A very experienced European banks analyst I know recently told me he thinks the market needs to think harder about cost of equity for banks. I tend to focus on the earnings and take cost of equity as given. However, looking at the 3Q results of Svenska Handelsbanken (SHB) (OTCPK:SVNLY) I think it might have been a richer question than I first thought. From November 2015 to July 2016, SHB lost 23% in value. Since the low on 6 July, it has risen 36% and is 4.5% above where it started the round trip. The P&L of the bank has hardly changed during this time.
This is striking price volatility for a bank stock that is accurately regarded by many as almost bond like in its solidity - the reason for this is legendary. With a CET1 ratio of 24% and very strong asset quality, SHB is exceptionally unlikely ever to need equity investors to recapitalise it. The stringent domestic regulator is an irritant, but the sector has long embraced a lower growth, capital return philosophy that makes investors confident about pricing and risk control, and so also about returns. The following chart shows a disaggregation of SHB's pre-tax profit. It is quite hard to tell one quarter from another, but given what the stock was doing through the early period shown in the chart, one would have to qualify this sameness quarter to quarter as being a positive.
Source: Company data
While there was widespread margin pressure outside the core Swedish franchise, SHB enjoyed improving NIMs in its important domestic mortgage business, allowing NII to improve for the quarter. There was also an improvement in securities transactions income and with stable costs, this drove the lift in Q3'16 pre-tax profit visible in the chart.
In fact there is some growth at SHB, and it's consistent, which can be seen in the main funding and loan volumes of the bank. It edges forward every quarter and the period in the chart below shows >10% loan growth over nine quarters. This is low growth, but not zero.
Source: Company data
There was a dip in the stock price post the results last week when the CEO said on the analyst call that Basel IV remained a question and the capital buffer would come up for review during the coming months. The market got past this wobble very quickly and we need not spend much time debating it here, except to say that the market tends to focus on quite narrow capital questions with the Nordics and concerns about capital levels can get overblown very quickly. This reflects the fact that, in a low-growth world, the primary means of shareholder value is dividend streams and buybacks. So potential changes to these can assume great importance in the minds of those covering the sector. The Nordic banking universe is small - a handful of large stocks, a handful of smaller ones - and I wonder it might be an idea to give the analysts of Nordic banks (who are generally excellent) a wider geographical brief so they keep capital questions in perspective! The message to the retail investor is that dividend streams should remain in a healthy zone and are very low risk because capital ratios are high. As I wrote in another recent piece, whether Nordea can grow its dividend every year is of lesser importance than the level of the yield itself.
Back to Svenska's risk premium. ROTE remains around 13% in Svenska, and Price/TBV is about 1.75x, which allows for a little growth over a 10% cost of equity. For example, assuming 5% growth would return a 1.8x BV. If the market dropped cost of equity to 9%, the stock could rerate very substantially to 2.2x BV. My analyst friend is a sell-sider of vast experience and it's interesting to me that he is musing on this question now because he is long past the time when he thought valuation models mean very much vis-a-vis likely price action. His question reflects the fact that the sector has got through a rough market period, which suggested a scenario completely at odds with its fundamental performance. That scenario has not transpired, and the stocks are recovering. A few, like SHB has completely recovered. My own guess is that investors won't easily move away from the 10% cost of equity assumption currently being used, and therefore, Svenska is not so compelling up here on a relative basis. It probably shouldn't ever be that compelling- maintaining a full valuation and advancing in line with its growth. In that sense, a ~5% advance over last November is about right for a very high quality, 4% yield stock. The message is, wait for the next totally unwarranted dip to add to your holding.
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