Keith Davis is a Farr, Miller & Washington Partner and serves in the roles of financial sector analyst and our firm’s economist. Much of my weekly market posts are crafted by Keith. He is exceptionally, bright, capable, and articulate. Keith has kept our firm in front of this recession and the banking crisis. Clients know that we sold most of our financial stocks in the spring and early summer of 2007. All of our decisions are based on fundamentals and are made by our investment Committee, but Keith’s leadership was the key. Currently, we hold two banking stocks: JP Morgan and Goldman Sachs. Keith’s thoughts on banks follow.
As of the close on Friday, the KBW bank index was up 135% from its low on March 6. The large-cap banks are now trading at an average of about 7.5x the analysts’ consensus estimates for 2011, 0.9x book value, and 1.7x tangible book value. It is hard to determine at this point how ongoing capital raises will affect book values, earnings estimates, and valuation multiples. Some analysts may have included further dilution in their earnings estimates and some probably have not. So far today, we received news that at least five banks are offering new stock for sale in an effort to improve their balance sheets in the wake of the stress tests. These announcements are likely to continue as banks seize the opportunity while share prices are relatively high. Frankly, we have been surprised by the success banks have been having so far in raising capital. The new stock is being handily absorbed by the market, even at prices well above levels of just weeks ago.
Bank stocks have begun trading on “normalized” EPS and no longer on tangible book value. In other words, analysts are looking out into the future to a point when banks are no longer suffering from outsized credit losses and reserve additions. In still other words, analysts are “looking through the recession” to better days. Most analysts believe the first year of normalized earnings will come in about 2011. By my calculations, the average large-cap bank is projected to earn 132% more in EPS in 2011 than in 2010. Are analysts being a little aggressive in projecting bank earnings power in the post-bubble world?
What is clear to me is that the earnings power at these banks has been permanently impaired. Returns on equity and assets will likely never get back to the good old days for many reasons. Doug Kass put out a piece on the banks last week which echoes my sentiments exactly: several issues are likely to weigh heavily on bank profitability in the years to come. I have also added some of my own points.
- The surge in pre-crisis bank profitability was largely the by-product of twin bubbles in consumer credit and housing. These bubbles may take years to unwind and will likely result in a savings rates going back to the 6-7% range from near zero in recent years. The implication for banks is less consumer borrowing, more aggressive price competition, and slower asset growth;
- Capital raises at relatively low levels will be extremely dilutive;
- Many very profitable businesses within these banks have been sold to raise capital to satisfy regulators;
- It is premature to assume that the downturn for the consumer loan cycle will be complete by 2011;
- Losses on commercial real estate have yet to hit the banks in a meaningful way;
- Returns on equity will be limited by the requirement to hold more capital;
- New restrictions on previously-profitable (ie, high ROE) businesses are likely to weigh down profitability (credit card APRs, credit card fees, sub-prime lending, exotic mortgages, trading, etc);
- As of early next year, banks will be required to consolidate their off-balance sheet securitizations, which will require that they hold capital and reserves against these assets;
- Capital markets activity is likely to be subdued for a time, with new regulations to manage counter-party and other risks;
- The banking industry is highly exposed to a second leg down in the economy (Is it possible the stress tests weren’t stressful enough?);
- We believe there are significant risks that housing prices have further to fall (Option ARMs and Alt-A repricing in 2010-2011, 20% of mortgages underwater, mortgage rates unsustainably low, huge backlog of unsold and foreclosed properties, etc)
But perhaps the biggest question mark is how well will banks perform in the absence of the government support they have been receiving. Obviously, the government support is enabling a lot of banks to raise equity capital at much better prices than they otherwise could have. Some banks have been testing the water with issuances of unguaranteed unsecured debt as well. These capital raises would not have been possible without government support. Banks are benefiting enormously from a lower cost of funds than if the government had not gotten involved. There is a good article in section C1 of today’s Wall Street Journal that discusses this very topic. The basic point is that banks and the capital markets are still heavily reliant on government support. We have no idea when or if this support can be lifted.
Moreover, I believe that investors are extrapolating the results reported by the banks for the 1Q09. I do not believe these results are sustainable as they were highly dependent on 1) a massive refi boom; 2) a hugely profitable quarter for trading; 3) massive government support in the form of capital and loan guarantees; 4) purchase accounting marks; 5) benefits from tax rebates and other seasonal factors; 6) new mark-to-market accounting rules; and 7) in some cases, lower loan loss provisions.
Last but not least, I would also mention that the bank stocks have historically been supported by relatively high dividend yields. Now that dividends have been cut to close to zero nearly across the board, the large cap banks are only yielding about 1% on average.
I guess this was a long-winded way of saying that we are finding better value (with much less risk) in other sectors following this latest market surge. We continue to favor companies with rock-solid balance sheets and strong management teams in the Healthcare, Consumer Staples and Technology sectors.
Hang in there!