Barclays (NYSE:BCS) is still trading at just above ~0.5x its tangible book value.
It is expected to sustainably return on tangible equity (RoTCE) of above 10% in 2022 (and beyond) whilst absorbing substantial one-off legal and conduct charges emanating from an administrative error. This effectively translates to an earnings yield of 20%+.
It pays a healthy dividend (estimated at ~4%) which is complemented by sizeable share buybacks. The latter is currently the preferred way of returning capital to shareholders given the discount to book.
So why is the share price trading at such a distressed valuation?
There are two primary reasons for it in my view.
Firstly, it is to do with macroeconomic uncertainties and the concerns that a deep recession in the U.S. and UK will manifest in heightened credit losses. The real income of UK and U.S. consumers has been declining due to high inflation and energy prices. The concern is that this will drive up loan losses as the economies, in real terms, invariably contract.
I believe that these concerns are way overblown and BCS should comfortably be able to ride out any plausible economic storms. As can be seen from the slide below, BCS is very conservatively provisioned for unsecured credit, whereas the current run-rate of losses is expected to be well below pre-pandemic levels:
Secondly, it all has to do with recency bias and associated negative perceptions of this bank. BCS during the last decade or so (post the global financial crisis) has repeatedly managed to clumsily destroy capital through seemingly endless legal and conduct charges. Importantly, and in stark contrast to the large U.S. peers, BCS investment bank was a perennial underperformer and struggled to earn its cost of equity, only managing to eke out an unimpressive mid-single-digit RoTCE. The prior CEO Mr. Staley largely fixed these issues and the investment bank is now comfortably earning its cost of capital (albeit still with returns below its U.S. peers).
Essentially, the two reasons above explain why BCS remains unloved despite its sustainably strong financial performance.
The expected rate environment of 3% (or higher) is hugely beneficial for banks. Partly it is due to expanding net interest margins, as deposits do not reprice as fast as loans. A material part is the bank’s large liquidity portfolio, which now generates a much higher yield as securities mature and are purchased at higher yields. The slide below provides a sensitivity analysis of rates with an upwards parallel shift of 25 basis points:
Clearly, rates on the short and long end have moved much more than 25 basis points. As such, one would expect that benefit to be a multiple of the above projections, especially in the outer years. Keep in mind that the current market valuation of the firm is only GBP26 billion. This is exceptionally material to the returns of banks. It is also important to note, that the benefit as rates climb higher and deposits’ costs also creep higher will accrue mostly to the liquidity portfolio (otherwise known as the “structural hedge”). This was explained by BCS CFO in a recent analysts’ briefing:
our expectation is that the momentum in NIM moves from, if you like, product driven to hedge-driven. What really helps us here is the fact that our hedge programme has been rolling mechanistically for a number of years, so we are seeing part of the hedge roll off. If you look back five years, that would give you a good indication of where it is rolling off from and rolling on to the current curve. That is quite a degree of momentum, and perhaps explains some of the differential that you are seeing in some of the guidance that you hear from across the street. That is what makes us confident in that number, and why we have guided up from here.
The CFO is hinting strongly that the analysts’ consensus number is not fully reflecting the benefits of interest rates.
The nominal economy
Banks are beneficiaries of inflation or nominal growth of the economy in a number of business lines.
This includes products that have a fee associated with the transactions, for example, current accounts or credit cards for retail customers. Corporate banking will predominantly benefit transaction banking as well as trade finance business (e.g. financing energy trades). The biggest upside for Barclays is its large Payments business. The CFO highlighted this point in the recent analysts’ briefing:
If you look quarter on quarter, that Payments business is now ticking up simply because it is exposed to the nominal flow of economic activity in the environment…..But predominantly, it is going to be in the transactional businesses that relate to retail or corporate activity, so cards, both types, Transaction Banking, Payments is where you will see it.
This is probably the best macro environment I have seen for the large banks in the last 15 years or so. Interest rates are high and expected to stay elevated in the medium term. The inflationary settings and expected positive real interest rates going forward are strong tailwinds. Do not fight the Fed or the Bank of England (“BOE”) for that matter.
The banks (and Barclays specifically) are acting from a position of strength. BCS is highly capitalized, liquid, and conservatively provisioned for loan losses.
The strength of the USD compared to GBP and EURO is a tailwind to profitability. Trading volatility is a boon (especially in FICC) for banks with large trading desks such as Barclays.
The valuation at slightly above ~0.5x tangible book is simply enticing. It is too cheap to ignore. I expect it to rapidly close the gap to tangible book value and materially increase its dividends in the next 3 to 5 years. Now is the time to own Barclays in my view.