Comment: Top Performing Banks Get Short Shrift

A quick glance at the American Banker bank index on page 23 might make anyone think 1995 was a stellar year for banks in the stock market. Almost every month, the index outpaced the Standard & Poor's 500.

But take a closer look. Even the better-managed banks still don't receive the premium multiples investors pay for the leading companies in other industries that face similar problems.

In fact, a major Gemini Consulting survey shows market premiums for top- performing banks are barely half those of top firms in industries facing comparable challenges.

It's a stock market axiom that in any industry, no matter what its prospects, the top-performing companies typically trade at a premium to their lesser competitors. Yet this study indicates high performance by bank managements counts in investors' minds far less than the achievements of high-performing companies in other industries.

To gauge operating performance among banks, the study identified the critical success factors we believe separate bank managements.

Invariably, the better banks hew to strategies that foster value- creating cultures. These are the banks that eagerly embrace change, focus their strategic business mix, and constructively participate in deal making and acquisitions that embrace both of the above.

With an understanding of customer behavior and market potential, they stand out by marketing superior products, fostering customer relationships, building efficient delivery systems, and relentlessly controlling costs.

Based on these criteria, our list of top bank performers averaged a 12.5 price-to-earnings ratio and a trading premium of 2.0 times book value in the second quarter of 1995. In contrast, their lesser competitors, on average, had an 11.1 ratio and traded at 1.6 times book. So much for investors rewarding superior managements.

To put this discrimination in perspective, we surveyed 88 other industries facing issues similar to those confronting banks - slow growth, market saturation, high fixed costs, big expenditures for technology, and shrinking margins.

We focused on industries that also were strongly influenced by regulation and to some extent by interest rate cycles. The half-dozen that came closest were textiles, food wholesalers, health insurance, home building, retail stores, and securities.

For these industries, the average price-to-earnings ratio based upon 1995 second-quarter figures was 13.3, but that of the top performers was 19.3. Similarly, the average market-to-book value for the selected companies in the six industries was 1.8 versus 4.0 for top performers, a far greater premium than investors accorded to the top performers in the banking industry.

Bluntly put, investors don't differentiate between banks as they do between leaders and the also-rans in other industries facing similar challenges.

The discrepancy is significant. Typically, the better banks not only match the earnings growth of the leaders in the other industries, but generate higher returns and lower risk. In effect, investors are taking a double swipe against banks by lowering multiples and lowering relative premiums.

This is not a recent market phenomenon. We conducted similar tests using data going back to 1990 and found a consistent pattern over time.

Arguably, banks are inconsistent stock market performers, and this may have biased investors against bidding up their stock valuations. According to an American Banker survey of market-to-book valuations, only three of the top 10 performers among the superregionals in 1986 made the list in 1994. Of these, only two appeared twice on the intervening lists.

Also, banks have earned a reputation for self-inflicted wounds and negative earnings surprises. Investors with long memories worry that cyclical events will yet again disrupt earnings and cause massive writeoffs for injudicious loans.

Today any excessive concern is unwarranted. The economy isn't overheating. Banks are neither lending dangerously nor leveraging extravagantly. Spare capital frequently goes toward funding stock buybacks and larger dividends. Any change of direction in interest rates would most likely result in a welcomed increase in the slope of the yield curve, thus supporting bank interest margins. Moreover, the more sophisticated banks have learned to protect their earnings from rate movements through prudent hedging.

Still, banks do face plenty of challenges, not least the threats to their traditional customer bases from newer competitors, notably communications vendors. But if banking products are becoming commodities, then arguably no less so are the goods and services offered by the comparable industries studied.

Regulation? Which of those industries doesn't feel governments unnecessary restrict operations? Our analysis shows that managements at the six comparable industries face challenges that are, on balance, no less severe than those confronting bankers.

So the question becomes: What can bank management do that will encourage investors to raise those multiples and evenly weigh their doubts?

Unquestionably this will take more than burnishing an image, or making yet another acquisition or excessively boosting the technology budget.

The latter move is particularly fraught with danger. Adopting a new technology or new way to do business, if done too quickly or too wholeheartedly, can frustrate customers even as it unsettles a bank's traditional culture. Clearly, banks must foster differentiation strategies and develop a three-pronged approach that adroitly balances technology, customers, and the management of change, if their value is to rise in an increasingly commodity market.

Many of the winning banks going forward will not merely progress from a transaction orientation into general relationship banking, offering a widening array of financial products and services with higher yields and more consistent fees. They will develop a "value proposition" for each segment of customers, explicitly deciding which benefits will be delivered to which customers, a difficult but not impossible task.

Creating the structures that successfully link marketing activities, multiple sales channels, and product areas to successfully deliver the value proposition will take rare skills.

For those that succeed, the brighter future should be amply reflected in their stock market performances.

After all, survivors of banking's consolidation era will exhibit one characteristic virtually unmatched in any other industry: They'll make money 24 hours a day, seven days a week. Can it be long before investors recognize such a prospect and raise market multiples several notches?

Mr. Gregor is senior vice president of Gemini Consulting and co-director of its global financial services practice. Mr. Frieder, a professor of banking and finance at Florida A&M University, is the co-author of "Bottom Line Banking."

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