While the results of the U.S. presidential election may have taken financial markets as well as political pundits by surprise, the post-Election Day rally in stocks may be even more of a shocker to some market observers.
Recall that at one point during the overnight hours after the polls had closed on Nov. 8, Dow futures fell more than 900 points on investor fear and uncertainty as President-elect Trump’s upset victory was coming into focus. Yet, since the market close on Election Day and December 19, the Russell 1000 Index has gained more than 6%. Small-cap stocks have performed even better, with the Russell 2000 Index gaining about 15% during that same period.
Among the biggest winners since Election Day are bank shares. In both indices, bank shares have posted impressive gains, with small-cap banks up 26% and large-cap banks up 23%.1
Understanding Bank Value
In our view, perhaps the most important factor driving the rally in bank stocks – as it is with virtually every stock – is value. While the intrinsic value of a bank is a function of a number of inputs, for purposes of this discussion it may be reduced simply to valuation (Price-to-Book ratio or P/B ratio) is a result of profitability (Return on Equity or ROE).
The logic is straightforward: the higher the bank’s profitability, the higher the multiple the market will pay for it. As investors, we will pay a higher price, all else being equal, for a bank that can generate 15% returns on our equity investment than we would pay for a bank that generates a 10% return on that same equity.
If we look at the 35 banks in the Russell 1000 Index, we see that there is a general relationship between the level of ROE and the corresponding P/B ratio – the higher the ROE, the higher the P/B ratio, and vice versa (Exhibit 1).
The implication is clear: if we can identify improvements in ROE, there should be a corresponding increase in the market’s valuation of the bank’s equity.
Components of ROE
In researching banks, the Oppenheimer Value Team tries to understand the building blocks of ROE. The underlying components may be quantified by applying the DuPont formula.2 Generally, the DuPont formula breaks the ROE calculation into three measures:
- Operating margins,
- Asset turns, and
- Financial leverage.
It can be expressed as a mathematical equation as:
ROE = Earnings/Sales x Sales/Assets x Assets/Equity.
For banks we can simplify the equation to read:
ROE = Earnings/Assets x Assets/Equity.
The rationale for this relationship is straightforward for banks. A bank’s business model is essentially to borrow money from depositors and lend those deposits in the form of loans (mortgage loans, commercial loans, etc.), with the goal of earning profits from interest income that is greater than the cost of paying interest to depositors. If successful, the bank earns a positive Return on Assets (ROA). Since the early 1990s, U.S. banks’ ROA has generally averaged about 1% (Exhibit 2).
Assuming a bank can earn a positive ROA, it will generally use leverage (i.e., debt) to magnify its ROA over a smaller equity base. Since the financial crisis of 2008, leverage in the banking sector has been declining (Exhibit 3).
With leverage declining from almost 20x equity prior to the 2008 financial crisis to just about 10x today, we can calculate the aggregate ROE for the banking sector using the DuPont formula as:
ROE = ROA (~1%) x Leverage (~10X) = ~10%.
The current level of aggregate ROE, while somewhat higher than it was in the 1960s or 1970s, is meaningfully lower than the 1990-2007 period.
Will Bank Profitability Improve?
As bank shares rally, the market is betting that future ROE may be higher than it is today. Is that optimism justified? The Oppenheimer Value Team’s view is that both sides of the ROE equation (profitability and leverage) may improve going forward. We believe there are a number of reasons why this could happen:
- Higher net interest margins: Net interest margins (net interest income as a percentage of interest-earning assets) is the most widely watched margin in banking. Since the election, longer-term interest rates have risen – the 10-year Treasury yield, for example, has climbed to 2.5% from around 1.8%. Because many commercial banks hold short-term variable rate loans as assets, they may be able to earn higher interest on their loans, thereby improving net interest margins, which could drive ROA higher.
- Reduced regulatory costs: Regulations such as Dodd-Frank have increased the costs associated with banking. An administration focused on reducing the regulatory burden may also help banks improve ROA by reducing expenses.
- Lower corporate tax rates: The effective tax rate for the median U.S. bank in 2015 topped 30%. A reduction in U.S. corporate tax rates to 15%-25%, as is reportedly being considered by the Trump administration, from the current statutory 35%, would benefit margins as well.
- Reduced capital requirements: Relaxing so-called SIFI (systemically important financial institution), or “too big to fail” rules, may allow some banks (mostly smaller regional banks) to carry incrementally less capital.
Of course, the jury is still out as to which, if any, of these changes will come to pass. The equity market, which is forward looking, appears to be wagering that banks may be in a position to potentially generate higher profitability in coming years.
The Key Question for Investors
However, given the recent rally in banks, the fundamental question for investors going forward becomes: Is the expected improvement in ROE already reflected in share prices? In many cases that may be true; however, we believe we can still find bank stocks that, in addition to benefitting from the prospective changes cited above, may also benefit from company-specific improvements as well. These names include:
- Bank of America: Bank of America, the $230 billion Charlotte, NC-based institution, currently earns lower ROE than large-bank peers such as JPMorgan and Wells Fargo. As a result, its P/B ratio is among the lowest in the group. Cost-cutting efforts and an initiative to streamline its back office activities could potentially help drive ROA higher and with it a more competitive ROE.
- KeyCorp: KeyCorp is a mid-cap ($20 billion) bank based in Cleveland. KeyCorp could benefit from “self-help” cost cutting and efficiency initiatives and is currently better capitalized than peers, which could potentially lead to capital returns in the form of higher dividends and share repurchase.
- Associated Banc-Corp: Associated Banc-Corp is a $3.7 billion market-cap bank holding company based in Green Bay, WI, that also has offices in Illinois and Minnesota. The firm enjoys a very flexible balance sheet; approximately 20% of its assets are held in securities, primarily short-maturity, mortgage-backed securities. As interest rates rise, Associated may redeploy these assets into higher-margin loans.
As with any business model, changes in valuation multiples represent the expectation of changes in the underlying return on capital. Banks are no different. To the extent that the banking industry environment is supportive of higher returns on capital, we believe it is entirely feasible to expect investors to continue to buy bank stocks, pushing valuation multiple higher.
1 Source: FactSet, 12/19/16.↩
2 Also known as the DuPont analysis, DuPont equation or DuPont method. The DuPont Corp. developed it as a performance measurement in the 1920s.↩
As of 11/30/16, 6.19% of Oppenheimer Value Fund’s holdings were in Bank of America; and 0.78% in KeyCorp. Fund holdings are dollar-weighted based on assets and subject to change.
As of 11/30/16, 2.10% of Oppenheimer Midcap Value Fund’s holdings were in Associated Banc-Corp; and 1.46% in KeyCorp. Fund holdings are dollar-weighted based on assets and subject to change.
As of 11/30/16, 1.00% of Oppenheimer Dividend Opportunity Fund’s holdings were in KeyCorp. Fund holdings are dollar-weighted based on assets and subject to change.
As of 11/30/16, 1.70% of Oppenheimer Small Cap Value Fund’s holdings were in Associated Banc Corp. Fund holdings are dollar-weighted based on assets and subject to change.
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the Russell 3000 Index. The index is unmanaged, includes reinvestment of dividends but does not include fees, expenses, or taxes, and cannot be purchased directly by investors.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The index is unmanaged, includes reinvestment of dividends but does not include fees, expenses, or taxes, and cannot be purchased directly by investors.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
Securities issued by companies in the financial services sector may be susceptible to economic and regulatory events, and increased volatility. Equities are subject to market risk and volatility; they may gain or lose value. Value investing involves the risk that undervalued securities may not appreciate as anticipated.
These views represent the opinions of the Portfolio Managers at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.