Stock Watch: Hang Seng Bank

Bank stocks can certainly be a great investment. Banks, in normal times, are reliable profit spinners. Left-wingers and related Occupiers may complain about banks' corrosive impact on society and economies, but investors usually take the view that if you can't beat them, join them. Buy the bank stocks and share in their windfall.

Indeed, many Hongkongers have built their pension portfolios around one stock: HSBC. The financial crisis put paid to that strategy, but banks remain a somewhat inevitable part of any portfolio. But it's hard to understand these complex entities, which make nothing tangible yet somehow create fantastic profits.

So, here is a primer. This discussion will centre on Hang Seng Bank, which is trading at 2.7 times its book value, much more than its peers (see table).

Although, as we'll see, it is not as pricey as that comparison makes it seem.

First, let's take a step back to understand how banks work. A bank makes money by borrowing mainly from depositors, and sometimes by issuing bonds through the capital markets. It then tries to make a spread above borrowing costs by making loans to customers and investments.

The profitability of its portfolio is typically measured by comparing the net interest income (the difference between interest income and borrowing costs) with the value of the assets, which is known as net interest margin.

Deposits cost less, but they are usually short term and could vanish. Analysts use the loan-to-deposit ratio (loans divided by deposits) to assess a bank's liquidity position. A high ratio means that there may not be enough liquidity for unforeseen withdrawals, and a low one could indicate that deposits are not being efficiently utilised.

Banks are required to place part of their short-term liabilities (one-quarter of all liabilities due within a month, in the case of Hong Kong) in liquid and low-risk assets such as government bonds to meet unexpected withdrawals. This cuts profits since the returns on liquid assets are lower than those on loans.

Banks generate fee income from a range of services: private banking, credit cards, selling investment products such as mutual funds, trade services, stockbroking and investment banking. They also trade in foreign exchange, equities, fixed income and derivatives.

Fee and trading income enhance the equity returns of banks as they use minimal assets. They are highly dependent on markets, making them volatile. Trading is risky and can blow up a bank's balance sheet. JPMorgan Chase lost billions of dollars this year over botched trades meant to cut its credit risks.

To function, banks need massive technology systems, premises for branches and ATM networks, marketing, and an army of staff. Operating efficiency is measured by comparing operating expenses against income.

Because a large part of operating costs are fixed, banks routinely resort to lay-offs during downturns to shore up profitability.

Banks also have to minimise losses from loan defaults by setting aside provisions for this. You can get a sense of the adequacy of these provisions if you divide them by the total of all outstanding loans.

Leverage, or borrowed money, is like steroids for banks as it enables them to lend and invest more and, thus, make higher profits. It is typically measured by total assets as a multiple of a bank's equity, or money raised by issuing shares and retaining earnings.

When Bear Stearns and Lehman Brothers collapsed, they had assets of more than 40 times the equity on their balance sheets.

Deposits are basically a loan to the bank from the depositor. Banks can easily increase their leverage by taking in a lot more deposit money. Regulators, which are keeping an eye on banks' health and want to avoid a run on a bank, limit an institution's leverage by imposing capital adequacy ratios (CAR).

Simply speaking, those ratios look at a bank's equity with assets weighted according to their risks. New rules require banks to increase equity reserves (from 8 per cent of risk-weighted assets to 13 per cent).

To cut a long, somewhat tedious story short, this increased CAR acts as a drag on a bank's operations, making them less profitable but also less likely to go bust.

It also makes banks hold more capital to protect against losses from trading fixed income and derivatives, limiting their ability to engage in these activities which generate non-interest income. This is one of the reasons UBS recently decided to fire 10,000 bankers and close its fixed-income division.

Markets are also demanding banks hold more capital as a contingency and for growth. HSBC's share price plunged to a low of HK$33 in March 2009 when it conducted a huge and deeply discounted rights issue on the back of poor results and dismal market conditions.

Because equity is so critical to the survival and profitability of banks, they are commonly valued using price-to-book ratios. This measures a bank's market capitalisation against its book value, which is the net value of all the bank's assets.

Based on this valuation metric, Hang Seng Bank is priced at more than twice its peers. Does that mean the stock is grossly overvalued? Hang Seng Bank deserves a higher price-to-book ratio since it has the highest equity return among its peers, almost twice their average for the first half of this year. This is due to its low cost base and the fact it has the most profitable loan book among Hong Kong- based banks.

But its profit before tax has also been inflated by some 20 per cent through it recognising its 12.8 per cent share of the profits (called equity accounting) of mainland listed Industrial Bank, instead of just recording dividend income (which is lower than profits) according to normal accounting practice. If the latter were so, its equity return would fall to a (still impressive) estimated 19 per cent.

Hang Seng Bank's price-to-book ratio is also boosted by its high price-to-earnings multiple. It is trading this year at a P/E ratio of 13.4, based on Bloomberg estimates, about 14 per cent higher than its fellow Hong Kong listed banks.

If the earnings of Industrial Bank were not equity accounted for, the bank would be priced higher, at around 16.7 times its estimated earnings for this year.

Hang Seng Bank's higher price earnings multiple is in part due to its 1.8 per cent expected earnings growth this year, compared with a drop of 1.6 per cent for other Hong Kong-based banks, excluding BEA (whose earnings growth this year has been distorted by a lower base last year caused by trading losses). But the stock is not as overvalued as its price-to-book ratio suggests.

Still, Standard Chartered with higher expected earnings growth this year and lower price/earnings multiple looks a more attractive bet.