Good management and business agility are key to standing out in the banking sector | Capital Group

  • About Our Firm
  • What Sets Us Apart
  • Wealth Planning
  • Latest Perspectives
  • Contact Us

Good Management and Business Agility Are Key to Standing Out in the Banking Sector

By Brian J. Kennedy
Capital Group Equity Analyst

Analyzing the U.S. financial sector has always been unique because of the high levels of leverage many banks carry. This multiplies inherent risk and reward within the sector, making traditional valuation metrics less useful than in other industries. Another factor that complicates my analysis is the intensified scrutiny of the industry and calls for stricter regulations following the financial crisis. Many investors have been shying away from this sector because they believe higher capital requirements will pressure banks’ profitability. Though this is true to some extent, I view the changing regulatory environment as an opportunity. I believe banks with talented management teams have the ability to improve their profits in spite of the higher capital requirements. Furthermore, only certain business segments are affected by these regulations, meaning that financial institutions with the flexibility to adjust their business mix should be able to outperform peers that previously relied on leverage to increase profits.

The advantages of scale for big banks are being offset by tougher rules.

Since the financial crisis of 2008 revealed that the high debt ratios and interconnectedness of large global banks made the entire financial sector vulnerable to collapse, regulations in the U.S. have been proposed to address the size and complexity of banks, thereby limiting the potential risk they pose to the global financial system.

New capital ratio requirements are being phased in through 2019, but most banks are already compliant, with the ratio of tangible equity to risk-weighted assets at an estimated 50-year high. This is a massive and extremely rapid shift from seven years ago, when banks were maxing out leverage. There is an even more conservative computation for the largest, most complex banks. These regulations create earnings headwinds from derisking and deleveraging, but should reduce the impact of credit losses on the valuations of bank equities in the next credit cycle.

Large, complex financial institutions are most affected by the proposed regulations, and even though many of the new capital requirements have been established, there is still a risk that additional legislation could be imposed on banking behemoths. The current environment’s stricter directives have largely offset any advantages of scale that big banks used to have. These Global Systemically Important Financial Institutions (otherwise known as the “too big to fail banks”) require a 10% to 15% larger equity cushion than smaller banks and tend to be more dependent on wholesale funding than on deposits.

However, I still see opportunities in certain banks. I believe those financial institutions with the best management teams will be able to adjust their businesses in a way that will allow for higher returns down the road. Furthermore, there are many signs that the sector has strengthened considerably since the financial crisis. U.S. financial sector profits peaked in 2007 at almost 30% of the S&P 500’s earnings, falling to just 10% during the recession. They have increased significantly since the crisis, climbing back to 17% today. I’m more comfortable with what we’re seeing now than I was with the outsized profits leading into the financial crisis.

Credit costs are finally normalizing because loan losses from the crisis have largely been written off and are returning to historical averages. However, loan growth in the U.S. remains depressed. So far this decade, lending revenue has increased only 4%, compared with an average of more than 100% for the previous seven decades. Banks are holding more securities and highly liquid assets, pressuring return on assets (ROA). As loan demand increases, so will ROA, because securities will be displaced by higher-yielding, wider-spread loans. Typically, loan growth is 1.5 to 2 times U.S. gross domestic product growth during expansions, providing the fuel for a prolonged recovery.

Bank fundamentals are basically back to normal following the financial crisis, except for return on equity (ROE), which is 35% below historical levels. This lower ROE is driven by heightened regulation as greater capital requirements limit balance-sheet leverage.

The amount of capital in the banking system is much higher than before the financial crisis, making the system safer for depositors. Although equity investments in banks are still at risk, I believe there are notable gaps between the market and my expectations for improving ROE, signaling possible areas of opportunity for investors.

Increasingly diverse sources of revenue should eventually drive sector returns higher.

The market seems to be focused on the impact of leverage constraints on ROE, but every other driver of stock valuations is poised to improve over the next three years. I believe the key positive factor will be ROA, driven by improvements in revenue mix. For example, banks with the flexibility to rely less on capital-intensive businesses (lending and trading) and more on service-related functions (advisory services, underwriting and investment management) should do better going forward.

It’s not unprecedented to see higher ROA from less-capital-intensive revenues. Agile human and equity capital is the cornerstone of a successful investment banking franchise, and companies have demonstrated the ability to realign businesses because of changes in environmental opportunities. Banks that participate in mergers and acquisitions may be good investments because M&A activity has traditionally tracked economic prosperity very closely. As corporate confidence improves, M&A activity has the potential to more than double. Discussions with investment banks indicate a revenue multiplier of roughly 5 for ancillary services. In other words, every $1 of advisory revenue can lead to $5 in total client business.

Given my expectations and attractive valuations in the sector, I view the current environment as an opportunity to partner with companies that have strong management teams, flexible business models and the ability to adapt in the face of this new regulatory climate.

When it comes to portfolio holdings, we look for companies that reflect our belief that talented leadership is particularly important in the financial sector. One reason is that mistakes due to a lack of leadership can be greatly magnified, as evidenced by the multiple bankruptcies during the financial crisis of 2008. When researching companies for potential investment, I pay close attention to management’s track record and its ability to create a cohesive culture. This is important because I anticipate there will be much less leniency in the future for banks that exhibit potentially risky behavior that could threaten the stability of the financial system. I believe companies that actively and consistently promote a superior level of integrity in employee conduct are less likely to engage in irresponsible practices than institutions with a poorly defined culture. For this reason, I pay particular attention to the risk management segment of the business and whether there is a system in place to uniformly apply a culture of integrity across all the divisions of the company.

Brian Kennedy is an equity analyst with research responsibility for, among other things, U.S. banks. He has 16 years of investment experience, eight of them with Capital Group. He is based in Los Angeles.

The views expressed herein are those of the author and do not necessarily reflect the views of everyone at Capital Group Private Client Services. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, are subject to change at any time and should not be construed as advice. There is no guarantee that any projection, forecast or opinion will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with an Investment Counselor.