Is HSBC worthy of investment ten years after the financial crisis?

Thanks to the financial crisis of 2007-2009, I rarely review banks.

That isn’t because I think banks are intrinsically ‘uninvestible’. It’s because most of them suspended their dividends post-crisis and:

However, some UK banks managed to continue paying dividends throughout the crisis, and HSBC is the biggest of them.

So in honour of the fact that it’s almost ten-years since the global stock market lows of March 2009 (when many big banks and other financial firms took us to the brink of Armageddon), I thought it was about time I looked at HSBC to see how it’s coping in this post-crisis world.

HSBC sipped the Kool-Aid like so many other banks

As big banks go, HSBC was relatively well-insulated from the the debt-fuelled insanity of the west’s 2003-2008 housing bubble.

That’s because it’s an extremely international business with major operations in Asia, the Middle East and other non-western markets.

Even so, HSBC was still caught up in both the housing boom and its subsequent bust.

The chart above starts off with a downward blip caused in part by the Argentine Great Depression and and a financial scam known as the Princeton Note Matter. And of course the end of the dot-com bubble and its related economic boom didn’t help either.

But HSBC’s downturn was shortlived.

Thanks to record low interest rates, combined with all manner of newfangled ways to pump money into the housing market, the next few years saw HSBC and other banks grow at an astonishing pace (well, astonishing for such large, old and supposedly steady and boring businesses as banks).

The importance of a wide capital buffer

The key item in the chart above is net asset value, otherwise known as shareholder equity or capital. This is what drives earnings at a bank.

If shareholder equity is growing, and if the company can maintain a steady return on equity (ROE), then its earnings will grow and perhaps its dividend too.

In HSBC’s case, shareholder capital grew from around $45 billion shortly after the Argentine crisis to almost $130 billion at the height of the housing bubble.

That’s a tripling of capital in just a few years, which is very impressive. But it was also entirely unsustainable.

It was unsustainable because despite its growth, capital was becoming increasingly thin relative to the bank’s assets and liabilities.

And that’s important because shareholder capital acts as a buffer to protect depositors when loans go unpaid.

Here’s a very quick and simplistic example.

Imagine a bank which we’ll call Bank S. This bank has:

• Loans valued at £100m (which are a tangible asset from the bank’s point of view as it is owed the money by borrowers)
• Deposits valued at £90m (which are a liability from the bank’s point of view as it owes the money to depositors)
• Tangible shareholder capital valued at £10m (which is a combination of capital raised directly from shareholders plus retained earnings)

If we run into a recession then some of Bank S’s borrowers may default on their loans. With a £10m equity capital buffer the company can shoulder a 10% loss to the total value of its loans before being declared insolvent (which occurs when a bank’s liabilities exceed its assets).

In other words, Bank S has a capital buffer of 10%, which is the ratio of tangible capital to tangible assets (otherwise known as the Tangible Equity Ratio, although I’ll often refer to it as the capital buffer).

Alternatively, the capital buffer can be measured using a Tangible Leverage Ratio, which is the inverse of the Tangible Equity Ratio (i.e. the ratio of tangible assets to tangible capital).

Note: In practice, most banks focus on other ratios such as the Common Equity Tier 1 Ratio (CET1), which is defined by regulators and has a variety of complications such as risk-weighting the value of loans.

As for Bank S, its Tangible Equity Ratio of 10% is very high and suggests the bank could potentially ride out any major crisis without having to raise additional capital through a rights issue.

Before the crisis, HSBC’s capital buffer was far too thin

Back in 1999, HSBC had tangible assets of just over $980 billion and tangible capital of $47 billion.

That gave the company a leverage ratio of 21, or a capital buffer of 4.8%. That may sound like a thin margin of safety, but it was fairly typical back then.

Fast forward to 2007, just before the crisis, and HSBC’s tangible assets had ballooned to $2500 billion while its tangible capital had also grown substantially to about $66 billion.

That gave HSBC a capital buffer of just 3.8% and a leverage ratio of 26.2.

Again, this was not an unusually thin margin of safety at the time and was actually better than many of the other big UK-listed banks.

But it wasn’t enough. Not by a long shot. In 2008, HSBC’s capital buffer fell to 2.6% as the global economy seized up and borrowers defaulted on loans they couldn’t afford.

To save the bank from insolvency, a rights issue, a dividend cut and the sale of non-core businesses were used to increase the capital buffer.

This worked, to an extent, and as a result the company didn’t have to rely on taxpayers to bail it out.

The pursuit of acceptable returns without excessive risk

So that’s the back story, but what’s happened since the financial crisis?

I would summarise the last ten years for HSBC as an attempt to :

1. Reduce risk: By strengthening the balance sheet as new stricter capital requirements have been demanded by regulators
2. Increase returns: By cutting costs, increasing efficiency and directing capital to higher return opportunities

Let’s take each of those in turn:

Reducing risk by increasing the capital buffer

There are various ways to measure bank balance sheet strength. My preferred metrics are:

• Common Equity Tier 1 Ratio (defined by regulators, uses a different definition of ‘capital’ and risk-weights loans and other assets)
• Tangible Equity Ratio (ratio of tangible equity to tangible assets)
• Gross Revenue Ratio (ratio of total income to tangible equity)

For each of these ratios I have a minimum acceptable figure, below which my assumption is that the bank is inadequately capitalised, unless there are some mitigating circumstances (which there usually aren’t).

By a whisker, HSBC just about meets these minimum standards.

As you can see from the chart, the Common Equity Tier 1 Ratio (CET1) has been above my 12% target for the last few years, and 14% is the company’s stated target.

The Tangible Equity Ratio has improved steadily since the crisis and has now stabilised at a level which is just about equal to my 6.7% standard.

As for the Gross Revenue Ratio, it’s fallen from an unsustainable 100% in 2009 to a more sensible 50% or so in recent years.

You may think it’s odd to want to see lower revenues relative to tangible equity, but putting an upper limit on revenues is a sensible way to highlight banks that are doing lots of ‘off balance sheet‘ activity (which is another way of saying a bank is carrying hidden leverage).

If the gross revenue ratio is below 50%, it’s unlikely the bank has much in the way of hidden leverage.

So in summary, HSBC has spent many years strengthening its balance sheet and, as far as I’m concerned, the ‘reduce risk’ side of its recovery is now complete.

Let’s have a look at how the company’s ‘increase returns’ project has gone.

Increasing returns with less leverage has proven very difficult

Pretty much the whole point of leverage is to boost returns on shareholder equity. Given that premise, it’s quite understandable that HSBC’s returns have fallen since the excessively leveraged days of the housing bubble.

But just because a reduction in return on equity is understandable, it doesn’t mean it’s acceptable. And in my opinion, HSBC’s current level of profitability is unacceptably low.

Before the crisis, HSBC’s returns on equity were impressively high at around 14%.

But those returns were mostly due to excessive leverage and an economy where everyone wanted to get rich quick by buying and renting out at least a dozen houses.

The housing bubble imploded around 2008 and since then HSBC’s balance sheet has become much stronger, but its returns have become much weaker.

A reasonable standard for return on equity is 10%, since that’s the sort of return most investors expect from their equity investments.

If you look back through HSBC’s post-crisis annual reports, you’ll see that management were still targeting returns far above that 10% level.

In 2013 for example, management said “we reaffirm our return on equity target at 12-15%”.

However, in 2014 that target was lowered when management said “we are setting a revised return on equity target of more than 10%”.

And then in 2018 the goalpost moved again when management said “our target is to achieve a reported return on tangible equity of more than 11% by the end of 2020”.

So the goal has gradually been widened, making it easier for management to hit their target. Although so far they have still yet to score a single goal.

Note: HSBC’s tangible equity is lower than its equity, so switching from return on equity to return on tangible equity makes a given return target easier to hit. In this case, the old 10% ROE target translates into an 11.4% ROTE target (based on 2018’s balance sheet), so the new 11% ROTE target is yet another widening of the goal.

It seems as if management may be following one of Homer Simpson’s sayings: If at first you don’t succeed, give up…

To be fair, the company has had to deal with steadily tightening regulatory standards and other headwinds such as the UK Bank Levy introduced in 2011.

But even so, the current level of return on equity of about 6% or so is well-below the level I’d expect from a competitive company.

And competitiveness, rather than returns, is really the point.

Yes, it’s probably a bad idea to invest in a company where retained earnings could be reinvested within the company for a 6% rate of return, because you can probably get a higher rate of return from an index tracker.

But what’s worse is investing in a company with no meaningful competitive strengths.

Companies that cannot produce even the market rate of return on equity (10% or so) probably have no serious competitive advantages, because if they did they would have higher returns (either through higher prices or lower costs than competitors).

Companies with no meaningful competitive advantages are at the mercy of competitors, which means their future is very uncertain.

I’m not saying HSBC is about to go bust, but I am saying it doesn’t seem to have any material competitive advantages, and that’s a major problem.

HSBC still has issues to resolve before I would invest

So as things stand today, I wouldn’t invest in HSBC.

While its balance sheet is now strong enough, and its exposure to faster growing markets does make it more interesting than most other UK-listed banks, there are still problems.

Its return on equity is, as I’ve just outlined, simply too low. Unless management can get double digit returns on equity I cannot begin to believe that the company has any enduring strengths.

On top of that, it hasn’t really grown since the financial crisis.

To a large extent this lack of growth has been because of economic and regulatory headwinds, but the fact is that the company’s dividend is still below where it was in 2003.

Ultimately, I’m not willing to invest in a company with no track record of growth, weak returns on equity and no material competitive advantages, regardless of price.

Having said that, HSBC does have a very attractive dividend yield of almost 6%.

So, if that dividend can be maintained, and if the company can increase its return on equity back up to that 10% level, and if that growth of return on equity led to growth in its earnings, then maybe, just maybe, I would invest at today’s price.

But that’s a lot of ifs and maybes, so for now HSBC will stay on my stock screen but not in my portfolio.