There are several arguments these days for broadly avoiding the equity of developed market commercial banks, and at PIMCO our caution stems from a number of areas, but in particular our secular outlook. Within our paradigm of the New Normal, our concerns primarily revolve around three factors: loan growth, balance-sheet risk along with capital levels and regulation.
In the PIMCO Pathfinder Strategy, which is global and deep value in nature, we have stayed away from U.S. money center banks and have a paucity of European bank exposure with no exposure to banks in the Eurozone (as defined by MSCI Commercial Banks per GICS). More specifically, Pathfinder is currently limited to only a handful of banks that are best characterized by PIMCO as deep value opportunities, with none of the aforementioned exposure. A question posed by investors is why we take such a marked deviation from many of our peers and the strategy’s benchmark, which is the MSCI World Index.
To begin answering that question, I should point out some of the unique traits that characterize Pathfinder as actively managed. First, we pursue a number of strategies with a focus on achieving equity-like returns over the long term while striving to limit downside risk. Merger arbitrage, for example, is a strategy that invests in equities but has substantially different risk factors than traditional long-equity investing, such as historically less volatility than equities (although this may come with limited upside potential, at least in the short term) and a historically low correlation to equity markets. Second, we may meaningfully deviate from our benchmark in sector and industry weightings. This is by design as we seek to deliver attractive risk-adjusted returns by investing only in opportunities where we see the potential for substantial upside and limited downside. And in developed market banks we generally do not see meaningful upside potential in equity positions over the secular horizon. The key reasons potentially preventing material upside are explored below.
Limited Loan Growth
Loan growth has historically been a driver for banks and their share price performance. While it’s true that many factors affect the earnings of banks and their valuation multiples, we believe loan growth and net interest margin (NIM) can be powerful drivers of earnings growth. And based on our statistical analysis, we have found the relationship between loan growth and price-to-book multiples is statistically significant beyond the 99th percentile (i.e., the relationship between the two variables is likely caused by something other than random chance):
When looking at the backdrop in developed countries, our view is to expect limited loan growth due to the relatively high levels of consumer debt as well as the lower level of economic growth we anticipate in developed markets – all part of our New Normal worldview. Many investors may be looking at loan growth as the critical variable needed to drive bank stock prices higher due to a perceived lack of other drivers at this point; credit quality has generally improved and while cost cutting can presumably be done, meaningful earnings growth may be difficult to achieve without loan growth.
Balance Sheet and Capital Level Risks While we view the U.S. asset quality environment as one where there’s been a substantial recovery despite an economy close to stall speed growth, Europe has an ongoing issue with sovereign debt exposure on its banks’ balance sheets and interconnectivity issues regarding what could happen in a tail event in which a disorganized debt default occurs. Despite the completion of a second European stress test on bank balance sheets, we believe the results lacked plausibility for a number of reasons. For example, the test did not address broad sovereign “haircuts” (the consequences of a reduction in bank balance sheet assets due to marked down bond values). Hence, only eight banks failed overall and the stress test results indicate these banks would require only €2.5 billion in capital to “solve” the problem. Under any number of stress scenarios, we believe a number of the European banks found in the caution zone of the test (between a 5% to 7% core Tier 1 capital ratio) could have solvency or liquidity issues if their capital levels were depleted from current levels. These include a number of large banks such as Deutsche Bank, Unicredit, Societe Generale and RBS. Figures 2 & 3 list both the banks in the caution zone as well as those that failed (<5% Tier 1 ratio).
Even absent a major default scenario, we believe the dampening effect this sovereign crisis has had on European GDP growth and hence loan growth is not negligible. Related to our earlier point, without balance sheet expansion, improved share price performance may be difficult to achieve. And the potential downside associated with many balance sheets of European banks may be too much for a risk averse investor to accept. Furthermore, higher capital requirements mandated by regulators make the prospects for earning attractive returns on equity (ROE) much bleaker. While a debate exists here on whether capital requirements will escalate further and just how much time banks will have to fully implement Basel III requirements (2019 is the deadline and banks in the U.S. are beginning to communicate a willingness to wait until then to accommodate these rules), all scenarios imply to us generally lower returns for developed market banks.
Harsh Regulatory Environment
The regulatory environment for banks in developed markets remains harsh. This goes beyond the demand for higher capital levels to the passage of acts such as Dodd-Frank, which may have particularly onerous implications for smaller banks in the U.S. For smaller banks, due to size and scale issues, the additional compliance burden and costs can potentially have a negative impact on profitability. Even at the simplest level, the addition of a few more compliance personnel to deal with and interpret these regulations can be quite a burden for an institution with a low revenue and asset base. In Europe, we believe the EU is likely to implement similarly restrictive regulations following the U.S. moving forward with Dodd-Frank, and they are creating their own national regulatory programs as well.
In sum, it is our view that these three points combine to create an environment for banks where both the numerator and the denominator in the return-on-equity equation (net profit/average shareholder equity for given period) may be moving in a direction that implies lower valuations for many of these banks. Furthermore, the pressure on earnings referred to above results in a lower normalized earnings value. All else equal, lower normalized earnings generally lead to less compelling investment opportunities.
But as always, there tends to be more than one side to every story. The current selloff seen in both U.S. and European banks has taken many of the large cap banks to valuation levels that haven’t been seen in quite some time outside of crisis periods. Consider Europe, where price-to-book (P/B) levels appear to be returning to those of summer 2009, as seen in Figure 4:
Looking at earnings multiples, another conventional approach to bank stock valuation, yields the same result. In the case of the U.S., the four largest banks by market capitalization are clustered around the same valuation level and are trading at levels far below their long-term average (both individual and peer group average).
So could there be short-term upside potential in the large cap bank space in Europe and the U.S.? Perhaps a trade exists as the group has declined meaningfully this year and sentiment could improve. But longer term for Europe, we feel balance-sheet risk for the banks will persist due to sovereign debt issues. We have a more constructive outlook on the U.S., but believe the headwinds on loan growth, regulation and earnings power previously mentioned still exist and may limit upside.
Investment Conclusions
Longer term, we expect developed market banks to continue to be an overall value trap: names offering interesting valuations from an optical standpoint and occasionally showing glimpses of life, but at the end of the day not offering the upside potential needed or a path to actually monetize inherent potential.
This isn’t to say we see no potential value in financials, or even no potential value in lending institutions. Even within the banks, there may be individual companies that can deliver attractive ROA (return on assets) and have good management focused on steady growth and strong capital positions. We believe this is a combination for success and may help deliver improved returns to shareholders.
In absence of broad systemic loan growth, the Pathfinder strategy may favor lenders that have excess capital and attractive valuation with the ability to buy back stock accretively, thus growing book value. And importantly, at some point we expect that there will be a resolution of at least some of the issues mentioned earlier. We cannot accurately forecast when loan growth may improve or when a comprehensive resolution of European sovereign risks may emerge, but if they do, we believe that value opportunities may emerge. Even in the case of a somewhat disorderly resolution, value can often be found looking among the aftermath of a crisis. An analysis of historical crises can help an equity investor navigate some of the issues of today in developed markets.
Ultimately, Pathfinder tends to seek value in many places that may deviate substantially from a traditional index. When investing according to a defined benchmark, investors have limited choice. Using an active management approach with a value discipline, investors can access a wider universe of investment options. Shareholder returns tend to not only be generated by owning winners, but perhaps more importantly with equities, by avoiding losers. In many respects, seeking to avoid losses can potentially deliver benefits to investors over the long term from the compounding characteristics of such an approach.