This Cheap Bank is an Even Better Buy After the Brexit
Stocks around the globe plummeted when the U.K. voted to leave the European Union last week, but the hardest hit sector was the European banks
Investors are worried regional trade disruptions could stall economic growth, but they may be overlooking a golden opportunity in the midst of the chaos. One London-based banking giant relies on European business for less than 12% of profits and books a return on equity that’s 50% higher than the regional average.
Shares are trading for a 30% discount to the long-term price-to-book average and could be the best value in the banking sector this year.
A British Bank That’s Not So British
The Brexit vote is old news now, but the effects it will have on the European financial system are still unknown. European stocks plunged after the vote, and the British pound hit a three-decade low against the U.S. dollar.
Analysts now expect a recession in the U.K. in the second half of the year to force a rate cut by the Bank of England. Lower interest rates will continue to weigh on the net interest margin banks depend on to make money off loans.
On the face of it, it’s understandable that investors would rush to dump their positions in European banks, but the selling is also extending to strong names that may not have as much to lose as others.
HSBC Holdings (NYSE: HSBC) is the seventh-largest bank in the world by assets and the largest in Europe. However, the European region accounted for just 11.7% of profits before taxes last year, down from 15.9% in 2014 as Asia and other emerging markets contributed a larger part.
In addition to having $2.4 trillion in assets and one of the largest and most diverse customer funding bases in the world, HSBC holds to a low-risk model with a loans-to-deposits ratio of just 72% versus an average of 94% for its peer group.
The bank’s more moderate level of leverage compared to other banks hasn’t reduced its profitability, though. HSBC reported a return on equity (ROE) of 7.2% last year, more than 50% higher than the 4.7% average for European banks reported by the European Banking Authority.
This global footprint and lower-risk model likely helped HSBC in the aftermath of the Brexit vote last week. Shares dropped 9% on June 24 — a mild decline compared to other European banks like the 18% plunge we saw in Deutsche Bank (NYSE: DB).
But the Brexit sell-off has made this extremely cheap stock even cheaper, especially given the bank’s relatively low exposure to Europe and ability to increase leverage. Shares trade for 0.7 times book value. This is near their 10-year low, which is not the case with many other EU banks, and represents a 30% discount to its five-year average P/B.
The bank plans to cut costs by $5 billion by the end of next year. Over the longer term, a transition to digital banking should help HSBC reduce expenses and drive shareholder value. Management has targeted a 17.5% reduction in branch space (in square meters) and a 75% increase in digital sales volume over the three years through 2017.
HSBC is an attractive buy at current levels, and the recent spike in market volatility has made a popular income-generating strategy the ideal approach.
Cash In on Volatility Until Shares Rebound
Higher volatility means higher option premiums, which makes this the perfect time to be an options seller.
Specifically, I plan to use a covered call strategy. With a covered call, you are basically going long a stock while also skimming some money from Wall Street.
While it’s a conservative strategy, it can also be very lucrative. In fact, one of my Profitable Trading colleagues used it to skim $46,360 from some of the largest firms on Wall Street last year. You can find out exactly how she did it here.
With HSBC trading at $31.31 at the time of this writing, we can buy 100 shares and simultaneously sell one HSBC Sep 33 Call, which is trading around $0.71 ($71 per contract). This gives us a net cost of $30.60 per share, which is a 2.3% discount to the current price.
If HSBC closes above the $33 strike price at expiration on Sept. 16, our shares will be sold for that price. In this case, we will make $1.69 in capital gains, plus $0.71 for selling the call, as well as the August dividend, which should be around $0.50 per share. That gives us a total profit of $2.90 per share, or a 9.4% gain on our cost basis of $30.60. Because we’d earn that in 78 days, the annualized return works out to 44%.
If shares don’t surpass $33 by expiration, we can continue to generate income by selling calls as we wait for a rebound. The uncertainty surrounding the Brexit could limit gains in the short term, but I expect a rebound toward the end of the year as the bank benefits from its globally diversified asset base and strong profitability.
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