Emerging-market-focussed banks HSBC Holdings (LSE: HSBA) and Standard Chartered (LSE: STAN) are going through a very rough patch — over the past 52 weeks, shares of HSBC have fallen by 19%, while those of Standard Chartered have lost 55% of their value.
With both banks trading well below book value, are their shares undervalued?
Low Valuations
HSBC’s shares are currently trading at 0.76 times tangible book value (TBV), while those in Standard Chartered are worth just 0.49 times TBV.
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This indicates that the market believes the banks’ assets are worth significantly less than what it says on their balance sheets, and this usually means two things: more loan losses are expected to be made, and returns for the banks will likely be sub-par in the near future.
Low Returns
Returns on equity (ROEs) for HSBC have actually been below expectations for some time. They have consistently missed management’s medium term targets over the past 5 years, despite the bank twice lowering its ROE target, from 15-19% to 12-15% in 2011, and again to “more than 10%” in 2015.
In 2015, its actual ROE was just 7.2%, with the bank making a pre-tax loss of $858m in the fourth quarter. The unexpected weakening in the bank’s financial performance could be taken as a sign that its earnings outlook has taken a turn for the worse.
HSBC’s size and complexity means it is beset by higher regulatory and compliance costs than many of its rivals. This has meant that despite the bank’s efforts to cut costs and boost returns, HSBC’s total operating costs have actually risen in recent years, and its cost to income ratio remains stubbornly high, at 66.5%. Having a higher cost structure and carrying more capital means many local banks enjoy a competitive advantage against HSBC, particularly in those markets where HSBC has a smaller presence.
Standard Chartered, on the other hand, has had a great run up until the recent emerging market slowdown. Normalised ROEs have consistently been in the low- to mid-teens for the five years leading up to 2013. Up until recently, the bank had not made an annual loss since 1989, not even during the 2007/8 financial crisis.
But for 2015, the bank reported a loss of $2.36bn, following a near doubling on loan losses, to $4bn. The worst is not over for emerging markets, and earnings will likely stay low for longer, as loan losses continue to rise and revenue growth slows. Looking forward, management expects ROEs will only reach 8% by 2018. That’s a near three year wait for a return which is still sub-par.
Bottom Line
Both banks may seem undervalued on their low price-to-tangible book valuations, but these valuations do actually seem justified when we take into account their low profitability. In addition, as loan losses continue to rise, there are growing fears over a potential dividend cut at HSBC and a further capital raise for Standard Chartered.
With such uncertainty surrounding these bank shares and a weak outlook on earnings, these bank stocks resemble classic value traps to me.
