High yield value investing
“First, let’s analyze why the financial crisis occurred. If I could sum up the catastrophe in one word, it would be ‘leverage.’ “Steve Eisman (reimagined as Mark Baum in The Big Short)
Over the last few weeks we’ve looked at a collection of metrics designed to identify above average companies. These were:
- Growth Rate, which measures the per share growth rate of revenues, capital employed and dividends over the last ten years
- Growth Quality, which measures the consistency of per share revenue, earnings and dividend increases over the last ten years
- Net Profitability, which measures average net return on lease-adjusted capital employed over the last ten years
- Debt Ratio, which compares total borrowings to ten-year average earnings
These metrics work for the majority of companies, but not for banks. Since banks only make up a very small part of the UK stock market, one entirely reasonable response would be to simply exclude them from your investment universe.
However, I have nothing against banks in principle, so I would like to be able to analyse them and invest in them if the combination of quality and value are attractive.
So this week I want to focus on a couple of points: 1) What makes banks different to other businesses? 2) What bank-specific metrics do we need to be able to analyse and invest in them?
What makes banks different to other businesses?
Before we get into the details, here are a few definitions you should know:
At the risk of stating the obvious, banks are lenders. They lend out money to people and businesses in the same way that landlords lend (lease) property to retailers and equipment hire firms lend equipment to builders.
The customer gets access to the leased asset (whether that’s money, a shop or a digger) and has to pay interest, rent or other fees for the privilege. At the end of the loan period the asset (the loan, shop or digger) has to be given back to the lender.
So far banks seem to be the same as any other lender, but there is a difference. The difference is that money, unlike property or construction equipment, is a pure commodity. In other words, £100,000 borrowed from one bank is identical to the same amount borrowed from another bank.
This makes money lending a very low margin business in most cases, so the only way for banks to make a reasonable return on their capital is to lend enormous sums of money.
However, even though banks can create money out of thin air, they still need to fund some of their lending activities with equity capital and debt capital. For example, from a bank’s point of view customer deposits are long-term borrowings which will be used to fund long-term loans such as mortgages. As a result most banks have borrowing levels which would be unthinkable in any other business.
So the first difference is that the Debt Ratio doesn’t work for banks. We’ll need other metrics to measure bank balance sheet strength. Also, if we just assume that all bank borrowings are debt capital, then returns on capital employed for banks would be horrendous because of their enormous debts. This means we’ll need to update the Profitability metric as well.
Another difference is that bank’s don’t have revenues as the top line of their income statement. In most cases they’ll have interest income instead. Since revenue is used in the Growth Rate and Growth Quality metrics, these won’t work for bank’s either. At a minimum, we would have to use interest income instead of revenues in the Growth Rate and Growth Quality metrics, although in practice I use something else instead.
Updating Growth Rate for banks
The first thing I look when analysing a company is its Growth Rate, so let’s start there.
As I mentioned above, the problem with Growth Rate is that it includes revenue per share growth. Banks don’t report revenue, so clearly something has to replace revenues. But what?
Replacing revenue growth with total asset growth
The Growth Rate metric includes revenue because it’s the total amount of money coming into a business from its customers. This is important because it’s the original source of cash from which all future earnings and dividends flow. If revenues per share aren’t growing then any earnings and dividend increases will not be sustainable in the long run.
For banks, the top line of the income statement is usually interest income. However, interest income is strongly affected by inflation and central bank (e.g. Bank of England) interest rates, so a bank can see its interest income increase simply because central bank interest rates have increased, rather than because the bank is making more loans. To get around this, some bank analysts will look at net interest income, which looks at the income margin between the interest income on loans and the interest expense on borrowings. Since interest income and interest expense are both affected by interest rates in a similar way, net interest should be less affected by inflation or central bank policy.
Although net interest income is a reasonable alternative to revenue for banks, I think a more fundamental measure of future cash income from customers is the total amount of loans outstanding. Growing income by lending more money to more people is the most sustainable form of growth for banks. It’s far more sustainable than increasing interest income by lending to higher and higher risk (and therefore higher interest-paying) customers, and far more sustainable than reducing interest expense by using shorter and shorter-term funding sources (and don’t forget that using very short-term borrowings to fund very long-term loans was the main reason Northern Rock failed). So for me, total loans outstanding is the original source from which future bank earnings and dividends will flow.
Outstanding loans are recorded on the balance sheet as assets (under various names), and in total they’re usually the largest asset on the balance sheet. Given that the rest of a bank’s assets exist to support its lending business, I think a reasonable simplification is to measure the growth of a bank’s total assets rather than trying to specifically pick out the loan assets.
So, our first tweak for banks will be to use total assets per share in the Growth Rate metric instead of revenues.
The second component of Growth Rate is capital employed growth, so let’s take a look at that now.
Using operational borrowings instead of total borrowings
Banks have vast borrowings, mostly (but not always) in the form of customer deposits. If we used total borrowings in our calculation of lease-adjusted capital employed, capital employed for banks would be huge and their returns on capital would be terrible.
This would not paint a fair picture of a bank’s true profitability. With banks then, we need to separate out operational borrowings used to buy property or computers from borrowings used for other reasons, such as funding lending or protecting depositors. Here are some definitions:
In terms of calculating capital employed, we’re mostly interested in operational borrowings. Sometimes it will be easy to spot on the balance sheet with a clear name such as “operational borrowings” or “loans and overdrafts from other banks”. But in many cases you’ll have to look in the notes to the accounts, at the back of the annual report, rather than just the balance sheet.
In fact, in some cases you may not be able to come up with a value for operational borrowings, in which case you can either put that bank to one side or carry on in the knowledge that you are missing some information.
So far we’ve looked at revenues and capital employed, and that leaves the last component of Growth Rate, which is dividend growth. Fortunately dividends are no different for banks, so there’s nothing to change.
In summary then, Growth Rate for banks will measure growth across:
- Assets per share
- Lease-adjusted capital employed per share (using operational debt capital rather than total debt capital)
- Dividends per share
Calculating Growth Rate for banks
Here’s a quick summary of the calculation:
Steps to calculate Growth Rate for banks
Note: The caret symbol (^) is used to identify exponents, so in the calculation above, “^1/7” should be read as “raised to the power 1/7”. The seven is there because two three-year periods at the start and end of a ten-year period are effectively seven years apart.
We’ll work through an example in a moment, but first we need to update the Growth Quality metric.
Updating Growth Quality for banks
Growth Quality measures the consistency of growth across three important factors: revenues per share, earnings per share and dividends per share.
Respectively these represent the total income from customers, the net income after all expenses and the amount paid out to shareholders.
Banks don’t report revenue, so Growth Rate uses assets per share instead. This applies to Growth Quality as well, giving the following bank-specific calculation:
Steps to calculate Growth Quality for banks
Updating Profitability for banks
My Profitability metric is based on average returns on sales (ROS) and average net returns on lease-adjusted capital employed (net ROLACE). Here’s a quick refresher on how to calculate these ratios:
Return on sales is the ratio of net earnings to revenues:
ROS = net earnings / revenues * 100%
Net return on lease-adjusted capital employed is the ratio of net earnings to the sum of shareholder capital, debt capital and leased capital:
Net ROLACE = net earnings / (net assets + borrowings + lease liabilities) * 100%
To calculate Profitability, take the ten-year average of ROS and net ROLACE and calculate their combined average, so:
Profitability = (10yr avg. ROS + 10yr avg. net ROLACE) / 2
To make this ratio work for banks, we need to replace ROS and net ROLACE with their banking equivalents.
In place of return on sales we’ll use return on assets (ROA), and in place of net return on lease-adjusted capital employed we’ll use net return on lease-adjusted net assets (net ROLANA).
Steps to calculate Profitability for banks
Banking rules of thumb
To keep things simple, I mostly use the same rules of thumb for banks as I do for other companies. However, one difference does appear with return on assets, which replaces return on sales.
For return on sales, I have a rule of thumb minimum of 5%, but banks almost never produce a return on assets of more than 5%. This isn’t necessarily a weakness, but it does reflect the relatively commoditised nature of banking (money is money, regardless of which bank you borrow it from, so it’s hard for banks to differentiate enough to earn high rates of return on such a commoditised asset).
Return on assets for most UK banks has historically been below or close to 1%, so I have set my return on asset rule of thumb at 1%, minimum. Here’s the initial set of banking rules of thumb:
Defensive value rules of thumb
Additional ratios for banks
So far we’ve updated some of the core metrics so they work for banks. In addition, I use some bank-specific ratios which help me assess the strength and profitability of a bank’s balance sheet, both of which are important factors given their highly leverage nature.
The Net Interest Return ratio
In the previous section we looked at return on assets as part of a bank’s Profitability score. The problem with return on assets is that returns can be skewed upwards if a bank has significant non-lending activities such as fund or wealth management.
It would be useful to isolate the performance of the bank’s lending business, and one way to do that is to look at the ratio of net interest to tangible assets.
Since tangible assets are mostly made up of loans to customers, this ratio tells us how much income the bank is generating from its lending activities, net of the cost of those loans to the bank.
It’s a simple ratio which isolates the profitability of a bank’s lending activities, and I use the following rule of thumb:
Defensive value rule of thumb
Most banks don’t exceed that 2% hurdle rate, which means that only the most profitable banks will ever end up in a defensive value portfolio.
The Common Equity Tier 1 Ratio
Imagine a bank with £100m of customer deposits held across thousands of current accounts. Those are the bank’s liabilities (otherwise known as its sources of funds). The bank has loaned £99m of those deposits out to small businesses and homebuyers, leaving £1m in its vault as a daily cash float. Together the loans and cash float make up the bank’s assets (otherwise known as its uses of funds).
In that simplified example everything works fine when all loans are repaid on time, but in the real world some loans are not repaid on time and some are not repaid at all. If £5m of the bank’s loans are not repaid (i.e. are defaulted on) the bank would have £100m in liabilities (those deposit accounts) but only £95m in assets (£94m in loans and £1m in cash). The bank would no longer have enough money to pay back its depositors and so it would be technically insolvent; shareholders would almost certainly be asked to put up additional capital through a rights issue to make the company solvent again.
To avoid this situation, banks use additional sources of funds which act as a buffer to protect customer deposits. This may involve some form of long-term unsecured debt, but the primary buffer is shareholder equity.
Imagine the same bank as before, but this time instead of having £100m of deposits the bank has £90m. It now also has £10m of equity capital in the from of cash, giving the bank the same £100m of funds as before. If £99m is lent out and if the same £5m of loans is not repaid, it has the same default rate as before, but this time the bank’s remaining assets (£94m of loans that will be repaid and £1m of cash in the vault) are still worth more than its customers’ deposits of £90m. In this scenario, current account holders can still get all their money back and so a rights issue would not be required to raise additional funds.
The difference with the second example is that shareholders have absorbed the losses from defaulted loans rather than customer deposits. More specifically, shareholder equity has absorbed the losses by declining in value from £10m before those loans were defaulted on to £5m afterwards.
This sounds bad for shareholders, but if the bank is well run then it should be possible to rebuild the equity during good times (i.e. when loan default rates are low) in order to prepare for increasing defaults during the next economic downturn.
The important point is that by having a sufficient buffer of shareholder equity, a well run bank should be able to absorb loan defaults without having to suspend its dividend or raise additional equity capital through a rights issue.
To measure the ratio between a bank’s equity buffer and the amount of loans it has made, I use a ratio called the Common Equity Tier 1 Ratio (CET1 ratio). Common equity tier 1 is basically tangible shareholder equity with a few adjustments which we don’t need to worry about. It is, according to the latest banking regulations, the “highest quality component of a bank’s capital”.
So looking back at that previous example, with its £ 10m of shareholder equity and £ 100m of loans and cash (ignoring the risk weighting of the loans for the sake of simplicity), the CET1 ratio for the bank would be £ 10m divided by £ 100m, which is 10%.
One thing I should point out is that while the CET1 ratio is found in the annual and interim results, you will struggle to find it in older results because it’s fairly new. However, its predecessor, the core equity tier 1 ratio, is very similar and for our purposes the two are interchangeable. If I refer to CET1 then take that to mean either the common or core equity tier 1 ratio, depending on what was in use at the time.
Table 5.1 shows the CET1 ratio for several leading banks, before the financial crisis and after.
|Bank||2007 (pre-crisis)||2013 (post-crisis)|
|HBOS||7.4%||Taken over by Lloyds in 2009|
Table 5.1: Common equity tier 1 ratios for several leading banks before and after the financial crisis
Before the financial crisis, all of the surviving banks in Table 5.1 had lower CET1 ratios than they did a few years after the crisis. It’s interesting to see that HBOS, with the lowest pre-crisis ratio, was taken over, while Standard Chartered, with the highest pre-crisis ratio, was barely hurt by the crisis at all (although there were also many other factors, not least of which was the fact that Standard Chartered’s business operates primarily in markets that were not hurt so immediately by the crisis).
Of course, there’s much more to calculating the risks faced by a large bank than simply looking at its CET1 ratio. However, I think the ratio has a lot of merit to it. It’s usually easy to find the number in the annual reports, it’s used extensively by the banks themselves and it does appear to have a reasonable correlation to how well each bank withstood the stresses of the financial crisis.
As with many of the financial ratios and metrics in this book, I prefer to look at the average CET1 ratio over a number of years.
Calculating the average CET1 ratio
To calculate the average CET1 ratio you’ll need:
- Common equity tier 1 ratio (CET1 ratio) – For the most recent five years. This isn’t part of the balance sheet but it should be found fairly prominently towards the beginning of a bank’s annual results. Older results may refer to the similar core equity tier 1 ratio instead.
There is only one step to calculating this metric:
Steps for calculating the average CET1 ratio
What is a reasonable minimum CET1 ratio?
The latest banking regulations state that a bank must have a CET1 ratio of at least 4.5% at all times. On top of this, an additional buffer of 2.5% (taking the total to 7%) should be built up during good times so that it may, if necessary, be drawn down in bad times. Finally, there is an additional buffer for systemically important banks of up to 2.5%, taking the maximum requirement at any time to 9.5%.
That seems like a fairly reasonable minimum to me. As Table 5.1 shows, before the financial crisis most banks had a CET1 ratio of less than 9.5%. After the crisis they have all moved to ratios above 9.5%.
I want any bank that I invest in to have been slightly more cautious than the maximum caution stipulated by the regulators, so initially my rule of thumb was to insist that the average of this ratio be 10% at least.
However, Standard Chartered passed (one of my previous holdings) passed this test and subsequently ran into major problems, so now by CET1 requirements are even higher .
Defensive value rule of thumb
Given that Standard Chartered has had problems, let’s calculate its average CET1 ratio to see if it passes the new stricter rule of thumb.
Standard Chartered’s common equity tier 1 ratio
Standard Chartered is a FTSE 100-listed bank which operates primarily in Asia, Africa and the Middle East. For a while it was popular with investors because it came through the financial crisis with barely a scratch on it, largely thanks to its small exposure to Western markets and a relatively strong balance sheet.
The common equity tier 1 ratio is quoted in a bank’s annual results and you can see Standard Chartered’s CET1 ratios over the five years to 2018 in Table 5.2.
Table 5.2: Standard Chartered CET1 ratio for the five years to 2018
After running into significant problems in 2015 and 2016, Standard Chartered raised its CET1 target to between 13% and 14%, which is unusually high.
Given that my preferred average CET1 minimum is 12%, Standard Chartered does make it past this hurdle, and is one of very few UK banks to do so.
The Tangible Common Equity Ratio
Although the CET1 ratio is the standard measure of balance sheet strength for banks, I prefer simple ratios which I can calculate myself, directly from the income statement, cash flow statement or balance sheet.
A good candidate for a simple balance sheet ratio for banks is the tangible common equity (TCE) ratio, which is the ratio of tangible shareholder equity to tangible assets.
The key difference between CET1 and TCE is simplicity. The equity part of the ratio is just tangible equity rather than Common Tier 1 equity, and assets are taken as tangible assets rather than risk-weighted assets.
Steps for calculating the tangible common equity ratio
As with CET1, TCE shows us how much of an equity buffer the bank has to protect non-equity sources of funds (such as deposit accounts and subordinated borrowings) in the event of large-scale loan defaults.
A sensible minimum for the TCE ratio
If we look back at the financial crisis it’s easy see what was and wasn’t a sensible TCE ratio. It’s easy because most UK banks had very significant problems during that crisis, and most of those problems were self inflicted through excessive leverage and excessively thin equity buffers.
For example, in 2008, all large UK banks had TCE ratios of less than 4% and in some cases less than 2%. In other words, some UK banks would become insolvent if just 2% of the loans they expected to be paid in full were instead defaulted on. That was a recklessly thin margin of safety as the banks soon found out.
Since then most banks have increased their equity buffers and today many have a TCE ratio of 5% or more. That’s obviously better than 2% and it meets the current regulatory standards, but it isn’t good enough for me.
I don’t have to invest in banks, so if I’m going to invest in a company which is highly leveraged by nature, then I only want to invest in those with abnormal levels of prudence and balance sheet strength.
For me that means demanding an average TCE ratio which is comfortably above the average of any large UK bank:
Defensive value rule of thumb
In recent years, only small and specialist lenders have been able to exceed that 7% hurdle rate. That’s fine by me, because in my experience niche lenders tend to make better investments than the highly commoditised high street banks.
Close Brothers tangible common equity ratio
Close Brothers is a UK-focused merchant bank listed in the FTSE 250. It’s the only bank I’ve owned over the last few years and it has an unusually strong balance sheet. This shows up as a high average TCE ratio, which you can see in Table 5.3.
|Year||Tan. Equity||Tan. Assets||TCE ratio|
Table 5.3: The tangible common equity ratio for Close Brothers
As you can see, Close Brothers has consistently had a TCE ratio far above 7%, which means by that measure at least, it has a very wide equity buffer to protect it when loan default rates surge during lean economic times.
This is in fact a key part of the company’s strategy. Close Brothers nurtures deep relationships with corporate customers who need to know that their bank will continue to lend even during deep recessions. That is precisely when many of its customers need additional emergency funds, either to replace profits which are temporarily depressed or to invest in expansion while other companies are retreating.
Once you have a bank’s operational borrowings, you can use them to calculate the debt ratio:
Calculating the Debt Ratio for banks
The related rule of thumb is the same as for other companies. Banking is a cyclical sector, so that gives the following:
Defensive value rule of thumb
Rules of thumb for banks
Bank-specific rules of thumb
Next week: Insurers
Having covered banks this week, our next step will be to look at insurers, which in many ways are more like banks than other companies. We’ll be reusing some of the updated metrics from this week and introducing some insurer-specific measures as well.