We were recently asked a very fundamental question: is banking a good business? We analyzed this question from the vantage point of cost of equity. In an environment of economic stress, like that in which we find ourselves in today, it makes sense to own banks that are earning their cost of equity. In other words, these are the banks most likely to be able to earn reasonable returns even in an environment of further downturn. Obviously, those banks not earning their cost of equity will struggle mightily in an environment of even modest further stress.
Why does cost of equity matter? Think of the company as you would an investment property. Your rental yield equates to the company's return while cost of capital equates to your financing cost. Obviously if the financing costs are in excess of the yield, the investment loses money. The same can be said for equity investors about companies not earning their cost of equity.
So, which banks earn their cost of equity? To this end, we offer the two charts below. The charts include a blue line that denotes the point at which returns equal their cost of equity. Companies to the right of the blue line are earnings their cost of equity, while companies to the left of the blue line are not. There are two charts below. One reflects returns on book equity, while the other shows returns on tangible equity. Moreover, in each chart there are two datasets: red reflects next year's expected returns (2012 consensus) while yellow shows actual returns over the last twelve months.
We would argue that the better dataset to be using is the last twelve months (LTM). First, forward estimates are notoriously optimistic, as they incorporate the bullish bias of the sell side. Second, forward estimates rarely include any provision for what companies like to argue are one-time costs, but in reality are very much recurring (litigation, putbacks, etc). While we acknowledge that credit quality in certain asset classes (i.e. credit card) has improved over the past year, this is offset by the fact that reserve release has accompanied that improvement and is therefore overstating how good the past year has been. With little loan growth and non-existent returns on new deposit growth, we think last year's actual results are the better proxy for most banks.
Obviously the lower threshold in this case is tangible book value, as returns on tangible are greater than returns on book, though the cost of equity is fixed. In the case of the lower threshold, tangible book equity, we find that on an LTM basis, only a handful of banks earned their cost of equity: USB, MTB, PNC, JPM, WFC, CFR, CBSH.
On the stricter standard of book equity, we find that just USB, CBSH, MTB & CFR earned their cost of equity.
What Is a Bank Worth?
Of course, this only tells half the story. Clearly valuation needs to be taken into account somehow. In the following chart we combine the x and y axes from the prior chart into the x axis and add a third dimension, which is price to tangible book value on the y axis. This enables comparison of three dimensions in a simple two-dimension chart.
In the following chart we're looking at return on tangible equity (the lower threshold) on an LTM basis (the higher threshold). An x axis value of 1 means a firm is earning its cost of equity, while a value greater than 1 means a firm is earning in excess of its cost of equity and vice versa. As such, we would characterize banks to the right of the white line as "good" businesses, i.e. those earnings their cost of equity and those to the left as bad businesses. The y-axis in this chart reflects price to tangible book value per share. The diagonal dotted blue line represents the regression line for all these banks. In other words, firms trading above the blue line are trading at a relative premium to the group while those below the blue line are at a discount.
This chart enables us to break the bank universe into four quadrants. The bottom right quadrant would appear the most attractive. These can most simplistically be described as good companies that are trading at a discount to the group. These include PNC, Wells Fargo and JPMorgan. The banks in the upper left quadrant reflect bad businesses trading at a relative premium to the group. These include SNV, ZION, GBCI, SIVB, BBT and CYN. We would acknowledge that BB&T, CYN and SIVB are close to earning their cost of capital.
Obviously this is a single factor in what is always a multi-factor decision process. Moreover, we acknowledge that it doesn't lead to especially profound conclusions, i.e. most analysts/PMs already know which of these are the "good" companies. That said, it never hurts to quantify things and add a little precision to what are often vague generalizations.
In thinking about the fundamental outlook over the intermediate term, we think Europe remains on a path toward breakup. The only thing that would quell this would be an unconditional and unlimited willingness on the part of all EU nations to arrest the situation. Unfortunately, the actions coming out of Europe have been decidedly pointing in the other direction. If and when we see this unconditional and unlimited support, we'll quickly reverse our bearish outlook. Domestically, the primary positive "risk" factor we see if the rising probability of further monetary stimulus by the Fed (QE3). The chart below has a volatility component in it, and our argument is to remain long or overweight low volatility and short or underweight high volatility. However, a significant round of additional monetary stimulus would put that trade in reverse.
So to summarize, we continue to expect things to head lower, but we are mindful of what Europe could do to fix the situation and we are mindful of the Fed's ability to temporarily reverse the downward momentum.