The past six months has been a challenging period for global bank shareholders. The global bank stock index has declined by 20% since August, well below the 5% decline in the broader global market index (see chart).
Emerging market banks have been the worst performers over this period, but some developed market banks haven't been spared either. European banks, particularly those in the periphery countries, have delivered dismal returns. Despite the reduction of European banks' non-performing loans in the past two years, they still account for 7% of total loans, well above other developed markets (see chart). Non-performing loans as a percentage of total loans in North America and Australia are below 2%.
Among the emerging markets, the credit bubble in China continues to pose a key risk to the global outlook. Total debt of the private non-financial sector in China has lifted to 200% of GDP, double most other emerging markets (see chart). The debt build-up has been associated with over-investment, particularly amongst property developers.
Evidente has developed profitability adjusted book multiples as a framework for identifying pricing anomalies amongst stocks. I have extended this model to the largest 60 developed market banks (see chart). Valuation theory predicts a linear and positive relationship between an asset's expected ROE and price to book ratio. The trend line is associated with a strong R squared of 80%. A stock can lie above the regression line (ie. It has a higher profitability adjusted book multiple than the average of its peers) for a number of reasons: it is over-priced, it is cum an upgrade to its book value, it has stronger future growth prospects than its peers, investors are assigning a lower discount rate than its peers, or the consensus' ROE expectations are too conservative.
The chart shows that a number of UK and Australian banks lie above the regression line, but at different ends of the profitability spectrum. Some of the German banks, including Deutsche Bank, lie well below the regression line.
Global bankers should be more grateful for Basel and conservative prudential regulators
To dissect the under-performance from global banks in the past six months, I have sorted the 60 largest DM banks into quartiles, based on their respective deviations from the regression line. The premium stocks (those that lie above the line) have been far more resilient, declining by 15% while the discount stocks have fallen by over 30% (see chart). Many of the stocks that have high profitability adjusted book multiples probably have lower perceived risk or lower betas which has been associated with defensive attributes.
The volatility of returns for the premium banks (20%) is significantly lower than for the discount banks (26%) confirming the defensive characteristics of the former group. Moreover, the premium banks have 50% more loss absorbing capital in their liability mix. The ratio of shareholders equity to assets is 8.3% for this group, well above 5.2% for the discounted banks. Despite global bankers' predictable chorus since the financial crisis that regulatory requirements to lift the amount of equity finance in their liability mix are impeding their ability to lend, the analysis here demonstrates that banks with more loss absorbing capital have been resilient to the market turbulence of the past six months. Although more capital reduces expected ROEs (other things being equal) it also reduces a bank's risk profile. Bankers should therefore be more grateful to Basel and conservative prudential regulators.
The chart below shows the stocks with the largest positive and negative deviations from the regression line. I am not suggesting that the premium stocks are over-valued or that the discount stocks are under-valued. As cited above, premium stocks with defensive characteristics can continue to trade at higher profitability adjusted multiples than their peers for extended periods. But the model allows us to identify pricing anomalies. For the premium stocks, RBS and Standard Chartered stand out because they have low capital ratios and high return volatilities. Of course, its possible (but probably unlikely) that the stocks are cum-earnings upgrades. After all, analysts have downgraded their 12 month forward EPS forecasts for RBS and Standard Chartered by 15% and 50% respectively in the past six months.
There do not appear to be any anomalies amongst the ten stocks trading on the largest discounts. They all have low capital ratios and high return volatilise, suggesting that their defensive attributes are poor. As long as global risk appetite remains low, I recommend investors stay underweight this group of stocks as well as RBS and Standard Chartered. The key risk to this view is if global market sentiment swings quickly from risk aversion to risk appetite.