Global Financials: A Value Proposition?

Almost a year into the US subprime crisis, its effects have continued to be felt in the financial markets. Global financial giants UBS has seen shrinking balance sheets due to write-downs, and its share prices plummeting. Those in tune with the markets would have known of the collapse and subsequent acquisition of Bear Stearns, a global investment bank and securities trading powerhouse, by its competitor, JPMorgan.

The ‘big two’ of home mortgages in the US, Freddie Mac and Fannie Mae, have recently been in the spotlight as well. Both companies are US government-sponsored enterprises, whose primary business is to offer loans and loan guarantees, and at present hold about US$ 5,300 billion in mortgages. According to the Financial Times (as of 10 July 2008), the share prices of Freddie Mac and Fannie Mae fell over 87.37% and 84.41% respectively, over a 52-week period, due in part to potential losses arising from the credit crunch.

This crisis has even sparked action from the US Government, which stated that it will seek authority from Congress to lend money to the big two, in addition to investing into their equities and utilising the Fed’s discount window to prevent its collapse. However, in the wake of saving the big two, IndyMac, which is a smaller US mortgage institution, became the latest casualty in the credit crisis. The thrift bank collapsed on 11 July 2008.

With all this negativity in the financial markets, is it still prudent to invest in financials?

Global Outlook for Financials

“It is difficult to be invested in almost any asset class and not to have been impacted in some way from the subprime crisis,” said John J. Doyle III, Executive Director of UOB Asset Management. Echoing his views is Martin Kinsler, fund manager of the Henderson Horizon Fund – Global Financials Fund. “The outlook remains challenging for European financial institutions in 2008.”

Chart 1

Source: Bloomberg

As at 28 July 2008, the MSCI World Financial Index stands at US$106.50, a far cry from its 3-year peak of US$167.25 on 7 May 2007 (see chart 1). This alone would represent a 36.3% decrease in the value of the financials index since then.

Interestingly, the United Global Capital Fund still held 39.39% of its assets in the US markets. Amongst its top 10 holdings are US-based Northern Trust Corp, US Bancorp, Citigroup Inc and the Bank of America. Despite the massive write-downs reported by Citigroup Inc, John states that (the fund) still retains a significant position in Citigroup.

“We still retain a significant position in Citigroup, largely influenced by the strong performance of its international businesses, which has largely gone unnoticed due to the challenges (to its investment banking arm),” says John. He also favours the Bank of America due to its focused business model and performance record. “Bank of America remains the dominant retail bank in the United States, and is one of the most efficient and profitable retail institutions we’ve come across.”

European and Asian Financial Sectors

The Henderson Horizon Fund – Global Financials Fund has been concentrating on financial institutions relying heavily on investment banking revenues or in need of recapitalisation, in the first half of 2008.

“The acute crisis is over and we are now into the recapitalisation phase,” noted Martin. He expects the European financial sector to range bound in the second half of 2008, as its performance is being increasingly driven by macroeconomic factors. Apart from these macroeconomic conditions, an institution’s approach towards its balance sheet management matters too. Noting the difference between UBS and Credit Suisse, John notes that due to this key difference, Credit Suisse has managed to sidestep some of the problems of write-downs arising from toxic assets.

In the UK, Martin favours the Royal & Sun Alliance Insurance Group (R&SA) as well as the Paragon Group of Companies Plc (Paragon). He commented on the quality of R&SA’s prospects due to its strong cash flow generation, good balance sheet and defensive investment portfolio approach. While Paragon has been affected by the sub-prime crisis, Martin explained that the company has “no short-term funding requirement and (is) a better asset quality to peers.” He feels that the company could provide value for investors in the long run.

Martin has a mixed outlook for the Asian and Latin American financial sectors. With 18% of his fund invested in Asia, including positions in the Bank of China, Bank Mandiri and the Fudon Financial Holding, Martin feels that the performance of Asian financial institutions in the second half of 2008 will be dependent on the resilience of the bank’s asset quality and loan growth in a tightening environment. “The impact is likely to differ from country to country. Indian financials are likely to be under further pressure,” adds Martin. He also expects to see strong loan growth in Indonesia despite inflation, and remains optimistic on Chinese banks as their strong pricing power is likely to retain earnings visibility.

Conclusion – PB Ratio: A Value Judgement?

With the Price-to-Book (PB) ratios of some financials falling below 2.0X, is this a good time for investors seeking value to invest into financial stocks? Martin states that the PB ratio has even decreased to below 1.0X for many bank stocks, and is an important indicator of value. Additionally, the PB ratio is also less volatile than the traditional Price-to-Earnings (PE) ratio. However, a low PB ratio is, in some instances, a reflection of uncertainty surrounding the capitalisation levels of financial institutions, such as in its core capital or reserves.

“Current PB multiples are attractive and definitely are a value signal for the sector, but part of our analysis is focusing on the risk of capital impairment for different stocks,” added Martin. John also reflected this view, and stated that PB multiples need to be looked at in the context of a company’s profitability, growth prospects and cost of capital.

Thus both funds employ a holistic approach to selecting their equities and do not only look at PB values. In this fragile financial climate, the need for a more stringent and diverse selection criterion plays an especially important role.

As embedded losses in the financial institutions’ balance sheets become apparent in the near future, the need to identify stocks with profit potential that is not adversely affected by the financial crisis plays an even more important role now.

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