|Chart 1: S&P financials index and p/b ratio
|Chart 2: Average p/b ratio for us financials
Investors of global financials would have gone on a nasty roller-coaster ride in recent months with announcements of both negative and positive earnings forecasts and also, the anticipation of the long-awaited details of the plan to suck out toxic assets. In March 2009, Insurance giant AIG posted a record loss of $61.9 billion in the final quarter of 2008. On the other hand, Citigroup required the third rescue from government in less than four months. HSBC holdings Plc also announced that its full-year net income in 2008 would fall 70% after losses in the North American business.
On 9 May 2008, we wrote our first report on global financials (Global Financials Back in Contention). At that point of time (end April 2008) the book value of US financials was at 1.46X. As a recap, the basis for recommending the financials was that the Price to book ratios was already at very low levels. US financials traded at a lower PB ratio only during the Savings and Loans Crisis, hitting the lowest of 0.94X in September 1990. As at 20 March 2009, the PB ratio of stocks underlying the S&P US Financials index was only 0.63X, which is much lower than the 1.46X that we saw last year.
At that juncture, banks around the world have written down US$ 231.8 billion worth of debts and assets. From April last year till now, there has been a continuous strong spike in write-downs of bad assets. The total write-downs as at 23 March 2009 rose more than five-fold to US$1.23 trillion. In the third quarter of 2008, continued pessimism and bank failures (including the famed filing for bankruptcy by Lehman Brothers) clouded financial stocks and investors feared that more banks would get nationalized and could not survive this crisis. From end April 2008 to end December 2008, the S&P US Financials fell a further 56.9%.
Despite a continued spur of negative news which resulted in confidence being battered, there has been a rebound in the performance of US financials in March. The S&P Financials index jumped 34.3% in a mere two weeks from 6 March to 20 March 2009. This was the strongest surge since November 2008 and was ironically led by the hard-hit banks. Citigroup (Citi) and Bank of America soared 154.4% and 97.1% respectively during this period. Returns are in USD terms.
At this juncture, it would be difficult for anyone to reach a conclusion that the rally is sustainable. However, a comparison between what we have written in end April 2008 and the situation now would be that, more bad news has been priced into financials, which that of the US are trading at levels lower than 0.94X, a level reached only during the past financial industry related crisis – the Savings & Loans crisis.
Many investors are still skeptical as to whether the current market rally is sustainable and if the rally is backed by good fundamentals. Thus, we felt a need to find out the three main reasons behind the rally and present our take on how investors should react to the recent rebound.
Reason 1: Banks Reassuring Profits
First and foremost, the shares in US banks climbed following Citigroup’s reassurance on its profits. Prior to the surge, Citigroup's shares traded around $1 in most days of early March 2009. In the memorandum to employees, Citigroup’s CEO said the company’s share has been undervalued because of the misperception of its financial position. In fact, the company enjoys the best quarter-to-date performance since the third quarter of 2007. In the first two months of 2009, Citi managed to record a profit of $19 billion. The pro-forma tangible common book value of $3.82 per share would also indicate that Citi’s shares were seriously undervalued.
On top of that, the bank’s Tier 1 ratio was at 11.9% as of end December 2008, assuming 100% participation in the exchange of preferred shares into common stocks. They have also done their own stress testing by using more conservative scenarios than the Fed has outlined. The encouraging result shows Citi’s strong capital strength and reduces the chance of being nationalised.
|Table 1: Quarterly Revenue Estimates
|Bank of America
|Source: Bloomberg, in Billions, in USD terms, consensus estimate as at 23 March 2009
|Table 2: Quarterly Earnings Estimates
|Bank of America
|Source: Bloomberg, in Millions, in USD terms, consensus estimate as at 23 March 2009
Apart from Citigroup, Bank of America (BofA) and JP Morgan also expect profits in 2009. BofA expects to generate more than $100 billion of revenue in 2009 and would probably post a net profit for the year. Tables 1 and 2 shows the consensus estimates for the three banks that has been in the limelight recently. Aside from Citigroup (which consensus estimates are only expecting a turnaround in 4th quarter of 2009), the other big banks including BofA and JP Morgan are expected to see positive earnings for 2009. The bank is also confident that they would pass the government's stress tests and would not require more capital from taxpayers. JP Morgan also expects to achieve profitability in 2009 and the first quarter earnings will achieve the market expectation.
Reason 2: Treasury Secretary’s Plan
Investors have had various reactions to Treasury Secretary Tim Geithner‘s unveiled policy action on the industry. The significance of these measures would be the ability to restore the confidence of investors who have been disappointed by the actions of US government to rescue the economy since the burst of the financial crisis. For example, the much anticipated $700 billion troubled asset relief programme (TARP) bail-out that has had limited influence on the banking sector so far. TARP has been widely criticized because the amount involved was believed to be insufficient to stabilise the banking system and to boost banks to lend. Moreover, Geithner’s financial stability plan to shore up the troubled banks was lacked details and failed to assure investors that the government could solve the problem.
On 12 March, US Treasury Secretary disclosed a more complete proposal to encourage US banks to sell the troubled assets. The plan would offer subsidies via low interest federal loans to entice private investors like hedge funds and private equity firms to buy distressed assets. The Treasury also plans to expand lending through the Term Asset-Backed Securities Loan Facility (TALF). This would help to leverage the declining amount of funds from the TARP, given contributions from private investors to purchase the toxic assets (mostly residential and commercial mortgages). It would also create incentives for banks to resume lending. On 23 March, further details were given on the plan, which suggested that the TALF will provide US$ 500 billion in financing to private investors to get these investors to buy up distressed assets owned by the banks. The Treasury department said that the programme could be expanded to as much as US$1 trillion. With more concrete plans on the cards, financials continued to soar.
The rescue plan is important because those toxic assets have been hurting the US banking system by weighing down the bank’s balance sheets and damaging their ability to lend. More importantly, details of this plan showed the determination and ability of Obama’s administration to tackle the core problem of financial crisis. Having said that, it can help to restore investors’ confidence on the US government as well as the economic outlook.
Reason 3: Attractive Valuations Spurring The Panic Buy
The first two reasons are news driven as they are largely driven by news regarding the most recent profits of bigger banks in the US and also the actual steps taken to clean-up the balance sheets of US banks. However, there is one factor that we think could be more fundamentally driven – the already low Price to Book and Price to Earnings ratios. As at 6 March 2009, the S&P Financial Index dropped 84% from its peak in February 2007, surpassing the drop in the S&P's information-technology sector from its peak in March 2000 to its trough of October 2002.
The current PB ratio of U.S. financials (see chart 2) has dropped far below to its 1990s level, when the U.S. economy fell into a recession following the savings and loans crisis. The ratio stands at 0.74X as at 23 March 2009, much lower than the 18-year average of about 2.2X. This simply means that the banks’ shares are trading at a considerable discount. The discount reflects lack of confidence, possible further write-downs the near future and fear over banks being nationalized (or getting a large portion of their shares controlled by the government).
What we can now see on chart 2 is that, with the price-to-book ratio at levels below 1X, investors are paying much less than a dollar to get one dollar of the bank’s assets (net of liabilities and intangibles). This represents value for investors, which is probably one of the reasons why we see the market responding very quickly to any good news being disseminated by buying up depressed financial stocks very quickly in the past two weeks.
Volatility Continues, Financials Not for Faint Hearted
We believe that volatility in the financial sector will likely sustain in the short term as there may be a section of investors who are taking a look-and-see approach on the situation of banks to shore up their tangible common equities. These people will likely wait for the results of the Fed and the treasury’s bailout plan.
However, for aggressive and long term investors, it could be the time to reconsider the investment values and opportunities of US financials. The previous indiscriminative sell-off in the financial sector was irrational and made these stocks attractive on conventional valuation basis. However, do take note that financial stocks are not for the faint-hearted. Thus, we recommend this only to long-term Investors, who are willing to take the risk of short-term fluctuation of share prices for a potentially large reward in a 3 to 5-year perspective.
Another method of entering into financials would be through the dollar cost averaging method via a regular saving plan. Due to market volatility, it is also suggested to include US financials funds as part of the supplementary portion (which usually takes up not more than 20% of the overall equity portfolio for an aggressive investor) of the core and supplementary portfolio.
FLF Equity Finance World EUR
Fidelity Global Financial Services EUR
UOB United Global Capital Fund
Parvest Europe Financials (EUR)
Global Financials Back In Contention - Part I
Global Financials Back In Contention - Part II
Global Financials: Dead Cat Bounce or Sustained Rally?