In my search for value in the equity markets I simply cannot ignore the banking sector, where much of the sector now trades well below book value (and deservedly so perhaps). The problems facing the sector are grave. The cost of Interbank Funding is rising to levels last seen in early 2008. Politicians in almost every Western democracy now view banks as public enemy #1, mimicking the cries of the hoi polloi. Added to this, banking regulation and enforcement of capital & funding standards is changing toward a harsher future standard, fromwhat has been a lax past. The big problem with proposed banking regulation is not that it is harsh, but that so much of what is being proposed by both Basel 3 and individual state regulators has very little coherence or timepath toward adoption.
Society has a right to be angry with banks, bankers and their regulators. Yet in the midst of all of this anger and despair I am attracted to this sector like a horsefly in search of a dungheap. Despite having spent 14 years as a professional equity investor and having spent most of the last four as a specialist in Banks and Insurance equities, I have no idea what the future will be like . . . and neither do you. One of the issues of having spent so much time in financial markets in essence is that one knows too much, and most of it is junk. It can be difficult to discern signals from noise. At times like that I go back to valuation to stand as my sanity check.
I guess that this becomes simple in a sense. If you believe in the demise of fractional reserve banking, death of fiat money and maybe a return to some form of gold standard, then it makes no sense to invest in a bank. I am looking for banks precisely because at the present I believe they are the anti-gold. I am not a bullish person, and for much of the past 5 years my pension has not had any equity exposure and has been invested in commodities, short duration fixed interest and some structured products. Despite that, I find that the recent moves in gold highly problematic. The price action in Gold is going parabolic and parabola are unstable. While the very recent history of gold is a monetization of fear, the mirror image of that is what has happened to the price of bank stocks. They are two sides of the same coin.
So on Friday morning I purchased a 5% position in Lloyds Banking Group, for an all in cost of 28.3p/share. I am generally leery of highly leveraged business models, and it is pretty much impossible to run a bank at all without leverage. I do this with full knowledge and responsibility that in the present environment that banks in general and Lloyds in particular ‘can halve from any level’ to use a phrase from an old boss of mine.
Despite all of this I find that the sector has two principal attractions for me. (1) The valuation is outstanding and (2) I can find almost no one that wants to touch banks – even other value investors. The biggest investment calls that I have made in my career have been to do something that is the polar opposite to the crowd.While it makes no sense to be contrary all of the time – it can make huge sense to be contrary some of the time. I think that in 5 years time, this will prove to be one of those times.
Lloyds Banking Group plc
Lloyds is the largest UK Commercial bank, and is a result of the merger between Lloyds TSB and HBOS. In all probability Lloyds would have been better off never getting into bed with HBOS in what was a hastily convened shotgun wedding. Ironic it is then that while that it was the state that blessed this unholy union, the state now wants to see Lloyds broken up due to competition concerns. This means that Lloyds is a seller of many assets, from bank branches to loans to insurance businesses. There are several interested parties, but they are having trouble financing a bid. Other than that, met interest margins have picked up in the past 18 months, but remain well below what was once attained. Loan loss provisions, while falling remain elevated relative to what was once considered a ‘peace time’ norm so to speak.
In principal the valuation has attracted me to Lloyds Banking Group, to be more specific it has one of the lowest Mkt Cap/Deposits of any European Bank at 4.3%, as well as a trailing P/B of 0.4. The Banks that offer better value according to this metric are largely Italian popolari banks and the Irish banks.
The P/B valuation most certainly can get lower (many banks have hit zero in the past). Lloyds does not fit that bill. In particular, it is worth noting that at £46bn, the equity value of the bank now is over twice the combined equity of HBOS and Lloyds TSB during 2008. At the same time, the present balance sheet is 13% smaller than the combined balance sheet in 2008. Deleveraging will be slow and unenjoyable. At 0.4x book value that is a risk that I am prepared to take. A Graham & Dodd P/E of Lloyds is 8.3 times.
I got the idea of using Market Capitalisation/Deposits as a bottoming indicator for bank valuation from James Montier, an equity startegist with the value based investment manager GMO. In a prior life, Mr Montier worked at Societe Generale – there he authored a piece on bank stock valuation at the bottom of cycles. As a valuation tool, market capitalisation as a % of deposits below 4% has represented value in prior cycles. In Europe Lloyds is toward the bottom of the league in terms of this metric. It can be thought of as a price to unlevered balance sheet.
At the same time that the bank has been continually derated by investors, I find that equity/assets has been increasing back to levels last seen in the mid 1990’s. Return on Assets are well below historic levels, but give that Loan Loss Provisions will eventually normalise, I expect ROA too rise eventually.
I simply do not know when returns will begin to increase, but I do not buy the armageddon scenario that society is doomed. Deleveraging will be tedious and tortuous for many individulas, corporates and societies. That does not mean that our way of life is finished. Just not what it was during the last expansionary credit cycle. Impairments at Lloyds continue to improve and are now at 1.7% of loans versus 3.8% in 2009. I expect that over time provisions will fall back to 1% and perhaps lower. Given austerity and an economic slowdown the path to lower impairments is likely to be lumpy to say the least.
The funding pressures, if there were to worsen from here could prove fatal – and given a loan/deposit ratio of 144% the bank is reliant on financial markets for funding. Some of the most compelling investments often come with a whif of cordite – this is no different. It is dangerous and certainly high risk. As someone who is not a bull, I really should steer clear. However I am oddly calm about this one. The market is panicing (some of this is not without reason). I simply find that this presents more opportunities than threats to me. The future is uncertain, but that cuts many ways – what if the Net Interest Margin were to rise at some time in the future to a leve that was experienced in the past? What if Loan Loss Provisions were to fall below 1%. Presently only the dismal future is implied in the valuation – the hopeful future is not being discounted!
For what its worth, I find that the Scandinavian model of banking to be far preferrable to that existing in many parts of the world. In particular, I think the Danish mortgage market is simple and elegant in terms of its funding structure. In essence each mortage is securitized at source, and then funding is perfectly matched over the lifetime of the mortgage. Much of the Anglo Saxon world has faced banking pressure that were firstly related to how quickly funding can destabilise. I think a Danish solution is worthy of consideration.
Presently the only other banks that would attract me at present would be Intesa San Paolo and Bank of Ireland. They are for another day however.
I am now 10% invested in one month. I would like nothing more than for the market to cave. There are many companies with great business whose valuations while depressed now, would be solid gold if they were to face say a 30% fall from here. My next round of research is on an amended Greenblat screen. I have taken the traditional Grenblat Magic Formula and emended to to include an average historical 5 year RoCE, rather than the last years returns. I will more than likely overlay this with a leverage and Piotroski screen.