According to professors Dimson, Marsh and Staunton, in the latest edition of their Global Investment Returns Yearbook, investors often do well out of investing in companies which operate in “sin industries” and in countries where corruption is most developed. Doing bad, in other words, can often mean doing good for investor returns.
That set me wondering how scandal-riven banks might fit into this matrix. Is it fair to classify them as the market’s new sectoral “sinners”? Banks provide many valuable services to customers around the world, and in a capitalist system it is as yet not a crime to lose money, although losses on the scale incurred in the great financial crisis from stupidly risky lending practices – in some cases verging on the fraudulent as well as criminally incompetent – cannot be so lightly dismissed.
The recent publicity given to the activities of HSBC’s private bank in Switzerland, coming on top of a host of recent scandals, does however provide a justification for considering placing a number of banks in the “doing bad” category. The fact that several global banks have been found guilty of complicity in various combinations of product mis-selling, money laundering, rate-fixing, sanctions-busting and now tax avoidance and evasion points to some fundamental shared flaws.
To the extent that the worst offenders have shown themselves to be addicted to short-changing their own customers and gambling recklessly with their depositors’ money, those activities would seem to qualify them to sit in the “sin bin” alongside tobacco companies, arms manufacturers and casinos. In the conclusion to Shredded, his coruscating recent history of Royal Bank of Scotland, Ian Fraser points out that the bank has been carrying an unfunded liability of nearly £100 billion for litigation and redress (fines, compensation and so on) – a dubious badge of honour.
In another recent book, boldly entitled Criminal Capital, Stephen Platt, a barrister whose consultancy firm specialises in tracking down financial crimes and misdemeanours for regulatory authorities around the globe, argues that there are many ways in which global banks knowingly or unknowingly help to facilitate the commission of crime, and bemoans the fact that so little effective reform of the industry has yet been achieved.
But what does this all mean for investors? I asked Professors Dimson and Marsh to provide with me some of their long run historical data on UK sector performance. Their numbers show that over the long run (since 1920), banks have generally underperformed both the market and most other sectors, reflecting their once more sedate business models. Tobacco and alcohol companies have both generated more than 3% per annum more in annualised returns over time.
Yet this pattern changed dramatically in the early 1990s, which was exactly when the toxic combination of deregulation, securitisation, globalisation and cheap money began to usher in a short but ultimately disastrous “golden age” for bank investors. Between 1990 and 2007 banks outperformed the market by a compound 7% per annum. The institutional investors who clamoured for higher returns on equity and short term profits growth in this period cannot be excluded from blame from the ensuring catastrophe.
This was also of course the period when most of the bad practices we now read so much about started to flourish. Since the global crisis broke in 2008, in contrast, bank shares have badly lagged the rest of the market, on this side of the Atlantic at least. (It is not quite so bad in the US where steps to clean up the banking mess were bolder and have arguably been more effective).
Dimson, Marsh and Staunton suggest that one reason why “sin industries” tend to outperform is that activist investors with principles that prevent them investing in these sectors help to drive down prices to levels where valuations become sufficiently attractive to generate above average future returns. Will something similar happen to bank shares?
It is possible. Smart professional investors such as Terry Smith and Neil Woodford already refuse to hold any shares in universal banks on the principled grounds that they are uninvestable, their accounts and derivative exposure being too opaque to make it possible to understand the real risk profile of their balance sheets. (Mr Woodford did recently buy into HSBC but promptly sold it for fear that regulators would soon be stepping up their penalties and fines).
It is not easy to establish how far the surge in banks’ pre-crisis profits was the result of bad practices and how much simply by excessive leverage. What does not seem in doubt however is that, while many believe the banking lobby has successfully resisted wholesale sector reform, banking is no longer seen as the growth sector it came to be known as in the heyday of bad banking.
It is the shareholders of the banks who are now picking up the bill for the wrongdoing while managements by and large have escaped scot-free, financially if not in terms of reputation. (Mr Platt notes that no bank director is doing time for presiding over disastrous or illegal activity). If history is any guide however, the price of effective bank reform, if and when it happens, will continue to be felt in sub-market investor returns.
This column was published in the Financial Times on 23 February 2015.
Jonathan Davis 