R. Christopher Whalen
Sep 9, 20216 min
September 9, 2021 | In this issue of The Institutional Risk Analyst Premium Service, we consider two questions: Which are the top performers among the banks we follow in terms of equity market valuation, both relative and absolute? And which US financial will best weather the coming storm of a major equity market correction? Few of the largest U.S. banks are in this group, a sad commentary on the fact that many Buy Side managers prefer the liquidity of mediocre large-cap stocks to the superior financial performance of smaller names. And thanks to the Federal Open Market Committee, several perennial underperformers have also risen to the top of the proverbial airation tank. Will they survive a market correction? Read on…
In terms of relative value, that is, total equity market return over the past 12 months, the top-ten financials are shown below. Notice that the list includes several stocks that have not exactly been stellar performers, but rose to the top thanks to the FOMC and insatiable demand from Buy Side managers. A rising tide of monetary inflation lifts all asset prices.
Source: Bloomberg
Western Alliance Bancshares (WAL), which we have previously profiled in The IRA, is one of the best performing banks in Peer Group 1. The acquisition of residential mortgage aggregator AmeriHome from Apollo (APO) portfolio company Athene Holdings (ATH) positioned the bank for explosive growth in 2021 in terms of total equity returns.
Next on the list is CapitalOne Financial (COF), a monoline credit card lender with a bank charter. COF has traditionally traded below book value due to the high-risk nature of its loan portfolio. COF ranks in the 97th percentile of all large US banks in terms of credit loss, 1.2% of total loans and leases vs 0.16% for Peer Group 1. Even with the considerable push from the FOMC, however, COF still trades at just 1.1x book value, an illustration of how far this stock has run.
Another perennial dog is Ally Financial (ALLY), which we profiled in October of last year (“Bank Profile: Ally Financial Inc.”). ALLY has delivered over 100% equity returns in the past year, but the $180 billion asset specialty consumer lender continues to underperform its peers financially. Today ALLY trades at 1.2x book value, but was half that a year ago -- and for good reason.
The key structural problem with ALLY is that its high cost of funds makes the bank largely uncompetitive. ALLY’s cost of fund is over 1.2% of average assets vs < 20bp for the average of Peer Group 1. Even with a yield on loans and leases that is a point or more better than the large bank average, ALLY remains in the 97th percentile in terms of interest expense vs total assets. In any equity market selloff, we look for ALLY to underperform the market.
Another dog that has surged during the LTM is Goldman Sachs (GS), which delivered 103% total equity returns over the past year but has slipped in recent days. CEO David Solomon continues to build the firm’s assets management business via small acquisitions, but has resisted our advice to merge with a depository to stabilize the group’s funding base.
GS is a great broker-dealer and a mediocre depository that now trades at 1.5x book value, twice what it was a year ago. Like COF and ALLY, we look for GS to underperform in any equity market correction.
At Morgan Stanley (MS), however, the situation is different from GS in a qualitative sense. MS has a far stronger banking business and also a more stable and profitable asset management arm. Likewise, Charles Schwab Corp (SCHW) continues to grow its AUM and $500 billion plus core bank deposit base, and has a book value multiple that reflects this strength.
The table below shows the top-ten financials sorted by book value of equity (P/B). Notice that momentum plays such as GS, COF and ALLY have disappeared, but MS and SCHW remain due to their superior financial performance and operating leverage.
Source: Bloomberg
Fintech and payments play Square Inc. (SQ) dominates the rankings due to the overbought nature of the stock. We first got into SQ back when it was in single digits, this based upon our surmise that Buy Side managers desperate for fintech spice to add to portfolios would pile into the sector.
Sure enough, several years later SQ is one of the most overvalued financials in our surveillance group, especially when you consider that this company is basically a competitor of Visa (V) at 13x book value, Mastercard (MA) at 52x book value, and American Express (AXP) at 5x book value. But of course, SQ has added the magic word to its business model: crypto.
Another observation from this list is the inclusion of First Republic Bank (FRC), a high-touch asset manager and so-so unitary bank that shed its holding company in 2008. The decision to become a unitary bank made sense in terms of cutting operating expenses, but greatly reduced the bank’s public disclosure for investors. Bank OZK (OZK) shares this unfortunate characteristic.
Despite the $240 billion assets under management (AUM), FRC generates relatively little in the way of non-interest income. In fact, there is a 4:1 ratio between net interest income and total non-interest income at FRC – the polar opposite of SCHW, for example. The 1% ROA and 12% ROE are fine, but no different than the sort of asset and equity returns available from other banks.
Trading north of 3x book value and at a premium to SCHW and MS, we have a hard time justifying the #4 ranking of FRC other than to say that Buy Side managers clearly like the stock. Put FRC in the same outlier bucket as SQ and PayPal (PYPL) when it comes to understanding the public market valuation. To us, FRC is too small to survive as an independent bank, so perhaps we can treat the outsized equity market valuation as an impending takeover premium.
Another important name that makes both the relative and absolute value lists is Discover Financial (DFS), a monoline credit card issuer that consistently ranks among the top financial performers in Peer Group 1 along with AXP.
DFS ranks in the 99th percentile of Peer Group 1 in terms of interest income vs total assets, net operating income and overall net income. As and when a major equity market correction arrives, we’d hold onto DFS as a strong qualitative anchor in the storm for any long-term portfolio.
WAL, MS, JPMorganChase (JPM) and U.S. Bancorp (USB) round out the top ten banks in terms of absolute value measured by book value multiples. The fact that these names are in relatively "normal" positions, despite the FOMC’s extraordinary market manipulation, says to us that these names will likely fare better than some of the more highly valued stocks on the list.
As an analyst at MS wrote this week: “Stocks may fall 15% by year-end. The issue is that the markets are priced for perfection and vulnerable, especially since there hasn’t been a correction greater than 10% since the March 2020 low.” Indeed.
Those financials with basic operating strength are likely to perform far better than the Meme stocks such as SQ or PYPL. When we heard SQ co-founder Jack Dorsey starting to prattle on about the opportunities in crypto, that did not give us greater confidence in the company's business model. Perhaps long V and MA, short SQ, will be the short strategy of 2022.
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