Stocks in banks and other financial companies have suffered heavily because of the recent turmoil in financial markets. Fears remain about the extent of future writedowns linked to losses in the US subprime mortgage market.
However, sovereign wealth investment funds from the Middle East and Asia have invested an estimated $37bn in shares of western financial companies this year - a sign that the funds are taking a more optimistic view than other investors of the growth prospects for banks, exchanges and asset managers.
So which view is correct? Some equity analysts believe the worst has passed for financials and that bargain hunters could enter the maket soon. Others think that the bear market for banks is unlikely to end before the extent of subprime losses is clear - and that may take another year. And are there parts of the financials sector, or regions, where pockets of value lie?
Huw van Steenis, head of banks and financials research at Morgan Stanley, answer syour questions.
With the financials and the market in general increasingly turning into interest rate cut junkies, what is your position on equity values for financial institutions in the next three to six months?
Judy Yeo, Singapore
Huw van Steenis: We are ”cautious” on the banks in the near-term. Banks are always geared plays on markets and economies, and we continue to see growing risk of a US led consumer slowdown impacting banks earnings power (through lower growth, tighter margins and higher provisions). Whilst this is largely a US phenomenon, we do think this will lead to slower growth in Europe too. In addition, we think the very challenging period for banks funding is likely to continue to Easter next year. The deleveraging of balance sheets into year-ends, the re-intermediation of SIVs and conduits onto banks balance sheets and uncertainty on subprime and other potential knocks are contributing to cash hoarding.
Whilst banks with diverse funding can access markets, albeit expensively, the market is more challenging for some mid-cap banks who were more reliant on asset backed security funding (in the UK, Spain, Ireland and Italy). So, although we are seeing a positive policy response from the US and ECB, we see quite a few headline risks into Q1 next year.
At the moment, our preferred picks are mostly banks with solid funding positions, strong capital ratios and geared to more resilient growth (eg Asia, Norway, Greece etc) or some of the diversified financials such as the exchanges which prosper from the market volatility.
Do we lump all financials together? If not, how do we differentiate the banks that are hit worse than others? Does it make any difference that HSBC derives most its profits from Asia, Middle East and Latin America?
Liu Heung Shing, Beijing, China
Huw van Steenis: Like you, we embrace the growth in Asia, Middle East and LatAm as a great opportunity for banks, and see the secular growth far more appealing than say the US banking system today. Specifically on HSBC today, by colleagues Mike Helsby and Steve Hayne currently rate this as an ”underweight”, not because of its Asian exposure, but due to its US exposure.
Some 47 per cent of HSBC’s consumer loan book is in the US, whilst 50 per cent of its investment banking profits are in US/Europe. Given growing need for provisions for US consumer lending which is going sour, we find it hard to believe that Asia can offset the pain alone for HSBC. This said, as ever, this is a valuation call based on our view that the market has underappreciated the US downside within HSBC vs the strong appeal of their Asian franchise.
How important are tier 1 ratios in evaluating whether to invest in a financial institution? Does a bank in the 4.7-4.2 range (such as the Royal Bank of Scotland) represent too much risk?
Terry Matthews, US
Huw van Steenis: I think capital ratios - particularly core ratios - are a very relevant input to assessing the risk/reward profile of a bank. Clearly the larger the capital ratio, the better able a bank is to withstand a shock or knock from changes in the economy or markets - much like a ship with sails fully out is at risk as a storm brews.
Banks with thin capital ratios which were to get hit by an unexpected event are some of the ones which will need to raise equity in the markets at some considerable cost - as Citigroup highlights, or cut their dividend. This said, the raw number alone needs to be put in context of the type of business the bank is engaged in as well as the earnings power of a bank.
One of the key measures we use to help our investments calls is ”free cash generation” ie how much surplus is there after accounting for the capital need to grow the business and pay dividends. The greater the free cash generation, the greater the ability to rebuild capital ratios or return more capital to shareholders or support stronger growth. In a sector where we see capital more expensive and greater risks in running a highly levered business, the greater number of our ”buys” are ones with very strong free cash generation.
Do you think that the sovereign wealth investment funds will continue to invest in the private equity funds during the time of global turbulence in capital markets?
Huw van Steenis: Yes I do think Sovereign wealth funds will continue to invest in private equity, but as the market opportunity has changed so too will their allocations, with a greater tilt to strategic stakes in undervalued public companies and greater tilt in private equity to the higher growth emerging markets or ”distressed” investments
For instance, as highly leveraged buy-outs in Western markets look less appealing, many global private equity firms are shifting their focus to India, Turkey, Russia, Asia, Brazil and a range of other higher growth markets. For SWFs looking to find high returning opportunities in these areas they can obtain indirect and direct side by side opportunities in these markets via private equity. What’s more as long term investors, they should also be able to commit capital to funds which can prosper from stressed or distressed sales of assets or companies ahead
This said; I believe that a rich seam will also be SWFs taking 3-20 per cent stakes in public financials. Financial Services are the number one focus for SWFs in part as they should correlate with the growth of the emerging markets, in part as there are strategic benefits from partnering with players who can develop domestic capital markets and in part the need by some banks to raise fresh equity.
We estimate that SWFs have now invested $43bn in strategic stakes in Western financials. Of this $43bn, $34bn has been deployed in Q2-Q4TD alone. At this run rate SWFs could be set to invest more than $50bn in Western financials in 2008. In addition Chinese financials have invested $12bn in non-Chinese financials, of which $10.8bn this year.
HSBC has taken the step of putting its SIVs on its balance sheet. Is this a sign that the bank is seeing value in these assets? Do you think this is a sound strategy?
Clement Loh, Toronto
Huw van Steenis: We think that many banks may seek to emulate HSBC’s move to bring its SIV assets on effectively ”on balance sheet” from an economic point of view - independent on whether the bank thinks they cheap or expensive. Given the crisis of trust in many asset backed securities - in part prompted by the failure of ratings agencies to reflect accurately the risks in US subprime lending upon which many investors relied - its very challenging indeed to find funding for conduits and SIVs in the money markets.
As a result, banks need to fund these themselves from their own balance sheets, or otherwise lead to bigger problems. The US authorities have identified this as a key issue on which they are also trying to create an industry solution. I see a continued reintermediation of these financial assets back on to banks balance sheets - which in the long term is a good thing - but in the short term could create some indigestion, as they are being brought back onto balance sheet so quickly.
For instance the ABCP market has shrunk from $1.300bn to $800bn in a matter of months, with banks picking up the tab from the market, and we think this could continue to shrink to $500bn by Easter next year. Whilst the size and pace of this may create indigestion for some, I cant help feeling in the long term this creates a healthier system
Is there unprecedented value in financial stocks? And can you highlight or elaborate on the two or three trends across any of the subsectors (securities brokerage, hedge funds, asset management, wealth management etc) which you believe offer enormous profit potential for equity investors?
Peter Smedley, London
Huw van Steenis: The growth in global derivatives volumes on exchanges strikes me as one of the most powerful themes to embrace in global financials. The derivatives exchanges such as Eurex within Deutsche Boerse benefit from the growing uncertainty about the US economy on interest rate expectations and growing volatility in equity markets leading more investors to risk manage their positions.
Put another way volatility drives volumes and exchanges are the effective toll roads on derivative market volumes. In addition to the broader volume growth, in an environment when capital is expensive for the banks, they will look to net volumes with each. If they put all their buys and sells together through a derivative exchange it is far more capital efficient - which can further reinforce the volumes on exchanges. In addition to the top line growth, exchanges have strong economies of scale, so to line growth is boosted to profit growth and most of the accounting profit they generate is cash flow - making them some of the most cash generative financials in the market.
On top of this, there is global consolidation well underway in the exchange sector. Whilst the are some clear risks - from changes in regulation or mismanagement, we think the risk/reward for some of the derivative exchanges such as Deutsche Boerse some of the best investment opportunities in financials
A second trend we continue to believe is wealth creation in Asia, Middle East, New Europe and Latin America. Globlaisation and oil wealth creates significant needs for wealth management services - and what’s more this comes with negligible credit risk. We also think that the growth in high net worth wealth - whilst geared to global growth which is at risk of slowing materially from US consumer credit problems - should be more resilient than many trends in financials.
Whilst many wealth managers are embedded within larger financial groups, some of which have major subprime losses to should and some reputational issues to resolve, a pure play bank such as Julius Baer and others should benefit from this market backdrop, even if market levels fall impacting their asset levels
About the expert
Mr van Steenis has advised on financial institutions for 15 years and has seven times been voted the number one individual analyst in the Extel and Institutional Investor polls for Diversified Financials. As an investor, he was also ranked as Starmine’s top Stock Picker of 2005 for European Banks and Financials
In 2006 Mr van Steenis was asked by Morgan Stanley to take a year out of research to work on its own strategic initiatives in asset and wealth management, as well as kick-start Morgan Stanley’s practice of advising hedge funds and private equity firms on taking advantage of the public markets.