Sector Report

US Banks: Back in Black!

by Feb 9, 2017

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For the first time in a decade, US banks are transitioning from value destruction to value creation. That’s when they generate “excess returns”, or ROEs above the cost of capital. Since 1990, whenever this has been the case, bank stocks have never traded below 1.4x book value. Bank stocks, still a touch below this level, imply value destruction, as if – with apologies to AC/DC – they are on a highway to hell. On the contrary – banks are back in black. That means, for investors, let there be rock!

ROEs increasing even before a “Trump Bump” Over the next three to four years, ROEs should increase from 9% to 11% due to better optimization of expenses (branches, regulatory, legal, back-office) and balance sheets. Deployment of record capital and liquidity creates an inflection for growth. The net interest margin (lowest since 1955) should increase after a one-fifth decade-to-date decline. Other factors offset, with likely higher credit losses mitigated by the benefits of higher rates. An extra “Trump Bump”, or benefits from the post-election economy, could increase the ROE by another 2ppts to 13% (estimated).

Cost of capital, aided by a “Beta Bump” The cost of capital should decline from 10% to an estimated 9% due to de-risking benefits. Cost of capital is a function of the stock beta (stock price volatility), which correlates with earnings volatility. Given the lowest earnings volatility in a decade, betas – down from 1.8 to 1.3 – should head to 1.0 based on already demonstrated stability. Safety is further enhanced by the strongest balance sheets in a generation, the highest level of equity-to-assets in 80 years, and enough cushion to absorb not one but two financial crises. Banks have US$700bn more tangible equity, US$1tn more cash and US$3tn more core deposits than pre-crisis.
Good margin of safety for generating excess returns Banks should generate excess returns under a base case (ROE from 9% to 11%) or bull case (13% ROE) and get close even in a bear case (9% ROE) with no growth or rate increases. Three factors help.

• Optimization: banks have unique self-help potential. Regardless of the scenario, bank ROEs should benefit by 200bps from better optimization of expenses and balance sheets. 

• Rates: increases in interest rates from such unusually low levels increase margins and revenues without pressuring credit costs much, because still-low rates allow borrowers to service debts.

• Trump Bump: lower taxes, extra rate boosts, and faster loan growth can help ROE by an estimated 200bps (not reflected in this analysis).

16 years of lost bank-stock performance Even with the 2H16 rally, bank stocks have barely moved in 16 years and have been dramatic underperformers (up 3% since year-end 2000 versus 98% for the S&P500). Valuations remain below historical metrics based on price-to-book (1.3x vs 1.7x) and relative PE (71% vs 72% median and 80% average), a discount that would likely widen with a Trump Bump (estimated 20% EPS benefit).

Capital return, too, remains attractive, with dividends and buybacks combined likely to grow at a 12% compound rate from 2015 to 2019 given payout rates that we expect to rise from 65% to 85%. If so, the capital-return yield (dividends and buybacks) at the current market cap would increase from 5.0% to 6.7% (2019), the highest level since 2007.

Banks are better positioned. For the past 25 years, they have averaged a price-to-book ratio of 1.75x (versus 1.3x today) and an ROE of 13%. If banks were to improve their ROE, this higher valuation would seem attainable, especially since it would be with less leverage. Our models will incorporate the Trump Bump if faster GDP growth materializes.