Analysis: OCBC Bank

My First Stock Analysis!

I believe in investing for the long term and aim to achieve financial independence in the next 10 years. And I hope to do this through value investing. In 2007, I started off with $2,000 and invested in my first shares. Along the journey to today, I have made both gains and losses but what is most satisfying is the knowledge and experience gained. 

Starting 2018, I have decided to start writing my own financial blog to not only share with others about my investment ideas, but also as a way to improve myself. Through writing, I hope to deepen my analytical skills, financial knowledge and structured thinking ability. My writings will mainly be about my analysis of listed companies that are currently under my watch-list, my personal financial views, my travel stories and anything in between. 

To whoever is reading, I hope you will benefit as much as I do just like I had from other financial blogs!

To start off, here is my first stock analysis!

   

OCBC Bank
Last Trade Price: $12.99 (12 Jan 18)
Bullish Price Target: $15.00
Bearish Price Target: Below $10.53
Current Valuation Score: 2.9 over 5

Company and Environment

OCBC is Singapore 2nd largest bank in terms of revenue and market capitalization. It is one of the world’s most highly rated banks with Aa1 rating from Moody’s. It was also recognized as one of the World’s Top 50 Safest Banks by Global Finance. Its key markets include Singapore, Greater China, Malaysia and Indonesia. Singapore is its largest market generating over half of its revenue.

Chart A: OCBC Revenue by Market 2017

Source: OCBC Bank

As compared with other local banks, OCBC's key differentiator is its multiple non-interest income which represented nearly 43% of its revenue. This includes income from its insurance arm, Great Eastern where it has a controlling stake of nearly 88%. In comparison, DBS and UOB non-interest income is at 36% and 38% respectively.  

Chart B: OCBC Revenue by Service 2017

Source: OCBC Bank

Rising interest rate environment

The current rising interest rate environment bodes well for OCBC. Banks main source of income comes from Net Interest Margin (NIM). They lend money at rates higher than the cost of money they borrow from. For example, we deposit money into a bank account and it gives us a monthly interest rate. This is a cost to the bank. They then use our money and lend it to others (eg. car loan or housing loan etc.) and earned a higher interest rate. The difference is the net interest income that banks earn. Therefore, in a rising interest rate environment, banks are able to charge higher interest rate and this improve their net interest income and margin. As of September 17, the net interest income for OCBC represent 57% of its revenue. For DBS and UOB, it is higher at 64% and 62% respectively.

A widely used reference rate by the bank to lend money in Singapore is the Singapore Interbank Offered Rate (SIBOR). SIBOR is basically an interest rate used by banks in Singapore when lending funds to one another and the movement is 60% correlated to US central bank rate. As the US economy is currently improving, US central bank is slowly normalizing their interest rate by trying to raise it to pre-crisis level. This will mean that SIBOR rate will also start moving upwards. From Chart C, it shows SIBOR rates increasing from 2015 onward when US central banks start to increase its key interest rate for the first time in 11 years.  Barring any major adverse events, it is expected that SIBOR will continue to trend upwards and banks NIM could reach their pre-crisis level of more than 2%.  

Chart C: Banks Net Interest Margin and Income

Source: OCBC Bank, UOB Bank, DBS Bank, MAS

However, Chart C also shows that OCBC has the weakest performance among the three local banks in in terms of having the lowest net interest income growth (3yrs NII CAGR OCBC: 0.59%, DBS: 2.97%, UOB: 4.15%) and NIM (2017 NIM OCBC: 1.64%, DBS 1.74%, UOB 1.76%). This shows that OCBC is under competitive pressure as compared to its peers.

Taking a deeper look, let us refer to Chart D. OCBC and UOB has the same interest cost of slightly more than 1%. However, UOB is able to charge higher loan interest as compared to OCBC. Even with the highest interest among the 3 banks, UOB consumer loan growth is the highest at 6.3%. This shows that UOB is able to charge a premium over their customers.

DBS, being the largest bank in Singapore, is able to give the lowest interest rate for their customer bank deposit. This is because they have the largest share of Singapore dollar deposit in Singapore. I bet most of us Singaporean have at least a bank account with either POSB or DBS at some point of our life right? This makes DBS the leader in Singapore consumer loan market share. To put it in analogy, I would say UOB is the Apple smartphone  while DBS is Samsung. As for OCBC, they are somewhere in between.

Chart D: Bank Loans to Non-bank Customers, Bank interest cost and interest income

Source: OCBC Bank, UOB Bank, DBS Bank

Loan Demand

As Singapore economic outlook continue to improve, this will result in the acceleration of loan demand which slows down back in 2016 and 2017. During good time, companies will take more risk and expand their businesses by borrowing money while consumer will take out loan to buy cars and houses. Both OCBC and DBS are forecasting loan growth of between 7% to 7.6% in 2018 and 2019. Higher loan demand will increase banks' earning as they lend out more. 

Chart E: Singapore Loan Demand

Source: MAS

Risk: Oil and Gas

However, the current economic environment is not without risk. As a cyclical stock, bank stocks are affected by the overall economic sentiment.

The Oil and Gas sector is starting to turn around with the increase in crude oil prices due to healthy demand and lower supply as Russia and Organization of the Petroleum Exporting Countries (OPEC), which collectively produce more than 50% of world’s oil, curb its output through the end of 2018.

Source: OCBC

However, USA, one of the world’s top 3 oil producing nation which is not part of OPEC cartel, continued to increase its oil production strongly and this is counter productive to the goal of OPEC and Russia to balance the market oil demand. USA is expected to produce more than 10 million barrels per day (bpd) of oil by this month. This together with OPEC withdrawing its production curb and the unexpected slowdown in demand might once again cause global oil supplies to surge and send it prices south.   

Source: OCBC

As the oil and gas sector contributes 5% to Singapore economy, this might cause fresh strain to Singapore oil and gas companies, which in turn might impact on Singapore banks non-performing loan (NPL) from its oil and gas business customers.

Banks' NPL has been increasing since 2014 due to the contraction in oil and gas sector. It is to note that as compared to its peers, OCBC is more prudent with its asset management by having the lowest non-performing loan ratio since 2008. Moving forward, it is expected that bank’s NPL will start to recover as the oil and gas sector is slowly recovering.  

Chart F: Banks Non Performing Loan (NPL)

Source: OCBC Bank, UOB Bank, DBS Bank

Construction Sector

The construction sector, which also account for 5% of Singapore’s GDP has contracted for 2 consecutive years (2016: -2.7% yoy, 2017: -8.5% yoy) due to lower construction demand from private sector. With building and construction sector loan represent 18% of Singapore’s total bank loan, the continued sluggishness might cause construction companies with weak financial position to fail and default on their loan, thus adversely affect banks' profitability and financial position. 

Profitability and Efficiency

Chart G: Banks Revenue Growth

Source: OCBC Bank, UOB Bank, DBS Bank

OCBC has one of the fastest revenue growth rate, growing at 8.45% for the past 10 years. It has overtook UOB since 2014 after the acquisition of Wing Hang bank to increase their presence in Greater China. Over the years, OCBC has grown through acquisition. In 2010, they acquired Bank of Singapore which has helped grown its wealth management income. It has also acquired Barclay’s Asia wealth business in 2016 and this makes them the 7^th largest private bank in Asia-Pacific based on assets, improving from 11^th position in 2015. Most recently in 2017, OCBC has acquired National Bank of Australia’s Singapore and Hong Kong wealth businesses. Management has shared that they will continue to grow OCBC by identifying acquisition opportunities that fit into its long-term strategy and corporate culture and at the same time, strengthen its existing core businesses.

Chart H: Banka Net Earnings

Source: OCBC Bank, UOB Bank, DBS Bank

OCBC net income growth is also the strongest among the 3 local banks at 9.6% for the past 10 years. In terms of management efficiency in controlling cost, it has consistently been the most efficient among the 3 banks as it has the lowest cost-to-income ratio for the past 5 years with the exception of 2016. However, OCBC cost-to-income ratio has been creeping upwards since 2012. This was mainly due to cost associated with acquisition of businesses mentioned previously. 

Chart I: Banks Return on Asset (ROA) and Return on Equity (ROE)

Source: OCBC Bank, UOB Bank, DBS Bank

Compared to its peers, OCBC has the highest ROA and ROE. This indicate that its management are most efficient in utilising the asset and equity of the company to generate earnings. There was a spike of ROA and ROE in 2012 and this was because of divestment gain in their Fraser and Neave and Asia Pacific Breweries Limited shares.

Stability and Liquidity

Singapore banks are one of the safest in the world. There is a saying that if Singapore banks were to collapse, Singapore will not exist anymore. This shows how much trust we have in our own banking system. Nevertheless, we will still take a look at how stable our banks are by looking into their capital adequacy and liquidity.

Table 1: Banks Stability and Liquidity Ratio

Source: OCBC Bank, UOB Bank, DBS Bank

Capital Adequacy Ratio

For stability, we will look at the Capital Adequacy Ratio (CAR) of the banks. CAR was introduced by Basel committee, an international organisation set up after the 2008 subprime mortgage crisis that set out an internationally agreed set of measures to strengthen the supervision of banks. Their aim is to ensure that banks are well-capitalised to stand the test of a crisis by having the ability to absorb unexpected losses that arise during the normal course of their operations.

CAR includes Common Equity Tier 1 (CET 1 CAR) and Tier 1 CAR. According to Investopedia, CET 1 CAR consists of a bank’s core capital and includes common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income.

Tier 1 includes capital in CET 1 plus instruments that are not common equity but are eligible to be included in this tier. An example is a contingent convertible or hybrid security which has a perpetual term and can be converted into equity when a trigger event occurs.

In Singapore, our central bank, Monetary Authority of Singapore (MAS) is even more kiasu in its approach. They require Singapore-incorporated banks to meet a higher standard of CET 1 CAR of 6.5%, Tier 1 of 8% and Total CAR of 10% (Basel III guideline: 4.5%, 6% and 8% respectively).  If banks CAR drop below its regulatory minimum, the bank must build its capital ratio back to the required level or risk being overtaken or shut down by regulators.

From Table 1, we can see that all 3 local banks have capital adequacy ratio way above the regulatory requirements.

Loan to Deposit Ratio

As mentioned previously, banks take our deposit and loan it to others. Therefore Loan to Deposit Ratio is a useful measure to calculate the ability to cover withdrawals made by banks' customers. For example, during the Greece government debt crisis, fearing the collapse of their banking system, there was long queue forming outside the banks as Greeks want to withdraw all their money. This further threaten the banking system as banks will not have sufficient liquid funds to operate. The banks have no choice but to close and restrict the amount that a person can withdraw every day. 

To interpret Loan to Deposit ratio,if it is below 1, this mean bank has sufficient deposit to loan out to others. On the other hand, if it is above 1, in addition to customer deposits, the bank has borrowed additional funds from somewhere else and re-loan it. Note also that if the ratio is too low, it means banks may not be efficiently earning as much as it could. If it’s too high, the banks may not have enough liquidity to cover any unforeseen fund requirements or economic crisis. Therefore the general ideal level is between 80-90%. Referring to Table 1, all 3 local banks are well within this level.

Liquidity Coverage Ratio

The liquidity coverage ratio is also set out by the Basel committee. Banks are required to hold an amount of highly liquid assets, such as cash, Treasury bonds or corporate debt, equal to or greater than their net cash requirement (over a 30 days period). This means the ratio has to be equal to or more than 100%. The purpose is to ensure that banks have the necessary assets on hand to ride out any short-term liquidity disruptions. From Table 1, we can see that all 3 local banks have at least 40% more liquid assets than regulatory requirements.

Valuation

As an investor, our main aim is to buy shares at a valuation that is not overpriced. An undervalued shares will provide us a margin of safety while an overvalued stock have higher risk of making us lose money. Just as what investment guru warren buffet has said, "You don't drive a truck that weighs 9,000 pounds across the bridge that says 'limit, 10,000 pounds' because you can't be that sure about it." Therefore it is important for us try and get the true value of the shares to reduce our investment risk to the minimum. We shall look at some valuation metrics which serve as a guide. However, these metrics should not be relied on solely but should be measured with other metrics.

PE Ratio
PE ratio represents the premium investors are willing to pay for every dollar the company makes. According to Investopedia, a high PE ratio means investors are expecting higher earnings growth in the future or may also indicate the stock is overvalued. Low PE ratio means either a company is undervalued or it is doing exceptionally well relative to its past trends. Currently, all 3 banks are trading above the market PE ratio due to the recent surge in their share price. Base on peer comparison, OCBC PE ratio is slightly lower than UOB while DBS shares seems to charge higher premium. 

Chart J: Banks Price Earning Ratio (PE Ratio)

Source: OCBC Bank, UOB Bank, DBS Bank, SPDRS

Dividend 

Chart K: Banks Dividend Yield (%)

Source: OCBC Bank, UOB Bank, DBS Bank, Shareinvestor

All 3 banks have consistently distributed dividend to its shareholders every year. As banks earn profit, the bank may decide to use part of its profit to distribute to shareholders and retained the remaining for their own use. If banks profit increase, more profits may be distributed. This will provide shareholders higher returns for their investment. 

This trend is evident in Singapore local banks where OCBC annual dividend has increased from 23cents/share in 2006 to 36cents/share in 2017. Dividend yield is dependent on the entry price that individual investor bought the share. For OCBC, the closing price on 12 Jan 17 is $12.99. If I bought at this price, I can expect to receive 36cents/share of dividend, which represent 2.77% yield per year. Dividend yield is especially important to income investor who seeks a consistent yearly return from their investment and consideration of impact on capital is very much secondary. Comparing to its peers, OCBC dividend yield has been one of the highest for the past few years.

In 2008, there was a spike in dividend yield because of the sudden drop in the banks share price due to the financial crisis. If I bought OCBC shares at that point of time, I can expect dividend yield of around 8% per year. Assuming that I continued to hold until today with current year dividend payout of 36cents, I am looking at an annual dividend of nearly 10%!  

At current dividend yield of 2.77%, OCBC does not look attractive to me as I am more interested in companies that can provide dividend yield of at least 4%.  

Price-to-Book (PB) Ratio

Another valuation metric that we shall look at is the PB Ratio or in another words, price to net asset value ratio. The book value (net asset value) of a company is the total assets minus total liabilities and it compares the company’s current share price with its net asset. A lower PB ratio generally means that the company’s share price is undervalued while a higher PB means it is overvalued. The ratio gives an idea about how much value investor would be left with if the company were to bankrupt immediately. For example, if the PB ratio is 0.8x, it means for every $1 of the company net asset, I am paying $0.80. Therefore, I am buying a company that is worth $1 at $0.80, which is a 20% discount. Different industries have different PB ratio and therefore it is better to make comparison within its competitors.

Chart L: Price-to-Book (PB) Ratio

Source: OCBC Bank, UOB Bank, DBS Bank, Shareinvestor

All 3 banks are currently trading at a level higher than the post financial crisis period but lower than pre-financial crisis period. With the current market exuberance, there seems to be still room for share price to grow. Comparing with its peers, OCBC is trading at similar value and this signal its share price is fairly valued.  

OCBC Valuation

As I mentioned previously, there is still room for OCBC share price to go higher due to current market exuberance mood. However, how high is high? And when market is in a bearish mood like the 2008 subprime mortgage crisis, how low can OCBC bank value dropped? In order to answer these questions, I am going to get OCBC highest, average and lowest PB ratio from 2017 all the way to 2006 (I want to include both bullish and bearish period), determine the mean, minimum and maximum PB ratio for each year and after that, adjust it to today book value. This will allow me to find out 3 things:

1) Base on OCBC current book value, is it trading at above or below the average of its historical valuation?

2)Base on OCBC current book value, what is the highest share price it has ever traded? 

3)Base on OCBC current book value, what is the lowest share price it has ever traded?

Table 2: OCBC PB Ratio from year 2006 to 2018

Source: OCBC Bank, Shareinvestor

My data has produced the above PB ratio for each period and with that, I got the average, minimum and maximum PB ratio over the periods. The cells are color coded with traffic lights color and red means overvalued while green means undervalued.

Table 3: OCBC PB Ratio and Valuation

I then adjust the mean, minimum and maximum PB ratio with OCBC current book value and got the valuation of $12.23, $6.34 and $17.21 respectively. This means that during bullish market sentiment, based on OCBC current net assets, its share price has reached $17.21 while during bearish market, its share price has dropped to $6.34. With OCBC current share price at $12.99, it is trading above its average share price of $12.23.

To be more conservative with my calculation, I discounted the current valuation with its non-tangible asset which currently represent around 20% of its net asset. This is to only take into calculation its tangible assets valuation. With this, i got its discounted average, minimum and maximum valuation of $10.53, $5.53 and $15.01 respectively.

As I am currently holding on to OCBC shares, based on whether market is bearish or bullish, I will consider offloading my shares when it is nearing $15 while accumulate more when it trades below its average of $10.53.

Summary

To conclude, I have come up with 4 metrics namely profitability, stability, market and environment and valuation with different weightage based on what I perceived to be the more or less important metrics. I will then multiply by a score (out of a maximum score of 5) that I give to each metrics based on the above analysis to get an overall score. The score determines if the company is attractive to invest in. 

Profitability and stability: Collectively, both metrics, which is fundamentally important to all businesses, represent 40%.

Market and environment: This measure the current market risk or opportunity that is presented to the company which have an impact on the direction of its share price.

Valuation: Determine if the share price is currently undervalued or overvalued. 

Table 4: OCBC Valuation Score