Oh the banks! (1)

And HSBC Holdings PLC

 

Run on Northern Rock, 14 September 2007, courtesy Wikipedia

 

Everyone in the land was shocked by the collapse of three of Britain's largest banks in late 2008. And every investor in the stock market either saw the value of his bank shares crash by as much as 98% or thanked his lucky stars that he had the foresight or luck not to be invested in them. At one point, shares in RBS, HBOS, LLoyds and Barclays had all lost more than 90% from their previous highs.

Peak support for the banking system amounted to 1.16 trillion pounds (79.4% of 2008 national income), of which 133 billion was in cash according to the National Audit Office. Today, the taxpayer is still 115 billion pounds cash out of pocket.  

Subsequently our banks have been heavily fined for miss-selling payment protection insurance to their customers, rigging interest rates, money laundering for drug cartels and breaking the sanctions on Iran.  

Memories of dramatic events can influence our behaviour for generations. The German fear of inflation harks back to almost 3 years of hyperinflation in the early 1920s. One dollar was then worth 4.2 trillion German marks. It is understandable that British investors are wary of the banks. Indeed both RBS and Lloyds offer little for the investor; they pay no dividend and the shares held by the government, via UK Financial Investments Ltd, overhang the market. RBS continues to surprise observers with its ability to lose vast sums of money, this year to the tune of 8 billion pounds.

However, the banking sector is too large to ignore and investors will recall that the banks will be among the first entities to benefit from a sustained recovery in their markets. Four large banks listed on the London stock exchange, HSBC, Barclays, Santander and Standard Chartered, are worth a look.

Comparing the banks is a useful exercise.

1. Valuation	HSBC	Barclays	Santander	Standard Chartered
Share price	635p	273p	519p	1301p
Share price/net assets	1.16	0.75	0.82	1.12
5 yr PE ratio (1)	17	24	10	12
Net dividend yield	4.7%	2.2%	9.6%	4.2%
Return on Equity (2)	8.3%	1.4%	5.4%	10.4%
2. Balance sheet
CoreTier 1 capital/assets	13.3%	11.1%	11.7%	13.0%
Equity/assets	6.4%	3.3%	6.4%	7.0%
Cash/total assets	6.2%	7,3%	9.3%	8.9%
Loans/ deposits	74%	102%	108%	77%
NPL coverage (3)	41%	52.8%	72.6%	66%
3. Other
Efficiency (4)	53.5%	78%	49.9%	51.4%
Long-term credit rating	A+	A	BBB	A+
Market capitalization	122bn pounds	43bn pounds	60bn pounds	31bn pounds

(1) Average earnings per share 2008-12. (2) Most recent period of EPS/NAVPS. (3) Provisions/non-performing loans %. (4) Cost/revenue.

While banks, by the nature of their business, can be quantitatively analysed to exhaustion, investors will note:

1. Lessons from the financial crisis include,

·         Banks can report profits when they are on the verge of bankruptcy. Unlike trading companies, bank Income statements only indicate, broadly, how the business is going. In February 2008, RBS reported a 10 billion pounds profit for 2007, when in reality it was bust.

·         As banks are highly leveraged, any analysis must start with the bank's balance sheet, though even the Chairman or the Regulator might not understand what the trillion or half trillion in derivative assets mean. For investors too this is an opaque account. While liquidity, reserves, provisions and capital ratios are all useful indicators, none is definitive. The CEO of the Financial Services Authority informed the public that Northern Rock was solvent two days before it ceased trading.

·         Credit ratings, vitally important for banks, can turn on a sixpence. The Cooperative Bank lost six notches in its credit rating in one day last year, and then promptly defaulted on its obligations.

 

2. Political risk can only be assessed by reviewing the geographic location of assets and income.
 

3. Bankers are adept at bypassing rules that they find inconvenient. Off balance sheet items and the valuation of assets, especially derivatives, are a cause of serious risks. It is worth scrutinising management's record.

4. Some banking businesses are more volatile than others are. And volatility in combination with highly leveraged balance sheets means more risk.

5. Some bankers will do anything to earn a big bonus. They risk all on acquisitions and speculative investments, as RBS, Barclays, HBOS and the Cooperative Bank did. They underestimate risk for investments that offered higher returns (Collaterised Debt Obligations et al). They manipulate earnings per share by not making sufficient provisions for bad loans - a common practice. And, if necessary, they disseminate false hopes to the investing public to successfully make a rights issue as both RBS and HBOS did in 2008. Investors should never forget what they have done in the recent past.

----------------------------------------------------------------------------------------------------

HSBC Holdings PLC

View to Hong Kong from Kowloon, by the author

 

The Hong Kong and Shanghai Banking Corporation (HSBC) is, with Wells Fargo, the largest bank by assets and market capitalisation outside China. And Hong Kong is still its most profitable market. Of course size is not a guarantee of success. Six of the world's ten largest banks in 2008, led by RBS, had to be rescued by governments or by other institutions during the financial crisis. But size does enable a bank to gain returns to scale from IT, marketing, provide a broad service for multinationals and access new markets.

According to Interbrand, HSBC and JP Morgan are by far the most valuable brands in banking. HSBC is widely spread geographically, though dependent on Asia Pacific for its earnings (data from  HSBC's 2012 Annual Report).

% Business	By Risk Weighted Assets	By Operating Profit	By Gross loans and advances to customers
North America	33.5%	5.4%	14.3%
Europe	28.4%	14.5%	46.2%*
Rest of Asia Pacific	18.2%	35.4%	13.7%
Hong Kong	15.1%	33.9%	17.2%
Other	4.8%	10.8%	8.6%
US dollar value	$521bn	$18.6bn	$1,014bn

Source: 9 months data from HSBC *Of which 77% is in the UK

The failure of the American unit stands out. HSBC bought Household Finance Corporation, the second largest subprime lender in the US, in 2002. HSBC stopped Household's trading in 2009 while providing $16.3 billion in bad loans and a $10.6 billion write-down on its purchase. The bank immediately followed this with an $18 billion rights issue, which saved it from insolvency.

Today the risk is more obviously political and centred on East Asia. Japan and China dispute ownership of the Senkaku Islands. Japan, along with some other South East Asian nations, disputes China's new Air Defence Zone and its Economic Zone in the South China Sea. The war of words could spread to military confrontation. And there is always the threat of a possible conflict between North and South Korea. Kim Il Un, the new leader of the North, seems to be an unbalanced individual. If measured by gross loans and advances, HSBC has 21% of its balance sheet at risk in this region.

At the March 2009 stock market bottom, HSBC shares were 'only' 63% below the previous high. Since late 2009, the shares have traded in a fairly narrow band.

Graph courtesy Yahoo, click to enlarge

 

But HSBC has made progress since the rights issue that repaired its balance sheet. Consider:

 

1. The balance sheet is strengthened. Core Tier 1 capital is up from 9.4% in 2009 to 13.3%, while the equity to asset ratio has increased from 4.7% to 6.4%. And loans to deposits are down to 74% from 77%. However, the one ratio that has deteriorated is Non-performing-loan coverage, which is down from 73% to 41%. This is a concern as gross impaired loans have increased from $28 billion in 2009 to $39 billion in 2012, or from $8 billion to $22 billion after impairment charges.

 

2. HSBC's net asset value per share has increased by 28% since 2009, yet the share price is no higher now than when the bank reported 2009's result early in 2010. The bank's shares trade on a price that is just 16% more than its net asset value.

 

3. Earnings per share has more than doubled in this period, bringing the bank's historical PE ratio down to 14.

 

4. HSBC has increased the dividend by one-third since 2009, so that the shares currently yield 4.7%.

 

5. Return on equity is up from 5.1% in 2009 to 8.3% in 2012.

 

My valuation model, which assumes no great political risks, values HSBC shares at about 735p.* This is 17% above the present price of HSBC shares, which some investors might consider a sufficient margin of safety.

*EPS growth 10% per annum, equity per share growth 6%, return on equity 9%, average PE ratio 13.5, dividend payout 60%, all discounted at 10.9% (SLXX 3.9% + 2% operating risk + 5% margin of safety) for 2013 to 2017.

 

Investors will want to consider:

 

1.  The risk of a political crisis, perhaps leading to war, in East Asia, and the consequences for a bank that has so much invested in the region.

 

2. The $22 billion of impaired loans that are not covered by provisions. This represents 12% of net assets and it is equivalent to a full year's pre-tax profits.

 

2. Directors have overwhelmingly sold shares in the last 12 months. Major sales total 1.5 million pounds at prices ranging between 710p and 726p a share. One director bought 78,000 pounds of shares at 703p.

 

4. HSBC faces legal action in several US mortgage securitisation cases. The money at risk has not been quantified. As regulators continue to scrutinise the activity of banks in recent years, HSBC might face further large fines and damages.