In late July 2016 I recommended buying shares in Deutsche Bank, one of the world’s biggest investment banks. Most people reckoned it was about to need a bail out. I took a different view, and saw the dirt cheap stock as an opportunity…albeit a high risk one. Seven months later it’s up 65%. Despite that, there’s still room to double from here.
In the middle of last year, everyone had it in for Deutsche Bank (XETRA:DBK / NYSE:DB). This was the basic story:
- It was massively leveraged
- It was losing money
- It had huge potential fines hanging over it
- As a result, it would need to raise billions of euros of new capital
- Some big media organisations – probably briefed by US competitors – clearly had it in for Deutsche Bank
To summarise my view it was this:
- Yes it was leveraged, but so are all investment banks, and leverage is reducing
- The losses were temporary, and largely due to the fines
- The future fines wouldn’t be as bad as feared
- It hadn’t announced a capital shortfall. Even if it needed a massive capital injection, the stock was still dirt cheap
- The new CEO, John Cryan, is the best in the business and has a clear plan to turn Deutsche Bank around
- The media overdrive was just hype
You can read my full comments from the time at these links:
- From 7th July: “The huge investment bank that has everyone worried”
- From 12th July: “Is this stock a huge opportunity or toxic waste?”
- From 29th July: “Stock alert: hell-fire or hell yes?”
That last article was just after half year results had come out and included the recommendation to buy the stock. It looked like a two or three bagger over three to five years. In fact that was being conservative.
But it was always high risk. Put another way, you could make big profit, but you shouldn’t “bet the farm”.
Initially the price rose substantially, but then it fell to new lows by the end of September. Since then it’s pretty much been on the up and up, as shown in this chart (in US dollars).
When I wrote to you on 29th July the euro stock price was 11.81. As I write now it’s 19.53 euros, which means it’s up 65% in just seven months.
At the same time, the price in New York was US$13.89, which has now risen to US$20.52 at the time of writing. That’s up 48%.
The difference between the performance in euros and dollars is largely down to the relative performance of the currencies in the short term. Euros have been weaker, dollars have been stronger.
That may or may not continue in coming months and years. If the dollar weakens against the euro in future then dollar investors will get an extra lift. But either way – measured in whichever currency – it’s a great result in quite a short time.
The key reason I recommended the stock in July was that all the bad news – and then some – was already baked into the price. It looked dirt cheap.
Specifically, I used a specific valuation ratio known as “price-to-tangible-book-value”, or P/TB for short. P/TB is a handy way to value capital intensive businesses, such as banks.
“Book value” – which is also known in finance jargon as “net assets” or “shareholders equity” – is simply everything a company owns (assets) less everything it owes (liabilities).
“Tangible book value” just leaves out an accounting oddity called goodwill, which arises when companies do acquisitions of other companies. You’ll find further explanation in the articles from last year.
You can think of tangible book value as a company’s liquidation value at a moment in time. That’s assuming the amounts booked on the balance sheet are at least vaguely accurate.
If you bought the whole company, sold all its assets and paid off all its debts, the cash you’d be left with should be the tangible book value. (Give or take. It could be a bit higher or lower, depending on the circumstances.)
Therefore P/TB compares the company’s “market capitalisation” – value at the current stock price – with its liquidation value. If P/TB is less than one then the stock is trading below liquidation value.
Which brings us back to Deutsche Bank. When I recommended the stock it had a P/TB of just 0.32, which was wildly low. This is value investing on steroids.
As part of his turnaround plan by 2020, top class CEO John Cryan has a target to reach 10% return on tangible equity – a measure of bank profitability. If he achieves that then I reckon the stock will be worth a P/TB of at least 0.71, based on various assumptions (again see earlier articles).
That was upside of 122% in July, even assuming no increase in tangible book value. In fact, it could easily go to a P/TB of 1 without getting stretched. That’s upside of 213%, again with no growth in net assets.
Hence my conclusion at the time that this stock had the potential to rise by two to three times within three to five years.
So where are we today? Tangible book value per share was 36.33 euros at the end of 2016. With the price at 19.53 euros that means P/TB is now 0.54. That’s up, but is still a huge discount from where it should go – barring any big upsets.
It’s also interesting to compare Deutsche Bank with other investment banks. The whole sector is much less profitable than it was before 2007, including the highly successful Goldman Sachs (NYSE: GS).
Goldman never suffered the distress and complete profit collapse of Deutsche Bank or other competitors, either during the global financial crisis or since (and some wonder how…).
But, even with a clear run, Goldman only managed a return on tangible equity of 8.9% last year. That will probably improve in future, as they hack out more costs. Average banker pay is down a massive 42% from the 2007 top, and more and more jobs are being automated (more on that another day).
In the meantime the actual level of profitability at Goldman remains well below Cryan’s future target for Deutsche. But the Goldman stock has a P/TB ratio just above 1.2 at its current market price of US$251.65.
Admittedly that’s in a bubbly US stock market, and at least partly founded on excitement that Trump’s government might slacken bank regulations. But it’s interesting nonetheless as a potential future benchmark for Deutsche Bank, at least at a stretch.
Below is a summary of the upside under different P/TB scenarios, both from the original price at recommendation and from today’s level. I’ve called the scenarios “conservative”, “realistic” and “stretch”.
In all cases I’ve assumed no change to the US dollar / euro exchange rate over several years (current dollar strength could be fleeting). There’s also zero growth in the book value assumed (in other words there could be even more upside).
Deutsche Bank stock has done well since the dark days it suffered in mid-2016. Of course I don’t expect it to be a smooth ride from here. This was always a high risk and medium term play (3-5 years). So it needs patience.
If you bought it last year then I recommend you hang on. And if you haven’t bought this stock previously then I still recommend you buy it. There’s plenty more turnaround upside for the intrepid.
Just remember: don’t bet the farm.
Stay tuned OfWealthers,