This article first appeared in Capital, The Edge Malaysia Weekly, on April 4 - 10, 2016.

MALAYSIAN banks had a rough 2015. After multiple rounds of slashes in earnings forecasts and a series of negative news flows — from staff rationalisation exercises to rising loan impairments and even the rare regulatory penalty — they lost 6.8% or RM20.7 billion of their total market capitalisation in 2015.

Plagued by bearish sentiment, the sector has been trading at trough valuations in the past 10 years (see Chart 1). To put things in perspective, the current price-to-book valuation of 1.2 times is roughly two standard deviations below the 10-year mean of 1.8 times. The last time we witnessed such a depressed valuation was in the first few quarters following the global financial crisis, which almost brought down the world’s financial system in late 2008.

Fast forward to 2016, predictions of an imminent global financial crisis have not materialised and Bank Negara Malaysia has repeatedly assured markets that Malaysian banks are well capitalised and resilient enough to withstand a financial crisis. So, is the current sentiment reflective of the sector’s fundamentals or are investors overly pessimistic about its prospects?

To answer that question, first we must look at what has been driving the sector’s valuation down — return on equity (ROE). As shown in Chart 2, the sector’s valuation is largely driven by ROE, which has indeed been on a downtrend since reaching its peak in 2010.

Increased capital requirements and compliance costs have resulted in a lower ROE for most Malaysian banks, which traditionally have high ROEs. Over the past four years, total equity has increased an outsized 78% while net profit has increased just 2%, pushing ROE down from 16% in 2012 to 11% in 2015.

Enlarged equity bases arising from capital-raising exercises aside, another reason for the falling ROE is the slowing earnings growth momentum — net profit growth slowed from 29% in 2012 to 0.5% in 2014 and a contraction of 4.5% last year.

Earnings, the numerator in the ROE ratio, is generally driven by four factors. The first two are loan growth rate and net interest margin (NIM), which are by and large determined by the external macroeconomic environment and capital markets. On the other hand, banks typically have more control over the other two factors, that is, cost-to-income ratio (CIR) and gross impaired loans (GIL) ratio.

Aggregate loan growth for banks grew a respectable 10.3% in 2015, albeit somewhat helped by foreign exchange translation, from 11.5% a year ago (see Chart 3). As expected, NIM continued to compress to 2.6% in 2015 as deposit competition remained intense amid tighter liquidity conditions.

Meanwhile, cost-to-income ratios have been on the rise since 2012 (see Chart 4) on negative jaws ratio (that is, expense growth of 16.8% outstripped income growth of 12.1% in the four-year period). In 2015, this ratio surged to an all-time high of 51.2% due to staff rationalisation exercises carried out by three banks. Positively, asset quality is still holding up well with a healthy GIL of 1.8% in 2015. That said, given its highly leveraged business model, a seemingly small increase in non-performing assets could hurt its profit and loss statement and balance sheet should the macroeconomic conditions deteriorate.

A return of higher ROE in 2016?

If ROE is the single best indicator of the performance of bank shares, the questions are, did the sector’s ROE bottom out in 2015 and will it see a rebound in 2016? Bank managements generally say that 2016 will be a challenging year, while most research houses are adopting a cautious “wait and see” stance on the sector.

Despite the cheap valuations, the key concern is asset quality — arguably the most important indicator to watch and possibly the key share price driver in the late stages of the credit cycle. For local banks, the vulnerable sectors that are at risk include steel, oil and gas (O&G) and commodities.

Notably, just-concluded 2015 results show huge losses incurred by the O&G sector, particularly the upstream segments such as exploration and production (E&P), shipbuilding and chartering and support services. That said, according to Bank Negara’s Financial Stability and Payment Systems Report 2015, total bank credit exposure to the O&G industry accounted for a manageable 2.2% of total credit exposure.

However, AllianceDBS Research points out in a March 1 note that AMMB Holdings Bhd has the highest O&G exposure at less than 5%, followed by CIMB Group Holdings Bhd (3%), RHB Capital Bhd (3%) and Malayan Banking Bhd (2.8%) while Public Bank Bhd, Hong Leong Bank Bhd and Alliance Financial Group Bhd have the least exposure (less than 1%). The research house also conservatively assumes that credit cost will remain high at CIMB due to its Indonesian operations. However, it expects credit costs to ease in 2H2016.

Nonetheless, not everyone thinks all is doom and gloom for the banking sector. Affin Hwang Capital and CIMB Research opine that the sector is poised for a recovery this year, driven by a narrower increase in loan loss provisioning and a decline in operating expenses stemming from staff separation and related restructuring exercises carried out by three banks last year.

Nevertheless, AllianceDBS Research is of the view that earnings improvement in 2016, a result of kitchen sinking activities last year, will just be cosmetic and should not warrant too much excitement as there are no visible signs of improvement in the fundamentals of the Malaysian banking sector.

Which bank to bank on?

While the industry indicators do not appear to be overwhelmingly encouraging, there are perhaps banks with particular industry positions and company-specific competitive advantages that might continue to do well even in bad times.

AllianceDBS Research segregates the banks into three groups: (1) resilient banks with no capital-raising or asset quality issues and strong business drivers (Public Bank and Hong Leong Bank are top picks); (2) banks that have raised capital, have moderate asset quality indicators and are looking to re-energise business growth (RHB Capital, with Maybank and CIMB at the borderline); and (3) banks that may face capital-raising risks, have asset quality problems or struggle to find a business direction (Affin Holdings Bhd and AMMB).

A popular choice of the analyst fraternity is Public Bank — one of the best credit underwriters in the region with a defensive low-risk loan book. The country’s third largest bank by assets delivered a respectable ROE of 18.8% and year-on-year increase of 12% in net profit in 2015, aided by loan loss recoveries (see columns 3 and 4 of  Table 1). Furthermore, its cost-to-income of 32.6% and gross impaired loans ratio of 0.5% remain way below the industry average, thanks to its strong cost efficiency profile and credit underwriting culture.

Another popular pick is Maybank owing to its size and ability to attract deposits, well-diversified business portfolio with extensive regional exposure in Asean (15.8% pre-tax profit from Singapore, followed by 3.7% from Indonesia) as well as its attractive 6% yield. Nonetheless, the diversified portfolio also translates into volatile revenues, owing to currency rate movements and insurance operations. Additionally, management also guided for higher impaired loans in 2016.

For investors seeking deep value, a quick glance (see column 2 of Table 1) reveals that RHBCap is the cheapest among the mid-sized banks with its share price trading 21% below its book value. Although its ROE is at the lower end among its peers (see column 3), its recent rationalisation exercise should boost its bottom line by up to RM200 million this year. In addition, management targets to complete the corporate restructuring exercise by transferring the listing status to RHB Bank by 2Q2016, which could be a rerating catalyst.

As to what banks to avoid, analysts’ top choices are AMMB and Affin. AMMB is the worst performing bank stock, which saw its share price plummet 27.7% in the past one year (see column 5). Despite its 5% discount to book value and a decent 4% yield, AMMB is weighed down by compliance weaknesses, ongoing NIM compression and low current account, savings account (Casa) base, analysts say.

Affin, the smallest banking group by market value, is the worst performing bank in terms of financial metrics. The bank has the lowest ROE of 4.8% and the highest cost-to-income of 61.7%, owing in part to transaction and integration costs incurred to acquire HwangDBS’ business. In 2015, net profit plunged 37.7% from a year before while the share price declined 19.6% — the third steepest after AMMB and CIMB. Unless its earnings growth gains traction, the huge 50% discount is probably reflective of its single-digit ROE and potential capital-raising risks, which will in turn lower ROE.

Apart from ROE, what is perhaps the quickest way to boost valuations is the presence of suitors who are willing to pay at least 1.5 times book value. At a time when banks are rationalising to emerge stronger, some may well be just ripe for the picking. 

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