" To improve is to change; to be perfect is to change often." – Winston Churchill
The great statesman probably wasn't referring to equity portfolio holdings, but his comments may describe banks, especially those in Europe and the United States. Changes made by many banks after the 2008 global financial crisis put them on a very different (and much reduced) risk trajectory. With the tempering of risk, investors should also expect more pedestrian performance from post-crisis banks. However, we highlight the new dynamism in bank management. These current bank leaders must change their institutions continuously by shedding capital-intensive assets and low return business lines. Under the thumb of regulators, banks must evolve. Extreme leverage fueled the pre-2008 inflated bank returns. We are now surveying a wide array of banks with at least twice the equity capital-to-assets they held in the pre-crisis years. Returns on equity haven't yet crawled above single digits for many of the banks in the financials sector. This implies that many banks are just barely generating returns in excess of their costs of capital. The race to reduce risk-weighted assets and change the mix of existing assets will continue for years to come. In this period of change for banks, why has Causeway added significantly to both global and international portfolio weights in bank stocks? We asked Causeway portfolio managers, Conor Muldoon and Alessandro Valentini, to explain the Causeway rationale for banks in the years ahead.
Conor, the Causeway global and international portfolio weightings in banks have risen over five percentage points from the start of the year. Why?
CM: We have about 15% of international and 10% of global portfolios in bank holdings. Through our bottom-up fundamental research, we have identified and purchased shares in undervalued banks undergoing restructuring or deleveraging. With profits on the upswing, these banks should return capital to shareholders. The banks with relatively rosy futures have solved problems of capital shortfall and excess leverage. In fact, some of our favorite bank holdings have already raised sufficient capital and shed assets to meet the capital requirements of "Basel III," the global regulatory standard on capital adequacy. Basel III does not require that banks meet these requirements until 2019, but investors want the results delivered today—not in six years.
AV: Even better, those fully capitalized banks generally operate in markets where the competition has shrunk to a few key players. In the United Kingdom, for example, the vast majority of retail banking market share is held by only four banks. A consolidated market allows these participants
Conor, the Causeway global and international portfolio weightings in banks have risen over five percentage points from the start of the year. Why?
CM: We have about 15% of international and 10% of global portfolios in bank holdings. Through our bottom-up fundamental research, we have identified and purchased shares in undervalued banks undergoing restructuring or deleveraging. With profits on the upswing, these banks should return capital to shareholders. The banks with relatively rosy futures have solved problems of capital shortfall and excess leverage. In fact, some of our favorite bank holdings have already raised sufficient capital and shed assets to meet the capital requirements of "Basel III," the global regulatory standard on capital adequacy. Basel III does not require that banks meet these requirements until 2019, but investors want the results delivered today—not in six years.
AV: Even better, those fully capitalized banks generally operate in markets where the competition has shrunk to a few key players. In the United Kingdom, for example, the vast majority of retail banking market share is held by only four banks. A consolidated market allows these participants to sustain high returns. And, tougher capital and liquidity requirements thwart new entrants and smaller banks. Incoming competition must swallow a huge information technology investment and be confident they can grow quickly, to spread those costs over a large customer base.
What opportunities do you see in US banks? CM: Some large US money-center banks emerged from the financial crisis as stronger franchises. This improvement has come from consolidation. For example, JPMorgan (JPM, Financial) acquired Bear Stearns and Washington Mutual, and Wells Fargo (WFC, Financial) acquired Wachovia, all at distressed prices. Consolidation allowed dominant banking franchises to take market share and cement their positions as top competitors in most businesses. With the benefits of scope and scale, we estimate that several of the largest US banks will continue to generate returns on equity in the mid-teens, in the current interest rate environment.
AV: When investing in banks, we must always consider the slope of the yield curve and the economic environment. For the United States and Europe, short-term interest rates have reached a cyclical low and will rise from crisis-mitigating levels. A bank can benefit meaningfully from gradually rising interest rates because higher rates provide a near-term boost to its net interest margin (the difference between what a bank earns on its assets and what it must pay on its liabilities). Additionally, for the better-capitalized US and European banks, we expect a reduced drag from the costs of legal, regulatory, and control issues over the next two to three years. For the patient investor, the benefits of improved profitability outweigh near-term share price turbulence.
What else is the market missing in the current environment?
CM: Some banks have hidden assets to which the market is not ascribing any value. Take deferred tax assets as an example. Several large banks booked substantial amounts of deferred tax assets during the crisis. With a return to profitability, these assets offset tax expenses, creating additional capital.
AV: And there are other ways for banks to unlock value. Conor mentioned restructuring—shedding or downsizing the most capital-intensive business segments is a potent way for banks to become better capitalized and earn higher yields. Several of our bank holdings are shifting their business mix from trading-driven to retail-driven, which demands less capital. This excess capital should accrue to shareholders. We talked about Europe and the United States. Are you finding value in any other regions?
CM: We have found some opportunities in Japanese banks. Currently, our research is focused on the "megabanks" in Japan, the few national franchises responsible for the majority of lending to large Japanese corporations. Net interest margins for these megabanks will remain under pressure because of the low-rate environment and competitive pricing, but we are encouraged by evidence of loan growth. The weakness of the Japanese yen and the reforms enacted by Prime Minister Abe have increased the confidence of Japanese businesses, which may lead to a much needed rise in private sector capital spending. Currently, these banks are trading around book value, a level we consider reasonable given the potential for increased lending income.
AV: The Australian and Canadian banking markets benefit from some of the attractive characteristics we highlighted, with market concentration and financial strength. However, we don't currently have any exposure to banks in either of these markets. Why? The valuations don't leave room for further upside. That's a problem, as the banking cycle in these markets of low bad debts and low provisioning has likely passed its prime. However, the experience of Australian and Canadian banks offers a reasonable blueprint for the future economics of some of the other consolidating markets as the macroeconomic environment improves. Rather than look backward, we cast our eye toward rapidly changing banks aiming to position themselves for consistent profitability and rising dividend payouts.
Market commentary
the market commentary expresses the portfolio managers' views as of 10/18/2013 and should not be relied on as research or investment advice regarding any stock. these views and portfolio holdings and characteristics are subject to change. there is no guarantee that any forecasts made will come to pass. any portfolio securities identified and described do not represent all of the securities purchased, sold, or recommended for client accounts. the reader should not assume that an investment in the securities identified was or will be profitable.
The great statesman probably wasn't referring to equity portfolio holdings, but his comments may describe banks, especially those in Europe and the United States. Changes made by many banks after the 2008 global financial crisis put them on a very different (and much reduced) risk trajectory. With the tempering of risk, investors should also expect more pedestrian performance from post-crisis banks. However, we highlight the new dynamism in bank management. These current bank leaders must change their institutions continuously by shedding capital-intensive assets and low return business lines. Under the thumb of regulators, banks must evolve. Extreme leverage fueled the pre-2008 inflated bank returns. We are now surveying a wide array of banks with at least twice the equity capital-to-assets they held in the pre-crisis years. Returns on equity haven't yet crawled above single digits for many of the banks in the financials sector. This implies that many banks are just barely generating returns in excess of their costs of capital. The race to reduce risk-weighted assets and change the mix of existing assets will continue for years to come. In this period of change for banks, why has Causeway added significantly to both global and international portfolio weights in bank stocks? We asked Causeway portfolio managers, Conor Muldoon and Alessandro Valentini, to explain the Causeway rationale for banks in the years ahead.
Conor, the Causeway global and international portfolio weightings in banks have risen over five percentage points from the start of the year. Why?
CM: We have about 15% of international and 10% of global portfolios in bank holdings. Through our bottom-up fundamental research, we have identified and purchased shares in undervalued banks undergoing restructuring or deleveraging. With profits on the upswing, these banks should return capital to shareholders. The banks with relatively rosy futures have solved problems of capital shortfall and excess leverage. In fact, some of our favorite bank holdings have already raised sufficient capital and shed assets to meet the capital requirements of "Basel III," the global regulatory standard on capital adequacy. Basel III does not require that banks meet these requirements until 2019, but investors want the results delivered today—not in six years.
AV: Even better, those fully capitalized banks generally operate in markets where the competition has shrunk to a few key players. In the United Kingdom, for example, the vast majority of retail banking market share is held by only four banks. A consolidated market allows these participants
Conor, the Causeway global and international portfolio weightings in banks have risen over five percentage points from the start of the year. Why?
CM: We have about 15% of international and 10% of global portfolios in bank holdings. Through our bottom-up fundamental research, we have identified and purchased shares in undervalued banks undergoing restructuring or deleveraging. With profits on the upswing, these banks should return capital to shareholders. The banks with relatively rosy futures have solved problems of capital shortfall and excess leverage. In fact, some of our favorite bank holdings have already raised sufficient capital and shed assets to meet the capital requirements of "Basel III," the global regulatory standard on capital adequacy. Basel III does not require that banks meet these requirements until 2019, but investors want the results delivered today—not in six years.
AV: Even better, those fully capitalized banks generally operate in markets where the competition has shrunk to a few key players. In the United Kingdom, for example, the vast majority of retail banking market share is held by only four banks. A consolidated market allows these participants to sustain high returns. And, tougher capital and liquidity requirements thwart new entrants and smaller banks. Incoming competition must swallow a huge information technology investment and be confident they can grow quickly, to spread those costs over a large customer base.
What opportunities do you see in US banks? CM: Some large US money-center banks emerged from the financial crisis as stronger franchises. This improvement has come from consolidation. For example, JPMorgan (JPM, Financial) acquired Bear Stearns and Washington Mutual, and Wells Fargo (WFC, Financial) acquired Wachovia, all at distressed prices. Consolidation allowed dominant banking franchises to take market share and cement their positions as top competitors in most businesses. With the benefits of scope and scale, we estimate that several of the largest US banks will continue to generate returns on equity in the mid-teens, in the current interest rate environment.
AV: When investing in banks, we must always consider the slope of the yield curve and the economic environment. For the United States and Europe, short-term interest rates have reached a cyclical low and will rise from crisis-mitigating levels. A bank can benefit meaningfully from gradually rising interest rates because higher rates provide a near-term boost to its net interest margin (the difference between what a bank earns on its assets and what it must pay on its liabilities). Additionally, for the better-capitalized US and European banks, we expect a reduced drag from the costs of legal, regulatory, and control issues over the next two to three years. For the patient investor, the benefits of improved profitability outweigh near-term share price turbulence.
What else is the market missing in the current environment?
CM: Some banks have hidden assets to which the market is not ascribing any value. Take deferred tax assets as an example. Several large banks booked substantial amounts of deferred tax assets during the crisis. With a return to profitability, these assets offset tax expenses, creating additional capital.
AV: And there are other ways for banks to unlock value. Conor mentioned restructuring—shedding or downsizing the most capital-intensive business segments is a potent way for banks to become better capitalized and earn higher yields. Several of our bank holdings are shifting their business mix from trading-driven to retail-driven, which demands less capital. This excess capital should accrue to shareholders. We talked about Europe and the United States. Are you finding value in any other regions?
CM: We have found some opportunities in Japanese banks. Currently, our research is focused on the "megabanks" in Japan, the few national franchises responsible for the majority of lending to large Japanese corporations. Net interest margins for these megabanks will remain under pressure because of the low-rate environment and competitive pricing, but we are encouraged by evidence of loan growth. The weakness of the Japanese yen and the reforms enacted by Prime Minister Abe have increased the confidence of Japanese businesses, which may lead to a much needed rise in private sector capital spending. Currently, these banks are trading around book value, a level we consider reasonable given the potential for increased lending income.
AV: The Australian and Canadian banking markets benefit from some of the attractive characteristics we highlighted, with market concentration and financial strength. However, we don't currently have any exposure to banks in either of these markets. Why? The valuations don't leave room for further upside. That's a problem, as the banking cycle in these markets of low bad debts and low provisioning has likely passed its prime. However, the experience of Australian and Canadian banks offers a reasonable blueprint for the future economics of some of the other consolidating markets as the macroeconomic environment improves. Rather than look backward, we cast our eye toward rapidly changing banks aiming to position themselves for consistent profitability and rising dividend payouts.
Market commentary
the market commentary expresses the portfolio managers' views as of 10/18/2013 and should not be relied on as research or investment advice regarding any stock. these views and portfolio holdings and characteristics are subject to change. there is no guarantee that any forecasts made will come to pass. any portfolio securities identified and described do not represent all of the securities purchased, sold, or recommended for client accounts. the reader should not assume that an investment in the securities identified was or will be profitable.
