While Japan continues to recover from two decades of deflation and weak growth, its banks have yet to see their share prices match their strong earnings. Part of this is because the earnings are low quality, but Citi analysts Hironari Nozaki and Kana Saito argue that the banks are being systematically undervalued.
“Although Japanese banks continue to post strong earnings, share price performance has not necessarily matched this,” they write. Even though some of those earnings come from the sale of securities and reversing loan-loss provisions, but that can’t be the whole story. “When the earnings of Western financial institutions beat the consensus, share prices tend to reflect that immediately—even when the contributing factors, such as debt valuation adjustments (DVAs), are not based on an increase in economic value.”
Japanese banks’ earning quality increasing
Even though some of these factors are one-off effects, earnings quality is also increasing. “Results for Q1 FY13 indicate that banks’ core gross profit is starting to rise. Contributing factors include strong growth in overseas lending, a turnaround in domestic lending, and increased fees and commissions income from the sale of investment trusts and other products,” they write.
Japanese banks are second only to the U.S. in terms of earnings growth since the crisis began, but valuation continues to lag. Nozaki and Saito blame this on deep-seated market skepticism regarding Japan, but they “feel that investors are again underestimating the improvement as well as the rapid build-up of overseas lending which is boosting margins significantly and is likely to be a strong growth driver in the future.”
Overseas lending shares
Japanese banks’ share of overseas lending has risen steadily since the crisis began. Now that European banks are actively deleveraging, and U.S. banks aren’t exactly eager to take on more risk, Japanese banks with plenty of capital have lots more room to grow.
Japanese banks also have better capital ratios than most international banks, having already complied with Basel III, reducing their regulatory risk. Favorable economic and monetary policy will also have an impact over the next few years.
“Abenomics will contribute to banks’ core gross profit via several channels, including a steepening of the yield curve via inflationary expectations, an increase in lending driven by stronger domestic demand, a pick-up in household investment activity due to an improved economic outlook, and growth in yen-based earnings overseas fueled by a weaker currency.”