There are three bank shares in Singapore, namely, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11). How might investors who are interested in the banking sector differentiate between the three when looking at them as potential investments? There are many important factors an investor can dig into but I’d like to take a closer look at two in particular here: A bank’s efficiency ratio and its valuation. Efficiency – the key to survival A bank’s efficiency ratio (operating expenses as a percentage of revenue) is important to note because…
How might investors who are interested in the banking sector differentiate between the three when looking at them as potential investments? There are many important factors an investor can dig into but I’d like to take a closer look at two in particular here: A bank’s efficiency ratio and its valuation.
Efficiency – the key to survival
A bank’s efficiency ratio (operating expenses as a percentage of revenue) is important to note because it can be a good proxy for the amount of risk that a bank is, quite literally, forced to take on in order to generate a decent profit.
My colleague John Maxfield has a great explanation on why that’s so:
“Inefficient banks [with high efficiency ratios] appear to compensate for their inefficiency by taking on higher-yielding assets, which, not coincidentally, are also riskier. This allows them to generate profitability ratios in the short run that are comparable to their more efficient peers. But the downside to this approach is that, over the long run, it subjects the offending banks to potential failure when the credit cycle exacts its revenge.
Professor Charles Calomiris alludes to this in Fragile by Design: The Political Origins of Banking Crises & Scare Credit: “Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind.”
Furthermore, even if an inefficient bank wanted to maintain superior credit discipline, there’s reason to believe that it wouldn’t be able to do so. That’s because its more efficient rivals can afford to compete more aggressively on loan terms and screen potential borrowers more thoroughly. The net result is that less efficient banks are left fighting over a pool of less creditworthy customers.”
With this in mind, here’s how the three banks in Singapore stack up:
Source: S&P Capital IQ and banks’ filings
All three have done an outstanding job in terms of cost control by keeping their efficiency ratios way below 50% (the lower the better) since 2002 and there really isn’t much to choose between the three. To that point, over the period under study, DBS’s average efficiency ratio stands at 43.5%, OCBC at 40.4%, and UOB at 40.6%; all three figures are pretty close.
Valuation – the key to returns
When we invest, it’s always more favourable to invest when shares are cheap as compared to when they’re carrying high valuations (assuming all things remain equal). As such, it makes sense to choose between the three banks on the basis of their valuations as well.
The price-to-book ratio (PB) – a comparison of a bank’s share price with its book value – is a good way to do so. The book value of a bank is calculated by subtracting all its liabilities from its assets.
Here’s how the valuations of DBS, OCBC, and UOB look like currently:
Source: S&P Capital IQ
From this, you can see that UOB’s the cheapest of the lot. But, we can take the analysis one step deeper and compare each bank’s current PB ratio with their long-term historical average. Here’re the results:
Source: S&P Capital IQ
UOB takes the cake again by virtue of it having the widest gap between its current valuation and its long-term average PB ratio since the start of 2005. This helps set the stage for a reversion to the mean to occur.
Value investors may be familiar with mean reversion. It’s the simple idea that, as investment manager Dean Williams cleverly quipped, “something usually happens to keep both good news and bad news from going on forever.”
In investing, it manifests itself in the way below-average valuations tend to be followed by above-average results (the reverse is also true: above-average valuations often come before below-average returns).
A Fool’s take
Like I mentioned earlier, there are other important factors which can determine how good a bank share can be. But on the basis of the efficiency ratio and valuation, UOB’s the best bank share in Singapore at the moment; while there isn’t much difference between how efficient the three local banks are, UOB has the lowest valuation amongst the group.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.