During the last fifteen years anyone who invested in the banking sector for the long term would have lost money. A lot. On the other hand, those who had bought the sector in times of stress and resold it shortly thereafter would have made money. After these days of summer hysteria, which is ultimately healthy (the market, like plants, needs to be pruned every now and then in order to grow healthy…), banks are still between 30% and 70% above their 2020 lows. They have heavily lost momentum and relative strength and it is fair to ask if the time has come to say goodbye. We think it’s not time yet and that they will need to go up another 50%-70% on average to make their risk/benefit profile balanced.
Let’s start talking about the issues.
1) Banks as a business model have been in crisis for a long time, squeezed on the one hand by a regulator that pushed them to hold very high capital and on the other hand by low rates that limit lending profitability. In addition, new competitors (FinTech’s) have entered many of the fee-based businesses.
2) Many sources report that cryptocurrency and CBDCs (central banks digital currencies) could disintermediate them from their traditional deposit management business.
3) Cost structure and distribution networks need to be further streamlined.
However, answering point by point.
1) High capital and low profitability lead to a modest ROTE which, however, is well reflected in valuations that today, excluding particular situations, are around 0.4x to 0.7x tangible equity. Tangible ultimately means the cash owned.
2) Cryptocurrencies are to be considered, at core, speculative asset classes and certainly not substitutes for currencies, since they have neither an underlying nor a regulatory support. This is not the case for CBDCs, which in our opinion represent a next evolution of the financial system (we are talking about 5/10 years), but which will inevitably coexist with commercial banks, since central banks cannot be the lenders. The central banks will probably manage all or part of the deposits, deposits that they will give back to the banks for lending activities. This may turn retail funding into wholesale funding, which will be disbursed by the central bank based on criteria that reflect the lender’s ability to lend, such as capital and the ability to lend to worthy (which doesn’t just mean solid) entities. Proximity and local knowledge will clearly be an important feature, and from this point of view, banks will have an advantage. However, social networks and big tech, which have a large amount of data, may eventually enter the sector, going to support in particular private individuals who today are not always able to obtain credit easily.
3) Technology will allow banks to operate with leaner structures that will enable further margin improvements. In addition, the capillarity of their networks, combined with the consolidation process underway, will allow them to expand the services offered by the bank. If, over the last twenty years, banks have been able to acquire new sources of income by selling insurance and managed savings (trends that still have a lot of room), new services to manage the hyper-bureaucratization of our society are important: such as basic legal and commercial assistance, systems to centralize and manage multi-utilities for families and businesses, consulting to effectively benefit from state and regional subsidies, agreements with various suppliers (transport, artisan cooperatives, restaurants, etc.) and much more. These are services inherent to banking, unlike the sale of televisions and diamonds that some players have clumsily undertaken in recent years. The banks that remain on the market must present themselves as a capable and transparent consultant, who can become an essential point of reference for families. If we enter a branch today, we immediately understand that there is room for more dynamic operating models, based on the amount of paperwork to be signed, the slowness of procedures and the lack of enthusiasm.
While we agree that the future of banking is still uncertain, we would nevertheless like to highlight a few essential elements for the investment case:
a) Today, banks trade at valuations that incorporate their liquidation and therefore the risk is limited.
b) To those who point out that banks are risky subjects, with low capital compared to the risks (lending), we reiterate that they have probably never been so solid after fifteen years of capital reinforcements and this should emerge in the face of the criticality caused by the pandemic.
c) If a company does not earn its cost of capital, it will gradually reduce its capital by paying dividends and exiting unattractive businesses. If the capital held is significantly greater than the company’s stock market value, investing in a declining business can also be very profitable.
d) The possibility that M&A activity will lead to significant premiums and/or rerating is not marginal, given the potential for synergies (from basic service structures to technological infrastructure).
e) We would then like to venture a comparison with the pharmaceutical giants, which internally hold various activities that, if listed individually, would entail much higher valuations. Similarly, banks could monetize high-growth service divisions, which today are drowned in the conglomerate. A few days ago, Revolut, a four year old start up, raised 800 million USD in a funding round based on a 33 billion valuation. We as a society and as individuals use it because it gives us services for free or almost free. So we’re not surprised it’s growing so much. Revenues grew 57% in 2020 to 360 million USD and today it has 12 million customers. Losses have doubled to almost 280 mln usd. After this latest round of financing, the company has about 1 bln usd of tangible equity. Today SocGen and UniCredit are worth about 24 bln USD, almost 30% less than Revolut. Each has a tangible net worth of over 60 bln USD, will generate net profits of almost 3 bln USD this year and have 30 and 26 mln (profitable) customers, respectively. On the other hand, as we all know today, growth is very well priced, despite all the inevitable unknowns …
f) Finally, to sell banks just when the dynamics of rates could reverse seems to us a pity.
Value investing is clearly not buying something that has gone down and selling something that has gone up. Rather, it is buying or selling something based on the risk/return profile. Banks, despite the significant appreciation from the lows, we believe present an extremely attractive risk/return profile.
For those interested in learning more about possible developments in the sector, we attach below links to a series of reports that we believe are interesting:
IMF – Stay Competitive in the Digital Age: The Future of Banks
Economist – The future of banking
THE ECB BLOG – Preparing for the euro’s digital future
Bank of England – Future of finance
Fed of St. Louis – Central Bank Digital Currencies: Back to the Future
Bank of Japan – Financial System Report
I remember a few years ago when we were following and analyzing GAM, a Swiss asset manager. The stock was worth about 15 chf per share and the company was considered a little gem.Well managed and organized, good product range, solid reputation and growth. The company was worth about 2.5 bln chf. AUM was around 150 bln chf, implying a modest industry premium of 1.7% of assets, motivated by double-digit growth in profits and assets. This valuation premium would have been much less modest if it had been considered that 80 bln chf of AUM (private label) generated very low margins as they were held in the private label division which manages third party funds.
GAM’s main product, Absolute Return Bond Fund (ARBF), a flexible bond, managed around 11 bln chf and was often at the top of the charts. Tim Haywood, the manager in charge, was a star. Five years later GAM is worth CHF 300m. Excluding net cash (CHF 190m) and valuing the private label part (CHF 60m of AUM) at a measly 0.1% of assets, active management is valued at around 0.15%. If this part were valued at a modest 1% of assets and white label AUM at 0.2%, the company would be worth more than twice as much. What happened?
Actually nothing terribly serious, but still enough to destroy an asset manager with thirty years of history. This should be a lesson to everyone.
Founded by Gilbert de Botton in 1983, the company is known for its active management and reliability. In 2017, conflict erupted within ARBF’s management team. Tim Haywood and Daniel Sheard clash as the latter believes the amount of illiquid bond products tied to steel industrialist Gupta is excessive (11%). The querelle moves to compliance and then to the FCA (UK regulator) to which Sheard turns. The investigation uncovers a series of irregularities, more formal than substantial, on the part of Tim Haywood that lead to his suspension. This in turn generated redemptions leading to the freezing of the fund to prevent the weight of illiquid assets from increasing. The fund was liquidated, including the illiquid portion, without loss. But GAM’s reputation, built up over more than thirty years, was demolished. The company, in a couple of years, lost 60% of its AUM. Something similar happened with H20 or Woodford. In this industry, reputation is everything.
Today, the company is run by Peter Sanderson, an industry veteran. GAM remains an important investment house. Although they recently had to close another small fund tied to Greensil (and then back to Gupta) this should not create any losses again as the assets were all investment grade. The company is investing heavily in sustainability, trying to change the face and make people forget the recent past. Exactly how deceptively it looked attractive at 15 chf, now deceptively it looks expensive at 1.9 chf.
The asset management business is becoming increasingly polarized: boutique or industry. The synergies associated with fixed costs are significant. Business models such as multi-boutique (introduced by Natixis) are increasing, with great brand and reputational benefits. We believe that today the possibility of a bid at a substantial premium is realistic and Gam’s balance sheet strength allows us to wait for it to happen or for the turnaround to take effect anyway. The risk/benefit profile is attractive here.
New profit warning from ATOS. Last time it went down for a “qualified opinion” of the US auditors. Now the company confirms that the accounting issue was only formal but along with this good news the company revises downward growth and margins due to 45% of its business still tied to software infrastructure now migrating to the cloud (a known and common problem for companies in the industry). The rest of the business is tied to cyber security, cloud and decarbonization and is growing well. Today the stock trades at 0.5x EV/SALES (Capgemini 2x, Accenture 3x) and the infrastructure business is given negative value. Management has called 2021 “a transition year” and it probably will be especially so for them given the loss of credibility. The company is debt-free and profitable. Something will happen. Although further weaknesses are possible in the short term, we have doubled the position because we find the opportunity attractive. It is in these cases that portfolio diversification pays off and allows us to take advantage of unexpected situations