Recent events impacting Deutsche Bank (DBK.GY) and Wells Fargo (WFC) underscore – yet again – that the mega-cap banks, particularly those with (1) global investment banks and/or (2) operating in the U.S., continue to face significant regulatory/litigation risk, irrespective of quality. In general, these two categories of banks, which overlap, are not growing very fast (in some instances shrinking), have mid-single digit ROEs, and/or continue to face significant regulatory risk.

Our investment stance for our U.S. bank holdings is to significantly limit our exposure to these two categories of banks, in favour of mid-cap banks (banks with assets less than $100 bln). In general, relative to their mega-cap peers, these banks continue to grow EPS faster (see “Four Largest U.S. Banks See Earnings Decline 9% Y/Y in a Tough Operating Environment (While Mid-Caps’ Earnings Rise 9%)”). U.S. mid-cap banks are also consolidating/merging and also more rate-sensitive (particularly those focused on commercial and industrial [C&I] lending), making them more likely to continue growing EPS faster when the Fed Funds rate begins to normalize. Importantly, this category of banks has immaterial regulatory/litigation risk.

Attractive yield

Events continue to support our investment stance.

Two weeks ago, WFC – one of the most respected U.S. banks – became embroiled in a scandal about its treatment of customers resulting from the bank’s allegedly aggressive efforts to cross-sell its products. This follows a relatively weak Q2 earnings result, where the bank’s reported earnings actually declined 2.8% year-over-year. Last week, it was reported that the U.S. Department of Justice has proposed a US$14 bln fine for DBK.GY, which appears to be materially higher than market expectations, to settle its RMBS investigation.

As a result of these reports, both stocks have declined meaningfully. We expect they could remain weak, as they face an extended period of heightened legal/regulatory uncertainty where the size of any potential fines and their impact on bank capital remain unknown, but are likely to be highly material.

For additional commentary, please see the following Insights:
Five Reasons Why We Don’t Own C, JPM, BAC, GS and MS (June 14th)
Why the Global Investment Banking Model is Under Siege (March 24th

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