Financial Services: Re-Analyzing Banking Systems and Bank Moats

• Our overall financial services sector valuation remains attractive at a price/fair value ratio of 0.88. Credit services and life insurers are especially undervalued at a sector price to fair value estimate ratio of 0.85.
• Our revised methodology expands on our existing framework to more deeply and consistently analyze the strength of bank moats across our coverage. We examine the strength of banks' traditional financial intermediary businesses--chiefly retail and commercial banking--and of nonintermediary businesses, like investment banking and wealth management, which can impact a bank's moat. We also introduce a rigorous analysis of the banking systems in which banks operate, which is critical to our confidence in the sustainability of a bank's excess returns and evaluating the likelihood of value-destroying events.
• We've also added switching costs as a moat source for most banks, complementing cost advantage, as they play a key role in maintaining low-cost funding.

A banking system is the structural framework under which banks operate in a single country. Key parties involved in this framework are not only the banks themselves and the executives who run them, but also politicians, regulators, and other government officials, depositors, debtors, and shareholders.

Why are banking systems important to enhance our understanding of moats? It is true that banks offer relatively undifferentiated products and perform essentially the same services worldwide. Lending for mortgages, opening checking and savings accounts, issuing credit and ATM cards, and providing assistance with retirement accounts are similar services offered globally. It is also true that all banks are heavily regulated, as modern economies cannot function without banks, and banks are supervised by multiple agencies in many countries.

However, banking crises occur on a regular basis (we've tracked more than 150 events since 1800 across our coverage). This suggests that while banks may be similar, banking systems are clearly not. Certain countries such as Brazil suffer from repeated crises, while other countries such Canada and Australia rarely run into issues. As a result, being able to identify banking systems that support individual bank moats is critical to ensuring that we have a high level of conviction that the bank's economic moat is sustainable.

In addition to the strength of a country's economy, banking systems are also influenced by political, competitive, market-based, and regulatory factors and the complex relationships between banks and the overall environment they operate in. A strong banking system should score well across all of our factors, but our assessment is ultimately a holistic one. A strong economy can be undermined by a poor regulatory system, regulators can be undermined by political interference, and strong regulatory oversight and a stable economy can be undermined by a banking system beset with competition. In turn, an extremely profitable competitive environment for banks can be undercut by poor regulatory oversight or a very unstable economy.

Overall, we assign systems into four buckets: very good, good, fair, and poor. Our framework for evaluating banking systems includes multiple factors. We broadly group them under the regulatory environment, the macroeconomic environment, the competitive environment, and the political environment. Countries such as Australia, Canada, and Switzerland that do well across all four areas receive very good rankings. Countries that do not score well across one or more areas are typically ranked good or fair. These include Chile, Germany, and Mexico. However, very strong ratings, as opposed to fair or poor ratings in other environments, may still mean a system can be rated very good. Similarly, countries with mixed ratings across multiple environments will typically be rated according to what we consider to be the most important factors for a given country. Countries that do not score well across multiple environments are typically rated poor, such as Brazil, India, and Italy.

We also consider switching costs as a possible moat source. As banking relationships become entrenched, switching costs should increase. When banks capture more of retail and commercial bank customers' wallets with more products per customer, the banking relationship tends to become more entrenched. As those relative switching costs (both implicit and explicit) increase, the returns and moats of those banks should also increase. While switching is nominally free, the benefits are often unclear with similar bank products across firms, such as free checking accounts. Moreover, switching is viewed by customers as troublesome, especially for customers who use multiple products from their bank. As a result, retail banking customers tend to move banks once a decade.

Apollo Global Management

APO

Apollo is a global alternative asset manager with about $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, it manages AUM for Athene, a fixed-annuity provider, which provides Apollo with a $60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and is overlooking the strong growth prospects Apollo has in credit, thanks to regulators forcing banks to sell illiquid and risky assets to the firm at a discount.

Toronto-Dominion Bank

TD

With its strong retail network in both Canada and the U.S., Toronto-Dominion Bank continues to deliver excess returns during this low rate environment. We take comfort in TD Bank's relatively low exposure to the oil patch, which, compared with other Canadian peers, will not have a significant impact upon those returns should energy pricing remain subdued. Also with a high percentage of residential loans either government insured or currently at low loan/value ratios, we take comfort that any impact upon the bank due to a housing bubble burst will not erode TD Bank's capital base. With the expectation that mortgage rates will rise very slowly in the medium term, we think any impact upon the bank due to delinquencies caused by higher rates will be stretched out over several years, also minimizing the impact to TD Bank's capital. Trading at a significant discount to our fair value estimate and 10.8 times 2016 estimated earnings, along with healthy 3.9% dividend yield, we think this is an attractive opportunity for investors.

Banco Santander Brasil

BSBR

We think that Santander Brasil is undervalued because investors are overly focused on headline profitability metrics that do not capture the true earnings power of the company. In our view, Santander Brasil holds a strong competitive position within the highly concentrated Brazilian banking market with a narrow economic moat. We expect that the negative accounting impact from goodwill and excess capital will fade, and over the long term, investors will come to realize the bank's true earnings power.

More Quarter-End Insights

• Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
• Economic Outlook: As World Growth Falters, the U.S. Consumer Rolls Along
• Credit Markets: Plummeting Commodity Prices Take Their Toll
• Basic Materials: U.S. Construction Activity Provides Shelter From the Storm
• Consumer Cyclical: Near-Term Concerns Over China Create Buying Opportunities
• Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
• Energy: No Rapid Rebound for Oil Prices
• Health Care: Recent Pullback Opens Door to More Compelling Valuations
• Industrials: High-Quality Industrials Are on Sale
• Real Estate: For the Strong Stomached, Commercial Real Estate Looking More Attractive
• Tech and Telecom: Still Watching Foreign Exchange Headwinds and the Cloud
• Utilities: Low Rates Keep the Sector's Lovefest Raging