Are US banks currently attractive investments?
By Matthieu Duchesne, Head of Investment and Research at KCL Asset Management
The market value of US banks has been pushed down in the past few months. The pace of the coronavirus pandemic and the risks it poses to the credit market has significantly contributed to keeping prices low despite the recoveries seen in other sectors. Additionally, some leading investors were driven away from banks early on this year. Was it because the long-term fundamentals of banks have been definitively downgraded or was it to free up cash to temporarily place it in safer assets? Even if fundamentals have been hit, did they change as significantly as price variations hint? As shown below, banks’ fundamentals were, on average, on relatively good tracks pre-pandemic, before they were impacted by exogenous events. Assuming these events are temporary and extraordinary, is it possible to show that US banks are currently under-priced?
Eight of the biggest banks in the US will serve as proxies to conduct this analysis: Bank of America (BAC), Goldman Sachs (GS), JP Morgan (JPM), Bank of New York Mellon (BK), US Bancorp (USB), Citi (C), Wells Fargo (WFC) and Morgan Stanley (MS).
As of FY19, debt levels are about normal for half of the banks, with JPM, BK, USB, and WFC all having an Adjusted Debt to Equity ratio around or below 1.50 (as low as 0.88 for USB) but going as high as 3.08 for MS and almost 2.00 for BAC. GS and C both stand around 1.70, but the size of their interest charges pose bigger threats to the two companies as they represent around 50% of their respective gross incomes. This type of operating leverage is especially dangerous in the context of recession. In particular, GS earns its fixed charges 1.31 times, the same as WFC, being the lowest performers bar MS which earned them 1.28 times. JPM, BK, USB, BAC and C are all around 1.40-1.45, with BK & JPM down and up the scale at 1.37 and 1.49, respectively.
In terms of financial sanity, MS is clearly the lowest performer with its high gearing and low earnings above their fixed charges. USB takes the lead with a low gearing and fixed charges earned 1.48 times.
USB is also one of the most conservative in terms of balance of short term (ST) and long term (LT) debt behind WFC and JPM. In fact, it disposes of 58 cents of ST debt for every dollar of LT debt against 0.45 for the average-geared WFC and 0.41 for the even-safer JPM. GS, C, and MS all stand around 0.65. BAC and BK are the most aggressive with 1.10 and 1.25 respectively, although their high growth should facilitate their access to additional ST capital if need be. The other less aggressive banks still have some room for borrowing, provided the capital market window does not close excessively in the coming months.
On average, margins were good at US banks with around 75% of gross margin for all but GS and C, who hovered at around 65%. Operating income to gross was around 40% for BAC, JPM, and USB. BK and C were slightly more leveraged with around 35% of operating to gross. The highest operating leverage was used by GS, WFC, and MS with a ratio close to 30%. In addition, profit margins were standing quite high for half of the banks, being around 25% for BAC, JPM, and USB, with BK next at 21%. WFC and C were close to the 20% threshold - 18.81% and 18.75%, respectively - and GS & MS were the lowest performers with around 16%, which is still reasonably high.
In terms of growth over the past seven years, the aggressive BAC is the highest performer. BK, the second most aggressive as per their balance of ST and LT debt, has experienced high growth too with EPS of 4.51 in FY19 against 2.03 in FY12. This is not as high, however, as BAC which registered EPS of 2.75 in FY19 from 0.25 in FY12. JPM’s growth had been relatively stable up until a boom in the last two years. GS, MS, and C have experienced much more volatile albeit positive growth. In comparison, USB went through a steadier increase in its earnings in the same timeframe. USB was also the most efficient bank with an ROA of 1.49, ahead of WFC with 1.27. Next are GS, JPM, and BK with around 0.90, followed by BAC, C, and MS with an ROA close to 0.65. ROE performances were equally spread, with USB on top at 13.77 and C rounding out the bottom with 5.64.
In terms of earning power, USB appears to be the top performer if steadiness of earnings and efficiency are preferred. C, on the other hand, is the weakest performer of the group by this criteria. If high growth is the top criteria instead, then the aggressive BAC and WFC are the best and worst performers, respectively.
Dividends and price levels
The riskiest banks are not necessarily the ones with the highest dividend yield on average. In fact, USB is the second highest yielder with 2.83%, behind conservative but growth-fading WFC at 3.79%. C and GS yield 2.55% and 2.17%, respectively, whereas the lowest yield being offered is 2.04% by BAC. JPM, BK, and MS all stand near 2.60%. However, since dividends are not guaranteed during this exceptional period, investors may choose to attribute them a lower coefficient than usual in their overall analysis. Prices are more interesting and informative as all eight situate their PE ratio on or below the 10 threshold, with WFC being the cheapest at 5.93 followed by C at 6.34. Next are BK and USB standing around 8.50, followed by BAC, JPM, GS, and MS with PE ratios between 9.50-10.0.
It is important to note that these PE ratios are calculated with FY19 diluted EPS, not with TTM EPS. This is due to the assumption made at the beginning of the article that the pandemic period should be considered as extraordinary, thus leading us to use the aforementioned PE’s instead. Whether the banks are attractive or not at these prices is for each investor to decide, but what is for certain is that these low-PE companies were far from the worst pre-pandemic performers in the US.
1. The amounts of depreciation used in calculations for BAC, GS, JPM and MS are in fact the amounts of D&A. For simplicity, D&A was used as a substitute since Bloomberg did not provide depreciation data.
2. The data used in this article was obtained from Bloomberg and no claim is made as to its accuracy and correctness.
3. The discussion in this article is not investment advice.
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