04 finding value fundamental value equities€¦ · fundamental value equities q3 2018 at the end...

Taking Stock

FUNDAMENTAL VALUE EQUITIES

Q3 2018

Concentrating on long-term Value

04 FINDING VALUEAs Deutsche Bank restructures its business, we take a closer look at its valuation.

06 RESEARCH BRIEFINGEvaluating prospects for the financial sector 10 years on from Lehman.

02 THE BIG PICTUREValue as an investing style has extended its run of underperformance. What might trigger a change?

2

Fundamental Value Equities Q3 2018

At the end of September, the MSCI World Index was up almost 6% on a total return basis for the year to date. The index captures the performance of more than 1,600 stocks across eleven global sectors in the developed markets, but as a market-capitalisation-weighted index some stocks are more impactful than others. The trend we’ve observed this year is now quite familiar; as the post global financial crisis (GFC) market regime has matured, the leadership in the equity market has become increasingly narrow. Four stocks accounted for almost half of the return achieved by the index this year — Amazon, Apple, Microsoft, and Netflix. If you don’t own them, it’s bound to be hard to keep up.

More than TechBut it’s not just those four names. The market’s current appetite for “stocks that are working”, at seemingly any price, is remarkable. This is illustrated in Figure 1, where we ranked the stocks in the index by their price-to-book (P/B) ratio at the beginning of the year, divided them into quintiles and measured the year-to-date investment return. At the extremes, the cheapest quintile (those stocks with an average P/B of 0.9) underperformed the most expensive quintile (those stocks with an average P/B of 8.6) by 21%.

THE BIG PICTUREBarry Glavin Chief Investment Officer

But across the spectrum, the relationship of valuation to investment outcome was consistent — the cheaper the stock, the less likely it was to do well. Although this is counter-intuitive and at odds with long-term data, it is not unusual. We can find no meaningful correlation between valuation and investment outcome over short periods — see Figure 2. It takes time for fundamentals to assert themselves.

One of the key reasons why we target an investment horizon of three to five years is because it is only after that timeframe that one can observe a strong relationship, as is evident in Figure 3.

Figure 1: MSCI World Index: Year-to-Date Returns (30 September 2018) vs Starting P/B

0 2 4 6 8 10

30

10

20

0

-10

-20

40

Starting P/B (Trailing)

Return (%)

Most Expensive Quintile

Cheapest Quintile

Source: FactSet, MSCI, State Street Global Advisors.

Figure 2: MSCI World 1-Year Returns vs Trailing P/B: 1980–2018

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0

40

80

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0-80

100


1-YR Return (%)

Current Trailing P/B: 2.5x


Figure 3: MSCI World 5-Year Returns vs Trailing P/B: 1980–2018

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

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60

40

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-20

100


5-YR Return (%)

Current Trailing P/B: 2.5x


3State Street Global Advisors

All this is simply a long-winded way of saying that value — as a style or factor — has underperformed again. It may seem as if we’ve written this almost every quarter for ten years (we haven’t), and the creative challenge of not writing the same article every time is quite daunting. More importantly, it’s challenging from an investment perspective. How best should a long-term value investor deal with this inhospitable market environment?

Behind the Underperformance of ValueMany theories abound on why value has performed so poorly. One recent school of thought posits that the value approach fails to capture the unique and intangible economics of the new monopoly platforms. We would think about it slightly differently.

The policy regime since the crisis — fiscal austerity coupled with “whatever it takes” monetary policy — has impacted valuations across equity markets. In a zero interest rate world, stocks with low implied discount rates (or high multiples) are effectively high-duration stocks, i.e. very sensitive to changes in discount rates. The opposite holds for stocks with low multiples. In an environment where rates have fallen relentlessly, this represents a significant headwind for low-multiple stocks. Compounding this has been the fiscal/macro environment. Growth has been scarce, particularly in economically sensitive, or cyclical, parts of the market and as a result it has commanded an ever-increasing premium — as Figure 4 shows, we have arrived at a very extreme place.

Awaiting the TurnThis environment may well be changing, and the increase in volatility since the beginning of the year could be indicative of a regime change in markets. That would be healthy, but the transmission mechanism will most likely be messy and the timing will undoubtedly be very difficult to predict. For investors, the option to staunch the short-term relative performance pain by selling cheap stocks to buy expensive ones can be tempting. However, our focus remains on doing the job we were hired to do; take a long-term view and look to take advantage of the current misallocation of capital for the benefit our clients.

In doing so, we focus on value investing. Value investing involves detailed financial analysis of individual companies, thorough research on the fundamentals of their industry, developing a deep understanding of the strategy of the business, and building a case to support assumptions around long-term earnings power. This work allows us to value a stock, and in cases where the share price is significantly below that estimate of intrinsic value, we invest. When we do this well, we make money for our clients.

Value InvestingUltimately, value investing is different to investing in value as a factor, or indeed the performance of value proxies such as the MSCI World Value Index. Although the long-term data indicates this tilts the odds in your favour, we don’t believe that buying thousands of stocks you know nothing about on the grounds that a third party deems them cheap is an activity Ben Graham would recognise as value investing.

But it does describe the environment for value investors and our margin for error. When it’s supportive — as it was for most of the 80 years until the GFC — the market is quite forgiving when we make a mistake. In the environment since then, mistakes are punished very harshly. As already noted though, we believe that when our analysis is right, and the price is cheap relative to the earnings power of a business, we do well.

Figure 4: MSCI World Growth PE Premium

Jul2003

Apr2007

Jan2011

Nov2014

Sep2018

%

0

60

50

30

40

20

10

— Average— MSCI Growth Index PE Premium vs Value Index

Value Outperformance Value Underperformance


The BackdropSince 2010, the bank has raised €29 billion of capital. A significant chunk of this (€10bn) was used in the acquisition of Postbank with subsequent capital raising exercises undertaken in order to strengthen the group’s balance sheet. The intent was to place the bank in a position of strength to take advantage of anticipated opportunities as they arose; in particular, the investment banking market was experiencing retrenchment by some players within the segment.

However, during the same timeframe, the group incurred more than €27bn of charges for litigation, restructuring and goodwill impairments — in excess of €16bn were taken since 2015 alone. Accordingly, the company has been a persistent destroyer of tangible book value with a compound annual growth rate (CAGR) of -3.6% since 2010 and a return on tangible equity (ROTE) that fell to low single digits and more recently into negative territory.

Deutsche Bank Deutsche Bank is a German financial institution with leading franchises in investment banking (particularly fixed income and cash), global transaction banking, asset management and German retail banking.

Drivers of Profitability Against that background, Deutsche Bank’s share price has considerably underperformed its peers and its low valuation implies a lack of market confidence in the company’s ability to turn it around. We have closely scrutinised the company’s financials and considered its earnings prospects.

Revenues: We expect revenues to remain challenged in the near term. Within the Corporate and Investment Bank (CIB) division the management team has outlined their intention to refocus the business and ensure the balance sheet, operating costs and capital of the division are aligned to the group’s core strengths — particularly within global payments, foreign exchange and structured credit. This optimisation of the business will see the group reduce its commitment to areas such as US rates, global equities and commodities and we anticipate this will drag on revenues in the near term (in line with management guidance). However, this will ultimately support profitable growth as freed-up capital and management time is allocated to more profitable segments of the business. We believe Deutsche Bank will retain its ranking among the world’s top five fixed income and cash players.

Within the Private and Commercial Bank (PCB) division, we anticipate the weak revenue environment to continue for the short-to-medium term as modest volume growth is offset by continued margin pressure. But over the longer term — in a normalised rate and growth environment — we expect revenue growth in line with nominal German GDP.

FINDING VALUEDeirdre O’Leary, Research Analyst


4


Costs: Management have outlined adjusted cost targets of €23bn in 2018 and €22bn in 2019 from an adjusted €22.9bn in 2017; approximately 50% of the targeted cost savings will come from the CIB, largely through workforce reduction as the business is refocused. Other savings will be realised by establishing a leaner organisation, not just in terms of greater automation but also by streamlining the management structure and implementing an efficiency programme spearheaded by the CFO, the partial realisation of Postbank/DB integration costs savings of €900m, an FX tailwind and business disposals.

Over the longer term, the group is targeting a cost/income (C/I) ratio of less than 70% by 2021 versus 93% as reported at the end of 2017; part of the ratio improvement is anticipated to come from revenue growth. In assessing the company, we think the bank is more likely to sustain a C/I ratio in the 70s, which reflects what we believe to be more conservative revenue assumptions plus the inability of the group’s PCB division to achieve a C/I ratio comparable to other European retail banks given the structurally lower profitability of the German retail market.

Litigation: Having incurred €15.5bn of charges since 2010, we believe litigation concerns are now largely behind the group. However, reflecting our conservative investment approach, we assume the group takes an incremental €1.5bn post-tax charge for outstanding cases which is in addition to the €1.4bn reserve on the balance sheet at the end of June 2018.

Figure 5: Capital Allocation at Deutsche Bank as at 31 December 2017*

Private & Commercial Bank25%

Deutsche Asset Management2%

Consolidation & Adjustments 5%

Corporate & Investment Bank

67%

Source: SSGA, Deutsche Bank — *as based on Group disclosed risk-weighted assets.

Invested CapitalThrough the introduction of the Basel 3 framework, regulators have sought to address the flaws that became apparent during the global financial crisis. And although the evolution of the regulatory regime is unlikely to be concluded as yet, we believe it has matured and expect any changes not already flagged by regulators will be incremental rather than revolutionary. At the end of 2017, Deutsche Bank allocated approx. 70% of its capital to the CIB. We expect that to continue, partially reflecting our assumption of continued risk-weighted asset inflation within the CIB but also as we expect the group will remain committed to this division. The group reported a CET1 ratio of 13.7% and Leverage ratio of 4% at the end of June 2018; we expect them to maintain these ratios above 13% and 4% over the longer term, which would place them in a comparable range with peers.

ConclusionThe delayed recovery in earnings power has led Deutsche Bank to materially underperform its global bank peers and left the stock trading on a price to tangible book value (PTBV) of 0.4x. This implies it will be unable to generate returns greater than c.5% on a sustainable basis, which contrasts with management ROTE target of 10% by 2021. While we recognise the group still faces restructuring challenges and we do not expect it to achieve its aspirational ROTE target, we think that the refocused investment bank will enable the group retain its mantle as a leading European investment bank supported by a strong global transaction bank, asset manager and a more efficient retail bank. This could allow the group significantly improve returns in the medium term, thus making it attractive to value investors such as us.

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Bank Investing since LehmanThe 10 years since the Lehman Brothers bankruptcy have proved a trying period for those investing in bank stocks. Not only have banks been among the worst performing sectors, but the worst performing banks have been those that were trading on the lowest valuation multiples. For value investors this made a challenging period rather more difficult, but it has also served to demonstrate the value of solid fundamental analysis.

Our approach has remained steadfast throughout and involves, in the first instance, estimating the intrinsic value of a bank by determining the capital required to support our forecast of normalised earnings power. We then value that capital based on the relationship between the bank’s sustainable return on tangible equity (ROTE) and our required rate of return. In addition, we have always been acutely aware of the unique characteristics of this industry due to regulation, leverage, and liquidity requirements that the Great Financial Crisis (GFC) brought to the attention of investors like never before.

Identifying ValueAs the crisis took hold, bank stocks were sold indiscriminately as investors were unclear about the implications of the shutdown of interbank funding markets. In surveying the wreckage, we found that banks in the US and Europe were being offered at the lowest valuation multiples. But our analysis uncovered a number of crucial differences. The European banks came into the crisis more leveraged and more reliant on wholesale

funding, something compounded by the structure of the European financial system that was heavily reliant on bank lending — thus creating a vicious feedback loop. These observations were critical in arriving at our estimates of intrinsic value and drove our preference for US banks.

Following the ValueBy late 2011, having underperformed materially, the valuations of European banks began to look attractive; the ROE of the European banking sector had fallen from a peak of 17% in 2006 to just 8%, and the sector was trading at a 40% discount to book value. Not only was the market assuming that the new lower level of ROE was likely to persist, it was discounting returns to get worse, permanently. This appeared overly pessimistic and we began to re-orient our bank investments from the US to Europe.

Over the next two years, European banks re-rated, eliminating the discount to book value and many of our holdings traded at our estimate of intrinsic value. However, the ECB move to then introduce negative interest rates to combat the deteriorating inflation outlook prevented the banks delivering on those improved expectations, triggering a second period of sustained underperformance.

The Asia ExperienceBanks in Asia held up quite well through the crisis, reflecting the fact that they typically weren’t involved in the US securitisation market, nor were they highly levered or overly reliant on wholesale funding. Japan and South Korea were exceptions as both had banking systems that were tightly integrated with the US financial system.

Korean banks began to screen well for value around 2013, while Japanese banks really only became attractive to us around the time the Bank of Japan introduced negative interest rates in early 2016.

A different dynamic underscored the de-rating of Chinese banks that brought their valuations onto our radar. Concerns relating to the fallout from the fiscal stimulus programme China employed to stabilise their economy post-GFC hit Chinese bank share prices and we began buying in 2013. Since then, there have been numerous opportunities to purchase the larger Chinese banks at 30–40% discounts to book value even as ROEs remained solidly in the teens.

RESEARCH BRIEFINGOliver McClure, Research Analyst


Europe-US Bank Valuations Diverge Once AgainCurrently we see a similar picture to that observed in late-2011, except we also see opportunity in Japanese and Chinese banks. The spread between the valuations of European and US banks is back at historic wides. This can be illustrated by comparing the price to tangible book value ratio of a leading US bank — JP Morgan (JPM) — and a large European bank, BNP Paribas (Figure 6).

BNP has traded at an average discount of 35% since the GFC. This makes sense as the US banking system is structurally more profitable and JPM is best in class. What makes less sense is the current discount, which is almost 60%. At 2.1x tangible book, by our calculations, JP Morgan is discounting a return on tangible book value of 17% versus BNP discounting an 8.5% return. This reflects expectations of a significant improvement of returns at JP Morgan versus those reported in 2017 and a modest deterioration of those reported by BNP.

Figure 6: BNP Paribas vs JP Morgan — Diverging Valuations (Oct 2007–Oct 2018)

Oct2007

Oct2008

Oct2009

Oct2010

Oct2011

Oct2012

Oct2013

Oct2014

Oct2015

Oct2016

Oct2017

Oct2018

Price to Tangible Book Value

2.5

1.5

2.0

1.0

0.5

0.0

3.0

— JP Morgan— BNP Paribas

Source: FactSet.

Figure 8: JP Morgan ROTE (2011–2027)

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4

8

12

16

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Implied by Current Share Price Our Estimates

ROTE (%)

2011 2013 2015 2017 2019E 2021E 2023E 2025E 2027E

Source: JP Morgan, State Street Global Advisors.

Figure 7: BNP Paribas ROTE (2011–2027)

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Implied by Current Share Price Our Estimates

ROTE (%)

2011 2013 2015 2017 2019E 2021E 2023E 2025E 2027E

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6

8

2

0

10

MARGIN OF SAFETY

Source: BNP Paribas, State Street Global Advisors.

The contrast in the ‘margin of safety’ between holding BNP and JPM is clearly demonstrated in Figures 7 and 8. The dark blue bars represent the assumptions which underlie our estimates of intrinsic value. The light blue bars represent our estimate of what is discounted in current share prices. Our current upside to intrinsic value for BNP Paribas of 35% assumes they can achieve an 11% return on tangible equity (ROTE) within three years. Compared to the path of ROTE implied by the current share price we believe this give us a comfortable margin of safety. With regard to JP Morgan, we do not think it’s robust to assume they will be able to deliver sustainable the 17% returns implied by its share price, primarily due to the normalisation of credit costs from current historically low levels.

© 2018 State Street Corporation. All Rights Reserved.ID14649-2292272.1.1.GBL.RTL 1018 Exp. Date: 31/10/2019

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Italy: State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano) is a branch of State Street Global Advisors Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA ), with a capital of GBP 62,350,000, and whose registered office is at 20 Churchill Place, London E14 5HJ. State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano), is registered in Italy with company number 06353340968 - R.E.A. 1887090 and VAT number

06353340968 and whose office is at Via dei Bossi, 4 - 20121 Milano, Italy. T: 39 02 32066 100. F: 39 02 32066 155.

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Singapore: State Street Global Advisors Singapore Limited, 168, Robinson Road, #33-01 Capital Tower, Singapore 068912 (Company Reg. No: 200002719D, regulated by the Monetary Authority of Singapore). T: +65 6826 7555. F: +65 6826 7501. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich. Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-105.078.458. T: +41 (0)44 245 70 00. F: +41 (0)44 245 70 16.

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The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Investing involves risk including the risk of loss of principal.

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04 finding value fundamental value equities€¦ · fundamental value equities q3 2018 at the end...

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