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U.S. Banks offer attractive investment opportunity

U.S. Banks offer attractive investment opportunity

Large cap U.S. banks such as BAC and JPM, offer an attractive investment opportunity given my expectation for improved profitability driven by lower efficiency ratios and higher Net Interest Margins (NIM’s). Additionally, the banking sector currently trades at a historically large discount to the S&P 500 as well as the sector’s own history. Finally, banking sector balance sheets are much stronger than they were heading into the 2008 Global Financial Crisis, allowing the sector to emerge from this recession in a much healthier position.

 

The two major overhangs on the sector are the impacts of the COVID-19 pandemic on the economy, and weak NIM’s stemming from the low interest rate environment. Banking is a highly cyclical sector, and investors are likely concerned given the significant losses the banking sector incurred during the Global Financial Crisis. However, I think these concerns are overblown given the strength of the banking sector heading into the current recession as well as my expectation for NIM’s to increase going forward as discussed below. Great investment opportunities can emerge when a sector experiences extremely weak sentiment as the banking sector faces today.

Profitability should improve over time 

Improved efficiency ratios driven by consolidation


The banking sector has experienced massive consolidation over the past 20 years, with the largest banks continuing to get stronger. The top 3 banks by deposits (BAC, JPM, WFC) now hold a 33% market share, up from 20% 20 years ago. Additionally, the top 20 banks by deposits have a 62% market share, compared to a 40% market share 20 years ago. Furthermore, the number of U.S. banks has declined nearly 40% over the past 20 years from 7,800 in 2002 to 4,800 in 2018, and I expect the number of banks to continue declining due to further consolidation.

Unlike other sectors, bank mergers are frequently beneficial to the acquirer due to the substantial cost reduction synergies driven by reducing headcount, closing bank branches and consolidating technology spend. As a result, banking sector consolidation has increased economies of scale strengthening the sector’s moat and improving profitability over time. As you can see below the largest banks have consistently posted the lowest efficiency ratios over the past decade.

Absent additional consolidation, banks have been highly focused on cost cutting by reducing their massive branch networks and reducing headcount. Large cap banks reduced their number of branches by 23% from 2008 to 2Q20, leading to a material reduction in expenses over that time frame. Digitization is a key focus for banks driven by the increase in online and mobile banking which lead to further improvements in the efficiency ratio.

efficiency ratios

 

NIM’s to improve going forward

Net Interest Income makes up 60-65% of revenue for most banks, so NIM’s are a key driver of the sector’s profitability. NIM’s for large banks are expected to compress 39bps y/y in 2020 to 2.68%. This is driven by the low interest rate environment as well as banks defensively increasing their liquidity position because of COVID-19. For example, 32% of BAC’s total assets are in its global liquidity portfolio of treasuries and agencies earning 1.1%. Additionally, deposit growth has outpaced loan growth, and many banks have kept excess deposits in cash.

Picture3

 

However, I expect NIM’s to improve for several reasons. First, banks will deploy their excess cash into more attractive securities and loans, as the economy continues to improve, likely in 2021. Goldman Sachs estimates that bank EPS would be 10% higher if excess deposits were lent out.

Additionally, deposit costs should further decline driven by the Federal Reserve keeping the Federal Funds Rate at 0% for the next few years. Lower deposit costs will lead to a higher NIM. Finally, I expect the yield curve to steepen gradually, given the Federal Reserve’s policies which would also lead to higher NIM’s.

Historically Cheap Valuation

Currently banks are extremely cheap with the P/E of the banking sector roughly 50% of the overall S&P 500. On a P/TBV basis, banks are also extremely cheap relative to the S&P 500, and more importantly their own history. Admittedly, P/TBV is not the best metric for valuing the S&P 500 given the rise in the value of intangible assets, however, it is instructive to look at where banks are trading relative to P/TBV’s over time.

Bank P E

 

Bank P TBV

 

Strong Balance Sheets


Bank balance sheets have been much improved since the Global Financial Crisis, driven by increased regulations stemming from the Dodd-Frank Act and entered this most recent recession with strong balance sheets. This is evidenced by much stronger capital levels, improved asset quality, record liquidity. Additionally, Federal Reserve stress tests on large banks provide another layer of protection for the sector. While the economic impacts from the COVID-19 pandemic continue to be felt in late 2020, I expect the banking sector to emerge in great shape.

Capital

Bank capital ratios have nearly doubled since 2008 from 6% to 12%, per the below chart from the Federal Reserve. Furthermore, Bank’s Tangible Common Equity ratio was at its highest level since the 1930’s heading into this pandemic at roughly 8%. While capital ratios declined slightly in 2Q20, banks have halted share repurchases for the year and are generating strong enough earnings that I don’t expect capital ratios to decline further.

capital ratios
Source: https://www.federalreserve.gov/publications/2020-may-supervision-and-regulation-report-banking-system-conditions.htm

Asset Quality

Similar to capital levels, bank asset quality was extremely benign heading into the pandemic. Non-performing assets (NPA’s) are at their lowest level since 2008 and net charge off’s (NCO’s) are similarly at their lowest level since prior to the financial crisis. While asset quality will weaken, driven by impairments in commercial real estate (CRE) and industrial loans to sectors such as energy, asset quality metrics have held up extremely well through 3Q20. As a result, I don’t expect nearly the increase in NPA’s and NCO’s that banks experienced during the financial crisis.

Additionally, banks provisioned heavily during the 1st and 2nd quarters of this year, and provisions declined substantially in 3Q20. Depending on further fiscal stimulus and the economic recovery, banks may be able to release some of their reserves providing a boost to earnings going further.

asset quality

Source: Barclays Research, FDIC and Federal Reserve

Liquidity

Bank liquid assets as percentage of total assets have increased substantially from roughly 6% during 2006-2008 to 18% in 2019. As a result, the banking sector as a whole is much better positioned from a liquidity perspective relative to its position leading up the Financial Crisis.

 

liquidity

Source: https://www.federalreserve.gov/publications/2020-may-supervision-and-regulation-report-banking-system-conditions.htm

Conclusion

Investor sentiment remains weak for large cap U.S. banks. Specifically, JPM’s stock price is down 28% year to date, and BAC’s stock price is down 32% year to date. However, I believe large cap U.S. banks represent an attractive investment opportunity driven by my expectation for improved earnings, and attractive valuations. Additionally, bank balance sheets entered this pandemic with record capital levels, benign asset quality and excellent liquidity. As a result, I believe the sector will more than survive the current recession, and I expect strong investment performance for many U.S. large cap banks.

Disclaimer

As a disclaimer this article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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