Morningstar - Q3 2023 - 66

Investors
Banking on Bank Stocks
The sector offers good deals for investors
with fortitude.
SECTOR RAP
Laura Lallos
Bank stocks are cheap. The crisis sparked
by a run at Silicon Valley Bank in early
March seems to have ended when First Republic
was sold to JPMorgan Chase JPM on
May 1. Investors still have reason to be cautious,
however. In a recent Financial Services
Observer,1
equity strategist Eric Compton
warned that there may be negative surprises
with deposits or funding ahead, there
are not many positive earnings catalysts on
the horizon, and there is a potential recession
around the corner.
" But as we apply our long-term valuation thinking, "
Compton writes, " we believe that throughthe-cycle
earnings power, while it will be hurt
by current events, still warrants higher
valuations than we see today. " Morningstar's
equity analysts believe the sector on average is
undervalued and will see returns in the
future that exceed cost of equity and likely the
overall market. Compton points to several picks
that are particularly attractive today.
We sat down to discuss these opportunities and
risks on June 8, and our discussion reflects
conditions and valuations as of that date. It has
been edited for length and clarity.
Laura Lallos: This year's banking crisis seems like it
was set off by concerns limited to a few specific banks.
What happened? Is it over?
Eric Compton, CFA, is an equity
strategist, U.S./Canadian
banks, at Morningstar Research
Services, LLC.
Eric Compton: Banking is a pretty unique industry.
It has nonlinear outcomes, where something
doesn't matter, doesn't matter, doesn't
matter, then all of a sudden, it's the only thing that
matters. In a fractional reserve banking system,
which is the typical banking system you see
in the modern era, banks are always sensitive to
a run on the bank, which is related to a loss
of confidence in either that specific bank or the
banking system in general. No bank can
lose 50% of its deposits in a week. Any bank could
break under the right circumstances. That's an
unfortunate feature of the banking system.
But there was a specific setup at some of these
banks where you're playing with matches and
you've piled the room full of dynamite. One
was deposit concentration risk: When you've got
deposits coming from one type of client, one
type of business, that increases the chances that
all of them act together. That was a key risk.
First Republic had unrealized losses sitting
on the balance sheet equal to or greater than the
total equity in the bank. It didn't matter as
long as the bank could stay in business and let
those things mature away. But it's the only thing
that matters if you start to lose all your
deposits too quickly and you're forced to realize
those losses. And there's some circularity
there, too. It doesn't matter as long as everything's
stable, but the fact that that big hole exists
on your balance sheet can contribute
to people losing confidence. So, it kind of feeds
on itself.
Then there are crypto-related risks. Some of the
banks that have gone down did have material
exposure to the crypto universe, and that
turned out to be pretty toxic. So, the setup was
uniquely bad for those specific banks, but if people
start to lose confidence in general, it can
start to affect other banks that weren't set up
poorly. That's the tough part of being a bank.
Have we seen the worst? That acute phase at the
beginning, where people weren't sure if there
was going to be another bank going down over
the weekend, is over. Deposit levels have stabilized
after that initial drop after March 8. Now
everyone is trying to deal with the potential
longer-term fallout, such as fundamental changes
in the funding costs for the industry or in
regulation that could hurt profitability going
forward. There is also a psychological
element to it. It's hard to tell when investors will
feel comfortable investing in banks again.
Lallos: What are your thoughts on how regulators
have handled things so far, and what do you foresee in
terms of increased regulation?
Compton: As far as the initial response to the
crisis, I think the regulators did a decent job.
There are some heated debates. Some argue that
we shouldn't bail any of them out, that this is a
natural way to let risk sort itself out in the system
and force investors and depositors to be
disciplined. The other side is that the government
should have stepped in even more and insured
all deposits. I lean more toward that end
of the spectrum, personally. What's the point of
letting regionals that weren't poorly run fail?
I also don't think it makes a ton of sense to expect
ordinary depositors to be bank analysts.
Fine, let Silicon Valley Bank fail. But I do think
the regulators could have come in with
some more explicit deposit insurance guarantees.
1 Compton, E. 2023. " Banking Outlook 2023: The Sector Is Cheap Again, Even if the Road Forward Won't Be Easy. " Morningstar Financial Services Observer. April.
66
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