«Is UBS a Strategic Value Investment? And Credit Suisse?»

Maurice Pedergnana

Maurice Pedergnana

There will come a time when we look back mournfully and ask ourselves why we didn’t buy bank shares back in July 2016, finance professor Maurice Pedergnana writes in an essay for finews.first.

finews.first is a forum for renowned authors specialized on economic and financial topics. The texts are published in both German and English. The contributions appear in cooperation with Pictet, the Geneva-based private bank. The publishers of finews.ch are responsible for the selection.

There will be a time when some will look back remorsefully at these moments in July 2016 and regret not having bought bank shares at sales prices. The current sales or evaluation prices do not correspond to the general high of the stock markets.

One may think of stocks in general as overpriced, but a look at banking and insurance stocks will put that in perspective. Most people would argue that the big names are undervalued on the market despite comfortable financial bases and good ratings. So what does that mean? There is no euphoria-driven upward movement of the market, sorry.

Yet here we have to differentiate. Not everything in this summer sale is a steal. Here are a few examples of the price book ratio of big banks that are well positioned and will presumably make a good profit in 2016:

  • Barclays: ca. 0.4
  • BNP Paribas: ca. 0.6
  • Intesa SanPaolo: ca. 0.6
  • Credit Suisse: ca. 0.4
  • UBS: ca. 0.9

Are these titles simply smart buys for investors focused on the value of a company? Or is there more to it? Is it either overvalued booking or too low stock market prices that lead to low book values of equity?

If we assume that the book positions are deemed sustainable, we have to wonder why there is a discrepancy of up to 60 percent at the moment. The share price, indicator of the book value of equity, is shaped by the expectations of the market regarding cash flows and profits. Both estimates of a share's value consider the future development according to available figures. So what does the market know that accounting does not?

«The market does not trust theses banks»

We can look back to the classic credit business of recovering assets of folding companies. They range between 40 and 60 percent. Regarding the gap between the market value and the book value of some big banks, it looks as if the market did not trust these companies and suspected possible failures.

The market does not believe these banks are able to adequately pay interest on borrowed money and make a profit. Seeing that the cost of capital is higher than the return on capital, the market obviously considers the profits as inadequate.

What's more: banks should be closed and liquidated if the market, judging according to the market efficiency rule, does not trust them to make an appropriate profit. The market does not expect them to be profitable in the long run. The market does not even hold the banks with a low book value of equity to wind up their business efficiently.

If for instance Credit Suisse, with a book value of 45 billion francs, were to be liquidated, the cash value would only amount to 22 billion francs, a measly 40 percent. That would mirror the present market value of CS.

In short: the market does not believe in banks. Is this a simple case of bank bashing? Or is there a good reason for it? We believe that it is important to distinguish between viability and hope. And that enables us to find some opportunities as well. Solid considerations pertaining to the intrinsic value of a company be the basis for investments, should they not? Chance-based investments might degenerate into mere speculation.

«Free of charge is not risk-free»

To give an example: Schweizer Universal Bank (SUB), a division of Credit Suisse Group, is able to generate a corrected profit of 1.6 billion francs (before taxes). Even in the bad recession years 2008/09, its business was profitable. The typical market value of equity of 10 to 12 for this Swiss bank represents two thirds of the present market value of the whole group.

As a shareholder of Credit Suisse Group you get to profit from their assets, the service, the infrastructure and the good customer relations in London, New York, Tokyo, Hong Kong, Singapore for a song.

But free of charge is not risk-free. If one could only trust the top management to lead its staff to create more net value to the investor than losses, and fewer costly legal battles, one could take the Credit Suisse Group for «Value Stock», as proposed by a traditional «Value Investor».

If on the other hand you consider the roughly 120 billion francs of dubious positions in the books, you know that their liquidation would cost another maybe 6 billion francs core capital. Credit Suisse CEO Tidjane Thiam has proposed to the board that the liquidation should be processed speedily, and that might well result in ever higher costs.

«This feeds the rumors that special bonuses of $228 million are offered to specialists»

Since such an operation is invariably connected with staff cuts, valuable know-how of many departed employees may get lost. This means more losses in higher numbers than can be anticipated now. It will be the captain of the ship who has to bear the responsibilities and not the sailors gone overboard. This scenario feeds the rumors that special bonuses of $228 million (!) are offered to the specialists for staying on board for the whole restruction period.

Of course one could argue that steady revenue and the economizing procedures of the bank will soon amount to 1 or 2 francs per share again. Some insiders doubt this, feeling that the lemon can only be squeezed up to a point, after which only bitter residue remains.
However you look at CS Group, its dividend discount presents a sorry picture. In a market that is shrinking and is therefore even more competitive than before, battling with the zero-interest mark and a capital cost of 12 to 14 percent takes a great effort to justify a share price of 15 or 20 francs.

«It could be likened to a walk over burning coals»

Two courses seem to be on offer: the Swiss Universal Bank undergoes a partial IPO. That would diminish the profit of the shareholder and might not be sustainable in the long run. It could be likened to a walk over burning coals, something that becomes a fakir but not the governance of a company who has to deal with minority share holders, such as Roche/Genentech, St. Gobain/Sika, Georg Fischer/Agie Charmilles and others can report on such adventures.

The second way to get out of the squeeze is a further capitalization by perhaps 4 billion francs. That would have to happen if the share dropped to about 8 francs, which would be a damning indictment of the mistaken strategy of the new CEO and present management and would call for a new CEO and a new board.

We do not consider this scenario as likely, but never say never. The strategy is at present highly dependant on the general state of the financial sector. If the market loses stability and becomes more volatile, it is bad news for the recovery of the company. No wonder Thiam proclaimed steadfastedness saying: «The Group will stay intact. A takover is not a subject.»

This raises the possibility of a third way out, and it will boost the share price more than the expected quarterly results. Credit Suisse has become a pretty object of desire because of its low share price. A shareholder can hope for an offer that would be 30 to 40 percent higher than the average price of the last few months. If a solid and well capitalized U.S. bank would want to establish itself in Europe and the growing wealth management markets in Asia, this might be a prize goal.

«Credit Suisse would fit well into Wells Fargo»

We are not thinking of J.P. Morgan, which is strong already, but about Morgan Stanley or Wells Fargo. Wells Fargo is well positioned with a market capitalization of $240 billion. Their expected profit for 2016 equals about the present market capitalization of CS. It has shown healthier profits than others in its peer group in recent years.

Credit Suisse would fit well into Wells Fargo. To join Morgan Stanley would be more difficult, as there are several overlapping fields, but Morgan Stanley, too, is a healthy bank, and it could and would greatly profit from the Wealth Management section of the CS. A significant part of the global UHNWI clientele thinks highly of CS's Wealth Management platform. Morgan Stanley has passed the stress test of the Federal Reserve and has just decided to pay 33 percent more dividends. It is to be assumed that they still have some surplus cash that they could put to good use...

No such thoughts have to trouble the sleep of UBS, if banks ever do sleep, which is unlikely. UBS's Wealth Management looks very good. That the shares lost 32 percent over the last six months cannot be explained by slower growth in China, the commodities credit crunch or Brexit.

These facts do not weigh significantly on the balance sheets of UBS. UBS looks forward to a year of reduced legal costs and litigation risks. When it comes to difficult investment banking, it will analyze its cost management. UBS braces itself against turbulent times with high volatility, low volumes and tougher competition in a world of stricter regulations.

Unlike any other bank, UBS will be in a position to sort out the complexities of its actions in time. A ship of precious dimensions if it gets steered into calm waters.

Collaboration: Roger Rissi

Maurice Pedergnana is chief economist for Zugerberg Finanz, one of Zug’s largest asset managers with 25 employees and which focuses exclusively on the Swiss market. The Swiss academic sat on Zurich Cantonal Bank’s supervisory board from 1999 to 2011. He has authored several books and lectures in economics at Lucerne University of Applied Sciences and Arts.

Roger Rissi is an economics lecturer at Lucerne University of Applied Sciences and Arts. His PhD on the effect of regulation on bank business led to a role as a EU parliament expert on implementing capital standards. He worked for UBS for nine years.

Previous contributions: Rudi BogniAdriano B. Lucatelli, Peter Kurer (twice), Oliver Berger, Rolf Banz, Dieter Ruloff, Samuel Gerber, Werner VogtWalter Wittmann, Albert Steck, Alfred Mettler, Peter Hody, Robert Holzach, Thorsten Polleit, Craig Murray, David Zollinger, Arthur Bolliger, Beat Kappeler, Chris RoweStefan Gerlach, Marc Lussy, Samuel Gerber, Nuno Fernandes, Thomas Fedier, Claude Baumann, Beat Wittmann and Richard Egger.


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