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Conor Muldoon, portfolio manager, Causeway Capital.
Banks make money by taking in deposits and then lending that money out. So when rates are low or in negative territory, the amount they can charge for lending tends to fall. However, there is generally a floor of 0% on the money they can borrow from retail customers or from their depositors; hence, lower interest rates will put pressure on the net interest margin that banks make.
Currently, we have negative rates in many parts of the world, and this is putting a lot of pressure on financial institutions that operate in those regions. But, effectively, what banks do is banks tend to put on interest rate hedges to protect their net interest income. So the headwind that this creates tends to manifest itself slowly over time, over a period of three to five years as opposed to immediate impact, and this time really allows banks then to focus on potential offsets, such as cutting costs or asset repricing — so increasing the credit spread that they charge the lending side.
And then one of the other big benefits of lower-for-longer interest rates that is often overlooked by the market tends to be the positive tailwind that lower interest rates create on the bank’s cost of risk or the level of bad debt provisioning.
One of the key things that we pay attention to is the actual management of the bank or financial institution. We like management teams to be less focused on top-line growth, and management teams that are ultimately preparing their bank for a world… for kind of lower-for-longer interest rate, because typically what we tend to see is management teams that are focused on managing the cost base, de-risking the balance sheet and preparing for kind of a tough revenue environment.
UniCredit, an Italian listed bank, is one of our favorite companies. This is a bank that’s transformed itself over the last two to three years. A new management team came in, in 2016, late 2016, and what their sole focus has been over the last two to three years has been de-risking the balance sheets, improving the capital base of the bank and ultimately reducing its cost base. So in terms of de-risking, it is taking stock of non-performing loans that was close to 15% of the balance sheet, and it’s continuously reduced this down to a much more manageable level over the last two to three years. The ultimate goal of the management team is to reduce this to close to zero by 2021.
In terms of the cost base, it’s taken a cost base that was over 12 billion euros and reduced it closer to kind of 10 billion euros over the last three years. So, basically this de-risking and reduction of the cost base has improved the level of returns that this bank can generate significantly over the last three years and makes this bank very well prepared for kind of a much tougher revenue environment as interest rates continue to fall in Europe. And that obviously freed some headwinds in terms of the net interest income that the bank can generate.
What we like about this bank is none of this is really reflected in the stock price currently. So it’s currently trading at six-and-a-half times EPS and about 45% of tangible buck. We expect the return on tangible buck to be well north of 9% and even close to 10% over the next two to three years. And we also expect the bank to start to return a significant amount of capital to shareholders in the form of both dividends and share buybacks.
One of our other favourite financial companies in the portfolio currently is a U.K. listed company called Barclays. Similar to UniCredit, Barclays has gone through kind of a transformation over the last three to four years. Barclays has a management team that is focused on ultimately restructuring the cost base, reinvesting in its corporate and investment bank franchise, and ultimately improving the level of returns and tangible equity that it can generate. The management has a goal of generating returns in the 9% to 10% on tangible equity in 2019 and 2020, and they’re well on their way to doing so.
This bank is also trading at very attractive levels, close to six-and-a-half times earnings, and about 60% of tangible buck. And similar to UniCredit, this is a bank where we also expect a significant step up in the level of capital that comes back to shareholders over the next two to three years. So Barclays has rebuilt its capital position. It’s got north of 13% core equity Tier 1 and is now very well placed to start buybacks and increase common shareholder dividends in the next 12 months.