Have banking stocks been flying under the radar?

Equities have started the year on the front foot. World stock markets have notched modest gains, with a number of US tech giants already posting double digit returns for the year. Leading the way is artificial intelligence champion Nvidia, which is up well over 50%¹. Bond investors have been less lucky. So far this year, core US inflation has run at a 4%+ annualised rate, defying expectations that price increases will smoothly slow. That stubborn inflation has pushed up expectations for interest rates, with the 2-year Treasury yield rising to 5%. As bond yields have risen, their prices have fallen².

The date is March 9th, 2023, and the next day, Silicon Valley Bank (SVB) collapsed as losses on its bond portfolio prompted a run by its depositors. Credit Suisse and First Republic fell in its wake, leading to unorthodox interventions from authorities and fear of banking contagion rippling through global markets.

Given that panic, it is remarkable to be back where we were just over a year ago—every observation in the first paragraph also applies year to date in 2024. Interest rate expectations have gone on a round trip, inflation is still running hot, and the tech titans are still thriving. (In another echo of early 2023, a small bank called Republic First collapsed just last week.)

More remarkable still is that the banks held in the Orbis Strategies the day before SVB collapsed have outperformed since then. Who would have imagined that the last year would be a rewarding time to own selected banks?

That they have survived did not surprise us. Most of our Strategies were overweight banks, but we held none in the US, and those we did hold were better capitalised, more diversified, and more conservatively run than the banks that got in trouble. Our core group was a diverse bunch, including Sumitomo Mitsui Financial Group, Mitsubishi UFJ Financial Group (MUFG), and Sumitomo Mitsui Trust Holdings in Japan; AIB, Bank of Ireland, and ING in Europe, and KB Financial, Shinhan Financial, and Hana Financial in Korea. All but MUFG are still significant holdings in at least one of our Strategies, and all but Bank of Ireland have outperformed both world stock markets and world banks in local currency terms.

Common to all is how banks make money. In essence, they try to lend money out at higher rates than they pay on the deposits they take in, profiting on the spread. That spread tends to be wider when rates are rising, but in the years following the global financial crisis, central banks kept interest rates pinned to the floor, starving banks from earning a hearty spread on their loans.

Since 2021, inflation has come roaring back, fanned by the pandemic and conflict in Ukraine, and central banks have raised rates to turn down the heat. This has allowed the banks to earn a good return on loans again, and has flowed through to healthy profits.

At least in most places. Japanese banks have had a tough time, as the Bank of Japan for many years kept rates below zero. Banks in Japan have effectively been altitude training, eking out a return from the thinnest of margins. This March saw Japan finally raise interest rates above zero, and the banks have outperformed on renewed optimism for higher earnings and higher returns to shareholders as corporate governance in Japan continues to improve. While we believe they still offer reasonable value, we have reduced our positions in the Japanese banks as their valuations have risen above 10 times earnings.

Our Korean banks have also performed well, with improving prospects that they will finally pay out a higher proportion of their earnings to shareholders. To say that Korean banks are overlooked would be an understatement in our view. Currently trading at around half their book value, the banks are priced as if they are in the teeth of a perilous crisis. But when we look for the red flags that might signal distress, we see nothing of the sort. Banks in a crisis have shaky balance sheets, but our Korean banks are solid. Banks in a crisis may hold assets at inflated prices that need to be marked down, but that’s not so at the Korean banks. Banks coming into a crisis are often overearning, but our Korean banks aren’t sacrificing resilience to chase returns.

In Europe, our bank holdings appear to be suffering from a similar strain of apathy. Markets seem to believe we’ll soon return to the bad old days of intense regulatory pressure, near-zero interest rates, and curtailed payouts. We disagree. With reasonable interest rates, we believe our European banks can earn returns on equity well above 10% over the long term. And with little need to rebuild capital, they can pay ample dividends—Bank of Ireland, AIB, and ING offer dividend yields above 5%.

Our banks have improved, as have the conditions for them to make money. Yet we don’t believe that is reflected in their share prices—our core Korean and European banks all trade for less than 8 times earnings.

In our view, the banks are good illustrations of how contrarian investing works in practice. In a year that has seen a banking crisis on one side and a wave of artificial intelligence enthusiasm on the other, this handful of humble banks has managed to outperform. That is often how it goes—fear comes in loudly but goes out quietly, and the road from all-out fear to a shrug of the shoulders can be a very rewarding one for long-term investors.

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Sources

¹ https://www.barrons.com/livecoverage/nvidia-earnings-stock-price/card/nvidia-s-earnings-are-hours-away-here-s-what-to-expect--WXSUk0PEGSZhQjUCeXi3

² https://www.ft.com/content/de014155-5d85-4f45-9bcf-46f1619ceef9

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