The key chart
Source: FT; CMMP analysis
The key message
In early June, I questioned the conviction behind the European bank sector’s rally that saw the SX7E index rise 45% from its April lows. I recommended viewing this more as a vote of confidence in the EC’s policy shift than a fundamental change in sector dynamics.
- The index fell -17% subsequently, before rebounding since the end of July to a level -8% below the June peak.
- Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.
- In many cases, lower trading volumes have accompanied the recent lacklustre share price performance (do investors care?).
- The 2Q20 interim results also supported my April conclusion that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic.
- Significantly, three index heavyweights are now trading below the pre-LLP threshold multiple associated with peak EM and DM banking crises.
- These banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets.
The lessons from 2020 include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.
Six key charts
In early June, I questioned the conviction behind the European bank sector’s rally that had seen the SX7E index rise 45% from its April lows (“EA banks: a high conviction rally?”). I noted that the rally had taken place (1) two months after the broader market, (2) despite a worsening operating environment, and (3) in the absence of the macro building blocks that are required for a sustained recovery in sector profitability. I also highlighted that the rally had coincided with the announcement of the EC’s proposed €750bn “Next Generation EU” fund and suggested that it could be seen better as a vote of confidence in the policy response rather than a fundamental shift in banking sector dynamics.
The index fell -17% subsequently, to a recent end-July low, before rebounding during August to a level -8% below the June peak. Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.
In many cases, lower trading volumes have accompanied the recent lacklustre share price performance. The chart above illustrates YTD share price and trading volume trends (7d and 21d MVA) for BNP Paribas, the largest bank in the SX7E index by market capitalisation. The current 21d MVA is just over 4m shares, only 62% of the 2020 average of 6.5m and 35% of the 11.4m shares at the peak of the sell-off in March (note these are MVA figures). In the case of Deutsche Bank, the only index heavyweight to have delivered positive share price returns YTD, the current 21d MVA is 12m shares, only 55% of the 2020 average of 22m and 31% of the 39m shares traded at its peak (charts available on request).
The 2Q20 interim results also supported my April 2020 conclusion that weak pre-provision profitability levels left EA banks poorly positioned to absorb the impact of the COVID-19 pandemic (“If you want to go there…”). At the time, I expressed concern about the low “pre-provision profit” cover of only 2.4X at the end of 2019 and highlighted low cover levels in Portugal (1.5x), Germany (1.8x), Italy (1.8x) and Spain (1.9x).
Six months later, the 32 largest European banks have set aside €56bn to cover loan losses. Santander, which was the largest SX7E bank by market cap previously, set aside €7bn to cover loan losses alone and booked a large write-down on its UK business. This resulted in the first quarterly loss in the bank’s 163-year history. Santander’s share price is down -50% YTD, the second worst performer of the heavyweights after Soc Gen.
Three index heavyweights are now trading below the pre-LLP multiple that is associated with peak EM and DM banking crises. Based on my experience of multiple banking crises in EM and DM over the past thirty years, I believe that a pre-LLP multiple of 2x typically marks a key “crisis-threshold” for bank valuation. Consensus forecasts indicate that Santander, BBVA and Soc Gen are currently trading on 1.5x, 1.6x and 1.8x 2021e pre-LLP multiples respectively. Contrarian traders may note with interest the fact that Santander’s trading volumes (post-loss selling pressure?) have peaked at a time of very distressed valuation.
These three banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets. Based on consensus 2021e forecasts the index heavyweights are trading on PBVs of between 0.22x (Soc Gen) and 1.04x (KBC) with an average of 0.45x. While these valuations appear attractive in absolute terms, they simply reflect depressed forecasts for 2021e ROEs, in my view. The average (no-growth) implied cost of equity for the index heavyweights is 10.8%. Given the very high risk to current forecasts, this implies a sector that is fairy-valued rather than genuinely cheap. Note, however, that implied costs of capital vary widely from 3.2% for Deutsche Bank to 16.1% for Santander. This suggests opportunities for active investors since such a dispersion usually indicates either (1) glaring valuations anomalies and/or (2) unrealistic forecasts.
Conclusion and key lessons
Recent lessons here include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.
The CMMP Analysis investment framework combines three different time perspective into a single investment thesis. The investment outlook at any point in time reflects the dynamic between these three different time perspectives. Conviction reflects the extent to which they are aligned – in June they were misaligned highlighting the fact that (absolute) valuation alone is not sufficient for sustained investment performance.
That said, the European and UK banking sectors have provided very important insights into wider macroeconomic trends and the pace, timing and nature of the recovery from the 2Q economic lows. This supports my view, that true value in analysis developments in the financial sector remains less in considering investments in DM banks but more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. More of this to follow in this “Autumn snippets” series.
Please note that the summary comments above are extracts from more detailed analysis that is available separately