February 10, 2006 – Motley Fool
By Vitaliy Katsenelson, CFA
Investing in the stock market is a never-ending learning experience. That’s what makes it so appealing and intellectually stimulating. And I inadvertently had one of those live-and-learn experiences just the other day.
In my piece on Lloyds TSB, I wrote that banks usually trade at lower price-to-earnings ratios to the market because they are considered riskier investments as a result of their high use of debt. That line caught the eye of Foolish financial editor Joey Khattab, who asked writers Stephen Simpson and Nate Parmelee whether they agreed with my logic. Both disagreed. They argued that larger banks have lower P/Es generally because they are perceived to have a slower or more limited growth potential.
At first, I thought there might be a conspiracy of Fools at work against me! So I asked several investment professionals for their opinion. And to my amazement, they all agreed with the Fools.
So I looked at some larger banks to see whether they had been slozw growers in the past, and I couldn’t reach that conclusion. Many of these banks, in fact, had achieved very respectable earnings growth and paid above-average dividends in the process. I then looked at expectations for future earnings growth, and they appeared not to be below average, either. With the exception of Fifth Third, which Wall Street once loved to love and now loves to hate, the rest of the pack was trading at a substantial discount to the market and still are.
The answer must be more complex than just the growth rates. I believe the answer to banks’ lower P/Es lies in the following four factors.
1. Cyclicality The banking business is closely tied to the health of the economy. As the economy expands, demand for loans increases and bad debt declines — a combination that improves banks’ profitability. In a contracting economy, of course, the reverse takes place.
Because investors pay up for predictability, they rarely pay a full market multiple for the volatility that comes with cyclical companies. Cyclical heavy-industrial companies like Caterpillar and Ingersoll Rand, for example, usually trade below the market P/E just as a many banks do.
2. Financial leverage We have not had a bank crisis in the U.S. for a while, so most investors have forgotten just how risky banks can be. But as Warren Buffett has said, by the time you find out a bank has a problem, it will be too late. The equity at most banks stands at meager 6%-10% of total assets, so when a bank does make a mistake, its high leverage amplifies the problem.
3. Interest rate volatility Banks are subject to the risks that come with changing interest rates. They prosper when the difference between long-term and short-term rates — in other words, the interest rate spread — is high. However, when that spread narrows, it becomes increasingly difficult for banks to make any money. Many banks have addressed the problem by boosting their fee businesses. For example, fees account for a full 46% of U.S. Bancorp’s income, thereby making the company less susceptible to swings in interest rates.
4. Complexity of financials I could teach my 4-year-old son to analyze retailers’ financials in about 20 minutes, if I could get him to sit and concentrate for that long. OK, maybe I’ll have to wait a couple of years. But the point is, retailers’ financials are very easy to understand. A quick look at the income statement and a glance at the balance sheet (especially the part that focuses on inventories) will very quickly tell you what happened during a retailer’s quarter.
Banks and insurance companies, on the other hand, are very different animals. Where analyzing a retailer is like playing checkers, analyzing a bank is akin playing two-dimensional chess. (I’ll save the 3-D chess analogy for insurance companies; their financials are even more complex than banks’ are.) Investors need to look at financial statements and at dozens of other sources to assess a bank’s true performance. And that’s a problem, since investors tend to embrace simplicity and shy away from complexity.
To make things even worse, banks’ financials are riddled with assumptions. Although all companies have to make some amount of assumptions in their financials, the complexity and magnitude of those assumptions increase exponentially with banks. Consider, for example, that it’s not uncommon for a high-growth bank to have its expected credit losses understated because of the immaturity of its portfolio (in other words, new loans have not matured yet). However, as growth decelerates and large portion of the loans matures, credit losses may skyrocket beyond the estimated provisions.
The quality of growth The very size of large banks often gets in the way of their ability to continue producing high-percentage growth. Instead, the bulk of growth for large banks comes from acquisitions. An acquirer is able to fold most of the acquired bank’s operations into its existing infrastructure, which, in turn, results in huge cost savings and, of course, higher earnings.
That sounds great on paper. However, acquisitions come with risks, including integration challenges. Bank One (now part of JP Morgan Chase) learned about that problem firsthand when it acquired First USA. Soon after the acquisition, Bank One ran into huge problems with the incompatibility of the combined companies’ computer systems, and the stock tumbled as a result. Regions Financial had similar integration problems after making successful acquisitions for a long time. To sustain its growth, it eventually had to start marking larger and larger acquisitions, and that’s when the problems began.
In addition to the integration risks, bank executives’ egos and their attendant desires to manage bigger and bigger (though not necessarily better) empires often get in the way of common sense. Ultimately, the acquirer overpays for the acquired.
Still, despite all of the potential pitfalls, acquisitions have been the main source of EPS growth for most large banks. In fact, I can’t think of a large bank that became large by way of organic growth. Not one!
Bottom line Growth by acquisition is much riskier and usually more expensive than organic growth is. Investors recognize that risk, and thus they put a lot less value on large banks’ growth. So, to a large degree, Joey, Stephen, and Nate were right: Slow organic growth is, in part, responsible for banks’ below-market valuations. However, I believe that higher risk caused by cyclicality, high financial leverage, and the complexity of financials contributes to the lower P/E as well.