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When, If Ever, Will Small-Cap Bank Valuations Return?

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By David B. Moore and Shiv Govindan

On March 9, 2009, trading almost 65% below their December 2006 highs, both the Nasdaq Bank Index and the SNL Micro-Cap Bank & Thrift Index hit generational lows.  This was not altogether surprising given the dislocation in financial markets and related economic turmoil.  Aggregate nonperforming assets (NPAs) were high and rising and profitability was on the decline.  As levered financial actors in a credit maelstrom, that small banks’ valuations were in the dumps was entirely understandable.david moore

Fast forward to today and we see a much improved, albeit still challenging, fundamental picture.  While many small banks continue to struggle with legacy credit issues and a shrinking net interest margin (NIM), a decent-sized subset of small banks have meaningfully reduced NPAs and are making significant strides in profitability.  While most of this latter group have not yet reached “normalized” levels of profitability, they are clearly on track to earn more than their cost of capital in 2012 and for the foreseeable future.  And yet the valuations of most of the banks in this group remain stuck in the mud.  To wit, the Nasdaq Bank Index and SNL Micro-Cap Bank & Thrift Index were just 17.3% and 0.1%, respectively, above their March 9, 2009 lows as of the end of 3Q11.  (In contrast, the S&P 500 was 70% above its March 9, 2009 low as of the end of 3Q11.)  So, despite significant improvement in the fundamentals and outlook vis-à-vis the darkest days of early-2009, many high-quality small banks are trading at otherwise distressed levels.  Which begs the question: When, if ever, will small-cap bank valuations return to more normalized levels?

The first issue is, of course, to define “normalized valuation levels”.  In order to properly discuss this issue we must merge theory and empiricism, with the hope that the results are consistent with both.

Empiricism first: Between 1990 and 2007, the median return on tangible equity (hereafter, “ROE”) for banks with assets between $500 million and $5 billion as of year-end 2010 (almost 900 in total, thus a fairly representative sample of small banks) was 13.9%.  The average trading multiple over the period for the publicly-traded subset of this group was 1.6x tangible book value.  This makes sense only if the average cost of equity for the group was approximately 8.9% over the period.  (In overly simplistic terms: 13.9% ROE/8.9% cost of capital = 1.6x tangible book value.) We’ll call this the “observed,” or “empirical,” cost of equity for the group.

Theory (or at least one theory) next: Over the period between 1990 and 2007 inflation averaged 2.7%, the real yield on the ten-year treasury averaged 2.9% (together equating to a nominal risk-free rate of 5.6%), and the average publicly-traded small bank had a beta of approximately 0.85.  [Over-simplifying again, beta is a measure of the correlation and volatility of a security relative to that of the market.]  Using the capital asset pricing model and the 5% equity risk premium observed over the 1990 – 2007 period results in a “theoretical” cost of equity of 9.9% over the period.  [Cost of Equity = Risk-free rate + Beta x Equity Risk Premium; in this case, 5.6% + 0.85 x 5% = 9.9%]  Thus, theory and empiricism yield similar, albeit not identical, results – in the range of 9% to 10% – for small banks’ aggregate cost of equity between 1990 and 2007.

The complication in determining the cost of equity for a bank at a given point in time is that the typical bank’s beta is fairly stable and generally below 1 during economic expansions.  But during economic contractions, primarily as a result of balance sheet leverage, most bank betas increase dramatically – often more than doubling.  That is, bank betas tend to be systematically understated during expansions, and dramatically overstated during contractions.  For example, if a typical cycle comprises four years of expansion followed by a year of contraction, then the typical bank’s beta will spend 80% of its time below 1 and the other 20% of its time as high as 2 (or more).  Thus, that bank’s beta may average slightly above 1 over a full cycle, but during the contraction its beta will skyrocket.

During the period 2008 to the present the risk-free rate has declined precipitously while bank stock volatility (and thus beta) has increased dramatically. Nevertheless – and somewhat coincidentally – the short-term cost of equity (that is, using only recent data instead of longer-term data) for most small banks is currently a bit under 9%, as the decline in the risk-free rate has more than offset the effects of higher volatility [2% + 2.25 x 3% = 8.75%; note: we have used Bernstein and Arnott’s (2002) 3% long-term equity risk premium for the recent period].  Assuming that we live in a mean-reverting financial world, the risk-free rate will rise eventually while small-bank volatility declines, such that we eventually end up in roughly the same spot where the cost of equity is concerned – the 9%-10% range – albeit with different numerical components.  Clearly, however, there could be a great deal of volatility prior to such mean reversion coming to fruition.shiv govindan

So, now that we have a reasonable framework regarding cost of equity, we need to determine what the future holds for return on equity.  In general terms, we believe that increased regulatory costs will have a modest negative impact on earnings while slightly higher capital requirements will reduce small banks’ ability to leverage.  (Which, as it happens, is not a particularly controversial stance.)  Consequently, that typical small bank that generated an average ROE of almost 14% between 1990 and 2007 may only be able to generate an ROE in the 11%-12% range a few years down the road (assuming the economy remains stable and NPAs continue declining).  (For context, the median ROE for publicly-traded banks with assets between $500 million and $5 billion was 3.7% in 2009, 6.1% in 2010, and 9.3% in 3Q11.)

Which brings us, at last, to the issue of future valuations.  If in the future the typical small bank’s cost of equity is (a normalized) 9%-10% while its return on equity hovers in the 11%-12% range, then we should expect to see average trading values in the range of 1.2x-1.3x tangible book value.  While this compares favorably with current valuations (a median 0.84x tangible book at the end of 3Q11), clearly this is a significant diminishment relative to historical levels.  That’s the bad news.  The good news is that those banks that generate above-average ROEs should garner proportionally higher valuations.  Likewise, acquisition multiples, reflecting anticipated operating efficiencies, should be proportionally higher as well.  Thus, if in the “normalized” future the typical publicly-traded small bank “only” trades at 1.2x-1.3x tangible book value and is acquired for 1.4x-1.6x tangible book, it is likely that a subset of high-performing small banks will trade at over 1.6x tangible book and be acquired for over 2x tangible book.
Consequently, while we see a high likelihood of improved small bank valuations at some point in the next few years, let’s not kid ourselves – the times they are a changin’ and it is unlikely that bank valuations return to those levels we witnessed prior to the financial crisis.

[Reference: “What Risk Premium is ‘Normal’?” Arnott, Robert D. and Peter L. Bernstein. Journal of Portfolio Management. January 10, 2002.]

David B. Moore is a managing director, and Shiv Govindan president, of Resource Financial Institutions Group in New York.

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Sterling rises above $1.37 for first time since 2018; UK inflation rises

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Sterling rises above $1.37 for first time since 2018; UK inflation rises 1

By Elizabeth Howcroft

LONDON (Reuters) – A combination of heightened risk appetite in global markets and UK-specific optimism lifted the pound on Wednesday, as it strengthened to its highest in nearly three years against the dollar and five-month highs against the euro.

The dollar weakened against major currencies for the third straight session, helped by U.S. Treasury Secretary nominee Janet Yellen’s urging lawmakers to “act big” on spending and worry about debt later.

The pound rose above $1.37, hitting $1.3720 — its highest since May 2018 — at 1045 GMT. By 1136 GMT it had eased some gains and changed hands at $1.3687, up 0.4% on the day and up 0.2% so far this year.

Versus the euro, the pound hit a five-month high of 88.38 pence per euro, before easing to 88.51 at 1137 GMT, up around 0.5% on the day.

The pound’s recent strengthening can be attributed in part to relief among investors that the impact of Brexit has not caused the chaos some feared, as well as a lessening of negative rates expectations, said Neil Jones, head of FX sales at Mizuho.

“Going into early 2021, there was a bearish sentiment building into the pound on the Brexit deal, in terms of maybe it had a limited reach, and then secondly an expectation of negative rates and so to some extent the market has been cutting down on sterling shorts because neither of those things have been quite so apparent as they were,” he said.

Bank of England Governor Andrew Bailey said last week that there were “lots of issues” with cutting interest rates below zero – a comment which caused sterling to jump.

The UK’s progress in rolling out vaccines is also seen as a positive for investors, Jones said.

Currently, the United Kingdom has vaccinated 4.27 million people with a first dose of the vaccine, among the best in the world per head of population.

“Further progress in vaccinations (a pick-up in the daily rate) by the time the BoE MPC meeting takes place on 4th February may prove enough to hold off on any additional monetary easing,” wrote Derek Halpenny, head of research for global markets at MUFG.

Inflation data for December showed that prices in the UK picked up by more than expected in December, to a 0.6% annual rate.0.6

Inflation has been below the Bank of England’s 2% target since mid-2019 and the COVID-19 pandemic pushed it close to zero as the economy tanked.

(Graphic: CFTC: https://fingfx.thomsonreuters.com/gfx/mkt/oakpeyayxpr/CFTC.png)

(Reporting by Elizabeth Howcroft, editing by Larry King)

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Euro sinks amid broader risk rally against dollar

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Euro sinks amid broader risk rally against dollar 2

By Ritvik Carvalho

LONDON (Reuters) – The euro struggled to join a broader risk rally against the dollar on Wednesday as analysts said the risk of extended lockdowns in Europe to combat the spread of COVID-19 and the continent’s lag in a vaccine rollout were weighing on the currency.

Down 0.1% against the dollar at $1.2117 by 1130 GMT, Europe’s shared currency had only the safe-haven Swiss franc and Sweden’s crown for company in resisting a broad rally against the greenback by the G-10 group of currencies.

“We’re getting more headlines that the current lockdowns will be extended further, which could mean that the euro zone would be flirting with a double-dip recession before long,” said Valentin Marinov, head of G10 FX research at Credit Agricole, noting Europe’s lag in rolling out a coronavirus vaccine compared to the United States and Britain.

“So all of that plays into the story that tomorrow’s ECB meeting, while uneventful in terms of policy announcements, could convey a relatively dovish message to the market. On top of that, President Lagarde could once again jawbone the euro, so the euro is kind of lagging behind.”

Marinov also noted price action in the pound, which hit $1.3720 – a 2-1/2-year high – and 88.38 pence – its highest since May 2020 against the euro – as a contributing factor to euro weakness. [GBP/]

There was also focus on a story by Bloomberg News, which reported the European Central Bank was conducting its bond purchases with specific yield spreads in mind, a strategy that would be reminiscent of yield curve control.

Elsewhere, the risk-sensitive Australian dollar gained 0.4% to $0.7727. The New Zealand dollar, also a commodity currency like the Aussie, gained 0.25% to $0.7133.

DOLLAR WEAKNESS

While the world will be watching Joe Biden’s inauguration as U.S. president at noon in Washington (1700 GMT), traders were more focused on his policies than the ceremony.

U.S. Treasury Secretary nominee Janet Yellen urged lawmakers at her confirmation hearing to “act big” on stimulus spending and said she believes in market-determined exchange rates, without expressing a view on the dollar’s direction.

The index that measures the dollar’s strength against a basket of peers was up almost 0.1% at 90.510. The euro forms nearly 60% of the dollar index by weight.

It also fell 0.1% against the Japanese yen to 103.81 yen per dollar.

While the dollar has perked up in recent weeks on the back of a rise in U.S. Treasury yields, investors still expect the currency to weaken.

“We remain bearish U.S. dollar, and expect the downtrend to resume as U.S. real yields top out,” said Ebrahim Rahbari, FX strategist at CitiFX.

“Continued Fed dovishness remains important for our view, in addition to global recovery, so we’ll watch upcoming Fed-speak closely.”

Positioning data shows investors are overwhelmingly short dollars as they figure that budget and current account deficits will weigh on the greenback.

(Graphic: Dollar positioning: https://fingfx.thomsonreuters.com/gfx/mkt/oakveyombvr/Pasted%20image%201611132945366.png)

UBS Global Wealth Management’s chief investment officer Mark Haefele reiterated a bearish view on the dollar, saying that pro-cyclical currencies such as the euro, commodity-producer currencies, and the pound would benefit “from a broadening economic recovery supported by vaccine rollouts”.

The cryptocurrency Bitcoin fell 4%, trading at $34,468.

(Reporting by Ritvik Carvalho; Editing by Angus MacSwan)

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England soccer star Rashford nets younger buyers for Burberry

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England soccer star Rashford nets younger buyers for Burberry 3

By Sarah Young

LONDON (Reuters) – Burberry stuck to its full-year goals on Wednesday after a media campaign fronted by high-profile English soccer star and social justice advocate Marcus Rashford drew a younger clientele to the British luxury brand.

Higher full-price sales would boost annual margins and Asian demand remained strong, Burberry said, while warning that it could suffer more sales disruption from COVID-19 lockdowns.

Manchester United striker Rashford, 23, has won plaudits for his campaign to help ensure that poorer children do not go hungry with schools closed during the pandemic.

A first coronavirus wave last year cut Burberry’s sales by as much as 45% before a bounce back on strong demand in mainland China and South Korea, which continued in the last few months.

Shares in Burberry were up 5% to 1,825 pence at 0905 GMT, with Citi analysts saying that improved sales quality from fewer markdowns would drive full-year consensus upgrades.

Burberry’s 9% sales decline in its third quarter was worse than the 6% fall in the second, and the company said that 15% of stores were currently closed and 36% operating with restrictions as a result of measures to curb COVID-19’s spread.

“We expect trading will remain susceptible to regional disruptions as we close the financial year,” Burberry said, adding that it was confident of rebounding when the pandemic eases given the brand’s resonance with customers.

In the third quarter, comparable store sales in Europe, the Middle East, India and Africa declined 37%, hit by shops shut in lockdowns and a lack of tourists visiting Europe, but in the same period, it posted sales growth of 11% in Asia Pacific.

Burberry said that Britain’s new relationship with the European Union would cause headwinds, warning of a modest increase in costs to comply with new rules and also the impact of an end to a scheme for VAT refunds for non-EU tourists.

This would make Britain a less attractive destination for luxury shopping when tourism returns after the pandemic, Burberry said, adding that it would try to mitigate the effect.

(Reporting by Sarah Young; Editing by Kate Holton, James Davey and Alexander Smith)

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