Friday Morning Coffee Nr. 121 : Where is the multiplier effect?

240920 Friday Morning Coffee

Friday Morning Coffee Nr. 121 : Where is the multiplier effect?

Allow us to reproduce the chart of the Eurozone banking index, which we are sure you must have come across quite often since the arrival of the Covid-19 hurricane;

Source: ECP, Bloomberg

What you see here in the chart above is the perfect set-up for the technical chartist to jump the ship and initiate shorts in the banking names. And here is another one,

Source: ECP, Bloomberg

In the second chart we compared the banking index against the price of copper, an important indicator of the health of the general economy. Historically, these indices have performed in line with the real interest rate expectations by the market participants. As we can see both the indexes were moving in the perfect lockstep up until the beginning of this year, but that correlation has broken post the Covid-19 impact. We understand the risk of supply shortage and the China factor on the Copper prices, but again China is the largest consumer of the metal, not the only.

It seems that the market participants are expecting an oncoming Armageddon in the European banking space or that they foresee a world without a need of banking institutions. In the latter case we are sure JP Morgan would roll in his grave upon hearing that thesis. Metaphors asides, in the YOLO and FOMO world that we live in the last thing an investor would try is to catch falling knives. Ever increasing regulatory red-tapes, lower for longer interest rates environment, negative real interest rate expectations, frequent occurrences of compliance issues, competition for market share and, consequently, low visibility on the future earnings make banking names specialist’s play.

However, for us value investors, these are the perfect pockets of the markets wherein we hunt for bargains. Over the last weekend, one such name came on to our drawing board, Société Générale, after they announced disposal of one of their asset management business “Lyxor” and creation of a new retail bank in France by the merger of its two existing networks. On the face of it, Société Générale’s shares are trading at distress levels. For a bank with EUR c 1.5 trillion in balance sheet assets, shares trading at less than 10 billion of market capitalisation looks an extreme.  On the price to book multiple, it is at x0.2 whereas the sector average is 0.6. What exactly is the market pricing?

For current year management has guided for Basel3 CET1 in the range of 11-11.5%, 195-245 bps above MDA (Minimum Distributable Amount) buffer. Expected -120 bps impact of Basel 4, has just been delayed, but still on the table. Factor in the risk of Covid-19 second wave, restructuring in France retail banking segment, exposure to Russia, Eastern European and African countries, and it carrying one of the largest derivatives book amongst the Global banks. We would not blame market participant giving least credibility to RWA and provision guidance provided by the management, as can be seen in the consensus ROE expectations of 3-4% in coming years.   

In contrast, our existing holding in the banking space “BAWAG Group”, nimble bank operating in Central European region with high quality assets that entirely consists of loan book. At c. 42%, it has best Cost-Income ratio in the EU region, in comparison Socgen has cost income ratio north of 75%. In the long term recession scenario, in line with EBA stress test, BAWAG is one of the handful bank names in the EU region which would have one the highest buffer over MDA and thus the prospective shareholder returns.