Systematic guide to spotting value in beaten-down lenders

AS we look back at the financial crises that the world has seen in the last 10 years, we might think that bankers never learn from their past mistakes. It's not that. Banks, like a good many other businesses, just want to cash in on the good times. So they lend aggressively when the economy is booming. But by doing so, they can get caught when the economy takes a turn for the worse.

Thing is, when times are looking good, central banks, such as the US Federal Reserve, like to crank up their lending rates. The idea behind that is quite simple. In a strong economy, where wages are rising, consumer prices could rise. But central bankers want to be ahead of inflation. So, they try to ensure that base rates stay above the pace of rising prices.

There is another reason why central banks raise borrowing costs when the economy is strong. They want to keep something in reserve when the economic cycle reverses, which always happens. They want to be able to stimulate the economy with interest rate cuts, when that happens.

So, interest rates can both go up and go down. Whether we are savers, borrowers, home owners or retirees, interest rate movements affect us all. But they matter most to banks. These financial institutions make the bulk of their income from the difference in the interest rates they charge borrowers and the interest rates they pay savers. This is known as the net interest margin.

The higher the interest rates rise, the wider the margin expands, and the greater can be the net interest income for banks. The first chart shows the median net interest income for 14 banks from 11 different countries. It was business as normal for many banks, even after the Great Financial Crisis. Commercial lenders that include China's Industrial & Commercial Bank and Singapore's DBS Group were still generating healthy net interest income, despite the worst financial disaster in living memory.

Balance sheet

However, our fears over many banks' ability to survive the aftermath of the financial crisis were reflected in their share prices. Some of us actually thought that they were about to fall off a cliff. As the financial crisis unfolded, the median market value of banks plunged by nearly two-thirds.

It didn't seem to matter where the banks were located. They were tarred with the same brush. UBS and Deutsche Bank lost 75 per cent of their value, BNP Paribas and Commonwealth Bank of Australia fell 50 per cent, while OCBC shares shed 40 per cent. It was an awful time to hold bank shares.

But it was a good time to be a banker.

While the market values of banks were being depressed by investor pessimism, the same cannot be said of their tangible book values. After an initial dip, the book values of banks improved gradually. In other words, shareholder equity in banks was rising, even though their market value was not.

The tangible book value of JPMorgan Chase jumped by a quarter in 2009, while that of HSBC improved by almost 50 per cent. Bank of China reported a 7 per cent improvement, which was similar to that at Malayan Banking Bhd.

The market, it would seem, was ignoring the balance sheet improvements. Many banks that had previously been valued at more than twice their tangible book value slumped to valuations that would suggest they were on the brink of bankruptcy.

The price-to-book ratio of Commonwealth Bank of Australia fell from a pre-crisis high of 3.6 to just 1.6 in 2009. Bangkok Bank fell from a price-to-book ratio of 1.2 to 0.7, while Singapore's United Overseas Bank's more than halved from 2.5.

Valuation, income

The price-to-book valuations of banks have now recovered to around 1.3. That looks conservative, given that the global economy is improving, gross loans are on the rise and interest rates are hardening. It is possible that as bank profits increase, then so too could their book values.

In hindsight, a good time to have bought bank shares would have been when they were valued at below their book values. But it is not easy to invest when news of the unfolding financial crisis was so dire.

Admittedly, provisions over bad debts did spike in the aftermath of the crisis. But so too did their loan books. Consequently, non-performing loans as a proportion of total loans was not that bad. They had jumped from around 0.2 per cent before the financial crisis to 0.6 per cent in the two years following. They are now back to where they were before the financial debacle.

The lesson is clear. When we invest, it is often easy to let our hearts rule our head. As a result, every financial number that is talked about seems to be equally important. But not everything that can be counted counts.

The important numbers to follow, when we invest in banks, are their net interest income and the price-to-book valuation. We shouldn't go too far wrong if we focus on just those two things. The first will tell us how well they are doing. The second will tell us how much we would have to pay to own a part of their business.

Disclaimer: All analyses, recommendations and other information herein are published for general information. Readers should not rely solely on the information published and should seek independent financial advice prior to making any investment decision. The publisher accepts no liability for any loss whatsoever arising from any use of the information published herein. David Kuo owns shares in HSBC. The Motley Fool Singapore does not own shares in any of the companies mentioned. The Motley Fool Singapore has recommended DBS Group and United Overseas Bank.