains.

There is as much, or even more, scepticism about European retail banks. Christine Schmid, head of global financials at Credit Suisse, says that because of the relatively poor state of the European economy, the rates of interest which banks must levy on small and mid-sized businesses to allow for the risk of non-payment are often prohibitively high for them – and this keeps loan growth low or even negative. 

Retail banks are, say wealth managers, the ultimate beta on the domestic economy,  and if the domestic economy is lacklustre or worse, as most European economies are, that makes them unattractive.

The same domestic factors make investors still wary of pushing the frontier of bank investment too far south. Although the banks in the southern European countries remain cheap according to Mr Vrouwes, “their economies are still not growing, so it is not worth investing there”. 

Widening the net

Given the headwinds facing European banks, some wealth managers and bank analysts see the primary opportunities within the financial sector not in the banks at all, but in other financial companies.

Asset managers rather than banks may offer the best value at this point in the cycle – a point when many potential investors still have a large proportion of their money in cash, but rising asset values are tempting increasing numbers into more active investments. Ms Schmid at Credit Suisse recommends Aberdeen Asset Management after a recent price correction. She says its specialism in equities offers higher margins than bond specialists.

ABN Amro is underweight European banks but overweight European insurers. Mr Duret’s reasoning is that “the risk profile of insurers probably matches the risk aversion of private clients more than banks do”. They are, he says, less cyclical than banks because demand for the underlying product is not as sensitive to the economy.

Particularly attractive, he says, is the potential of reinsurers, including Munich Re, because of their “very diversified” risk, in terms of “demography and geography”. Moreover, much of this risk is, he says, passed on through securitisation.

Emerging market exposure

For all their travails, European banks retain a trump card, however – some have an enviable exposure to expanding overseas markets.

Julius Baer’s Mr Lang illustrates the complex dynamics of European banks by looking at the sector in Spain. It is one of the hardest hit of the eurozone economies, making most of its banks unattractive even at their still relatively low prices.

An exception, however, is BBVA, described as a “very well-diversified, really cheap, high-quality bank not overly exposed to problems in the home market”. Plus it has a strong presence in the strongly growing Latin American economies.

Teresa Nielsen, Swiss bank analyst at Vontobel, has a ‘buy’ position in UBS in part because of its heavy exposure to overseas markets, including a healthy international wealth management business able to benefit from the same high inflows that are benefiting other asset managers.

She cites in particular UBS’ commanding position in Asia, where it is the market leader in private banking. UBS gains from the crossover in Asia between its investment banking and wealth management divisions, says Ms Nielsen. Its investment banking division is able to do deals with ultra high net worth individuals while its private bank can look after their wealth. The investment banking arm can also be used to offer good investment opportunities unavailable to the private clients of other wealth managers, such as the opportunity to buy into IPOs. Julius Baer, a ‘reduce’ for Vontobel, “doesn’t have this kind of relationship”, says Ms Nielsen.

Although many wealth managers and analysts currently tend to show a preference for large, diversified banks during a time of continuing uncertainty about underlying markets, Ms Nielsen also has a ‘buy’ rating for a bank that has abandoned its experimentation with a much broader banking business to return to its primary skill of private banking: the Swiss bank EFG International.

In addition to refocusing on a “core” area “which it knows about”, EFG holds another advantage: a thriving operation in Miami which has drawn in large amounts of private client money from the growing Latin American region.

Well-established Swiss banks might offer good prospects in the long run, but they are unlikely ever to generate a spectacular return. What might be suitable for the more risk-hungry high net worth investor?

While ABN Amro’s Mr Duret advocates Citigroup among US banks for the risk-averse, he also recommends Goldman Sachs, the US investment bank highly exposed to the vagaries of capital markets, “at the other extreme” of risk.

JP Morgan’s Mr Perez notes that “if you had bought some of the Greek banks a couple of months ago you would have doubled your money. For people who understand the risks such things are potential investments.”

Greek banks’ share prices have raced upwards in response to signs of a turnaround in the country’s financial system and economy. JP Morgan, says Mr Perez, is in the preliminary stages of considering launching a portfolio based on a European recovery, which would include some currently cheap bank stocks. In the coming months, he says, “there is an appetite for riskier assets, but we are primarily looking at this only for very sophisticated clients.” 

Asia attractive but expensive

Does the idea of a bank with ample capital, operating in a fast-growing economy with a still low penetration of financial services products, seem like an investor’s pipe dream?

Not in Asia. There is a small catch – the price.

“Many of the most profitable, value-additive banks in the world are in Asia,” says John Caparusso, head of bank equities at Standard Chartered in Hong Kong. “There are banks in Asia that are able to generate recurrent and probably sustainable returns on equity of more than 15 or 20 percent.”

This fabulous return is, though, reflected in the price – with some of the most attractive trading at three or four times book value. Bank Central Asia, one example cited by Mr Caparusso, is at 4.1. However, he notes private clients investing for the long term may not worry so much about the high prices, given such banks’ continued capacity to deliver returns.

The strong underlying characteristics of many national markets make many wealth managers and analysts keen on selective Asian bank stocks. Didier Duret, CIO at ABN Amro Private Banking, cites the likelihood of strong increases in revenue from underwriting activity in coming years, including IPOs and corporate bond issuance, as well as growth in retail banking as consumers buy increasing numbers of financial products.

He recommends the Indian bank ICICI. “It has a strong and efficient retail business, is benefiting from the growth of private banking in India, and does not suffer from capital constraints.”

Another option is to invest in European banks with a strong Asian presence, says Paul Vrouwes, senior portfolio manager specialising in financials at ING Investment Management. He is enthusiastic about the UK-headquartered banks HSBC and Standard Chartered: “These are largely Asian banks, which will benefit from Asian growth.”

HSBC is also highlighted by Mr Caparusso, partly because of its “culture of permanent cost control”, which has involved tens of thousands of job cuts.

He warns, however, of “danger spots” which could “upset” the “pretty good growth prospects” of Asian banks. One is the sometimes eccentric nature of Chinese bank lending. This includes large sums of money devoted to infrastructure projects whose underlying economic value, and hence ability to generate a return that could finance debt, is of doubtful validity.

Another is the inefficient system of infrastructure development presided over by the Indian government. This makes it hard “to generate a reasonable return” for bank borrowers that have taken on large amounts of debt to finance such projects.