Looking for a Few Good Banks

March 31, 2009             by        Bryan Banish

For the past few weeks I have been on the hunt for one or two solid international bank stocks. My goal was to find a conservatively managed bank presently benefiting from the favorable interest rate environment that I would want to hold on to for awhile. I know, “Buy and Hold? How old fashioned!” This is to fill a spot in a portfolio that contains about ten individual stocks of companies from different industries based in different parts of the world. About half are to be high-risk, high-reward stocks from cyclical and distressed industries. The others are intended to be solid, steady companies paying good dividends. The bank stock is intended to be in that latter, safe category and I have a preference for non-U.S. bank to give my portfolio a higher non-dollar weighting.

I thought I had the perfect stock a number of years ago in Lloyds TSB (LYG). Lloyds looked to be weathering the subprime storm well until the U.K. government asked them to acquire the bad bank HBOS last fall. The story is similar to Bank of America’s (BAC) government-encouraged acquisition of Merrill Lynch. Thus Lloyds (now called Lloyds Banking Group) went from the conservative side of my portfolio to the high risk side overnight.

Banking is becoming a very good business again. In the month of March, there have been a flood of pronouncements that banks have been profitable in the first two months of the year. At the core of bank lending is a simple idea: borrow at short term rates and lend at long term rates. In response to the global recession, central banks from around the world are making money available to banks as cheaply as possible (almost 0% short term) yet long term rates are meaningfully higher.

 This pattern of different rates over different durations gives rise to the yield curve shown in the graph above. The green line represents the current yield curve for U.S. government rates while the blue line shows the yield curve from three years ago (at the height of the U.S. housing bubble). Interest rates that private lenders and borrowers see tend to be higher but the shapes tend to mirror government rates. An upward sloping curve is very good for banks while a flat or inverted (long term rates below short term ones) curve represents a difficult banking environment.

Banks express the difference between short-term borrow rates and long-term lending rates in the term Net Interest Margin. For example, Citibank (C) recently reported a net interest margin of 3.22% on $1.6 trillion of interest baring assets. This means it has the potential to bring in more than $50 billion of net revenue to fund its business. In general, the steeper the curve, the more profitable the core businesses of banks are.

The problem with the global banks like Citigroup and Royal Bank of Scotland (RBS) is that they did not stick to the core banking business. Earnings growth came, not from banking, but from acquisitions, proprietary trading, and buying/selling mortgage backed securities. Combine good interest earnings with a balance sheet of unknown quality, though, it is unclear how much ends up dropping through as profit after write downs and one time charges.

There is reason to believe Citi, RBS, and other troubled banks will work through all their write downs soon. With the timing of that and the role of government ownership uncertain, buying their shares is a speculative (albeit potentially profitable) endeavor and not a fit in my search for a “solid bank”. Where are the banks benefitting from a steep yield curve, good net interest margin, yet free from balance sheet uncertainty?

Looking to Australia and Canada for sound banks. In surveying the globe for banks stocks that sidestepped the global financial meltdown, the countries of Canada and Australia stand out. The banking sectors in these two countries have many parallels. Both countries have highly regulated banking industries that provide a barrier of entry. Neither country experienced a boom in residential construction. Mortgage lending in these two countries tends to be done from banks to individuals, thus underwriting standards remained high in recent years. Mainly, banks take in deposits and make loans.

In short, banks are banks in these two countries. They are not financial supermarkets, hedge funds, or stealth investment banks. Insurance and investment banking companies exist in Australia and Canada but they labeled as such. Another plus is the markets are concentrated around five major banks in Canada and four in Australia.

I combed through a list of nine major banks and picked two favorites: TD Bank Financial Group (TD) of Canada and Westpac Banking Corporation (WBK) of Australia. Royal Bank of Canada (RY) and Commonwealth Bank of Australia (CBA) stood out as well but were edged out despite having very high Tier 1 capital ratios (a measure of financial soundness). TD Bank and Westpac have better net interest margins and, in general, were less exposed to bad mortgage assets than their respective country peers. TD Bank and Westpac are each working through major acquisitions that cause some short term uncertainty but provide potential for cost savings longer term. The table below summarizes the criteria I used in my evaluation.

 

Company	Ticker	Tier 1 Capital Ratio	Total Assets ($M USD)	Dividend Yield	P/E	Market Cap ($M USD)	S&P Credit Rating	2008 Pretax Earnings ($M USD)	NIM
Top Choices
TD Banking Group	TD	10.1%	$468,292	5.84%	9.57	$28,439	AA-	$4,104	2.42%
Westpac Banking (including St. George)	WBK	8.3%	$410,900	7.42%	9.29	$39,117	AA	$5,486	2.07%
Runner Ups
Royal Bank of Canada	RY	10.6%	$570,541	5.64%	11.22	$37,978	AA-	$6,005	1.57%
Commonwealth Bank of Australia	CBAUF	8.8%	$433,147	7.60%	9.43	$36,544	AA	$6,255	2.02%
High Risk Banks (for Reference)
Citigroup	C	11.8%	$1,938,470	1.50%	N/A	$13,090	A	($53,055)	3.22%
Royal Bank of Scotland	RBS	9.9%	$3,510,975	0.00%	N/A	$14,200	A	($59,451)	2.10%

 

Westpac is consolidating at home. Early last year the Australian banking system was dominated by the Big 5 banks: CBA, Westpac, National Bank of Australia (NABZY.PK), Australia and New Zealand Bank (ANZ), and St. George Bank. Westpac closed its 2008 fiscal year on September 30 with record revenues, net income, and dividends. Then in November Westpac acquired St. George Bank to create one of the top three companies in Australia by market capitalization. The combination, if integrated well, can provide earnings growth for the next two years.

 

Australia is a country with a rich history of speculation with land and mining booms aplenty. Westpac, one Australia’s oldest companies, began as the Bank of New South Wales in 1817. As the premier bank during the developing years of Australia in the 19th century, Westpac saw more than its share of banking crises and bankrupt competitors. This provides the company with a strong culture that prevents excessive risk taking. The culture was evident in the lack of write-down charges in 2008 derived from investments in bad assets.

Large corporate mergers are notorious for high shareholder expectations and poor management performance. The acquisition of St. George has a good a chance as any to succeed for a number of reasons. The geographic and business composition of Westpac and St. George are quite similar, allowing for easy integration. Their banking operations extend outside of Australia only to nearby countries like New Zealand, Fiji, and Papua New Guinea. Lastly, and most importantly, any clashes in corporate cultures between the two companies are likely to be small and well managed. Westpac CEO, Gail Kelly’s previous job was running St. George.

TD Bank is expanding into the United States. The TD Bank Financial Group is also known as Toronto-Dominion. As it has expanded into the northern United States, it has been using the brands TD Banknorth and TD Bank. These two brands result from the 2004 acquisition of Banknorth of Vermont and that of Commerce Bank of New Jersey in 2007. The U.S. presence represents slightly more than a quarter of its retail operations. TD Bank Financial Group has been steadily raising its dividend by 15% annually over the last 4 years yet it can still cover the dividend two times over with current earnings per share. Thus there is room for further dividend growth.

The history of Toronto and Dominion banking franchises go back more than a century and a half. The company has 152 year history of dividend consistency. Today’s TD Bank focuses heavily on customer service and, while its high fees (typical in Canadian banking) are not advantageous for consumers, they are good for shareholders.

Four of the five major Canadian banks have remained profitable each quarter throughout this global financial crisis. Canadian Imperial Bank of Commerce (CM) was the odd one out, facing multibillion dollar write downs from mortgage securities in early 2008 but has since returned to profitability due to the favorable dynamics of the Canadian banking landscape. Bank of Montreal (BMO) had profitability that would the envy of global banks but trailed behind TD Bank and Royal Bank of Canada. Bank of Nova Scotia (BNS) is also quite profitable but its exposure to Latin America gives me pause as the recession may still wreak havoc on emerging markets.

The recent turmoil in U.S. banking has seen brand names like Washington Mutual, Wachovia, and Citibank weaken or disappear. At the same time, TD Bank is among a group of banks such as PNC Financial (PNC) and BB&T (BBT) able to step in and bill themselves as stable, strong and actively lending. This should allow them to pick up new deposits from U.S. consumers looking for safety as well as acquiring smaller local banks. The Commerce Bank acquisition was not a distressed sale. This has its advantages in that the transaction did not come with problematic assets. However, it did come with a premium price that was booked on the balance sheet as goodwill, something that may have to be marked down in the future.

Near term credit costs are factored into the stock prices. Both TD Bank and Westpac are facing with rising credit costs from delinquencies of consumer and corporate loans. Neither is immune to the issues related to a typical recession but such concerns are largely reflected in their depressed stock prices. These factors should be more than offset by inherent operating profitability in the banking system that comes from monetary authorities almost giving money away to banks. As the two companies continue integration of their respective acquisitions, cost savings should improve earnings allowing for future dividend growth.

The business of “banking” has been a terrible problem for large global banks and an even worse one for the rest of us. This is mostly because our banks were doing many things other than taking deposits and making good loans. Whether or not the cycle of write downs for the problematic banks has run its course is unclear. Less debatable, though, is that monetary policy (low interest rates) is favoring banks that simply do banking like TD Bank and Westpac. They are looking at a bright future due to steep yield curves, weakened competitors, and their strong balance sheets.

 

Disclosure: The author does have long positions in Lloyds Banking Group as discussed.