Written by Ben Preston, Orbis Portfolio Management (Europe) LLP, London
Banking is a classic “value” sector that stands to benefit from a combination of low starting valuations and favourable exposure to the changing economic regime.
When interest rates rise, banks can earn a wider spread between the interest they charge on loans and the interest they pay to depositors. The impact on their profits can be transformational, and if the banks can pay out those profits, they can be rewarded with much higher valuations.
Over the last 13 years, banks have effectively been in altitude training. Near-zero interest rates hurt their lending margins, while regulations have limited their growth and pay-outs to shareholders. As the environment shifts, they are coming out of altitude training ready to run at sea level.
We have found increasingly compelling opportunities among banks. While there are opportunities globally, financials in Asia generally seem a bit behind those in Europe, which seem a bit behind those in the US.
US banks look less interesting than their foreign peers. They are further along in a favourable economic cycle, and trade at premium valuations, despite not generating sufficiently higher returns on equity.
In Europe, banks ING Groep and Bank of Ireland look attractive. Both are well capitalised and should be able to earn competitive returns over the long term, but both have traded at a steep discount to book value and at single digit multiples of earnings.
Japan’s banks appear especially attractive. It’s said of banks that you write bad loans in the good times, and good loans in the bad times. There have been a lot of bad times in Japan since its bubble burst in 1990. In general, these banks have their balance sheets in order, they’re relatively well-capitalised, and they are in a supportive environment where regulators want them to earn more money and are happy for them to pay that out to shareholders. On current profits and pay-outs, banks like Sumitomo Mitsui Financial Group and Mitsubishi UFJ Financial Group trade at 8-9 times earnings, with dividend yields of about 4% – already appealing.
But where Japanese banks could truly shine is if interest rates rise in Japan. Though the Federal Reserve, European Central Bank, and Bank of England have all been racing to increase interest rates, the Bank of Japan has stood alone, keeping negative short-term rates, and pinning the yield on 10-year Japanese government bonds.
With inflation now running well above the official 2% target and the Japanese yen having touched decades-low levels against the dollar, the Bank of Japan’s policy has begun to come under pressure. Interest rates may soon have to rise. If they were to rise from zero to 2%, the earnings of Japanese banks could approximately double, leaving them on 4-5 times earnings with 8-10% dividend yields—far too cheap. With the stocks trading at a 40% discount to book value today, we pay very little for that upside potential. When, or indeed whether, such a policy shift may come, we cannot be sure. But the tweak in yield curve control just before year-end is a positive sign of change.
The Japanese banks are paying dividends, but earnings are depressed. The Korean banks are the other way round. They have the earnings power, but not the pay-out ratio. Korea’s banks have made faster progress than their Japanese counterparts in terms of earnings recovery, but much slower in shareholder returns. This, too, may be changing, as activist investors begin to push for reform, emboldened by the appointment of a more shareholder-friendly leader of the country’s financial regulator. With dividend yields already high, at 7% for KB Financial, Hana Financial, and Shinhan Financial, increased pay-outs could make yields too high to ignore, attracting investors. Higher pay-outs also improve returns on equity, because there is less excess capital sitting unproductively on companies’ balance sheets. Higher yields and higher returns on equity should prove a good recipe for higher valuations.
