Svenska Handelsbanken Analysis- The Best Nordic Bank – Has The Best Moat There Is: Culture

Svenska Handelsbanken (called Handelsbanken in the rest of the article ) was founded in 1871 and is the oldest listed company on Stockholm Stock Exchange. The Bank has a nationwide branch network in Sweden, the UK, Norway, Denmark, Finland and the Netherlands. I have been long this stock for some years, and I believe this is the best-managed bank in Scandinavia, probably in Europe as well. In this article, I briefly argue for why I own shares in Handelsbanken and not the cheaper (and mediocre) peers. (This is not a recommendation to buy or sell – do your own due diligence.)

Summary: Why I’m long Handelsbanken

This analysis of Svenska Handelsbanken shows that the bank is a good “income” stock and is most likely undervalued.

• I believe it’s one of the most prudent and conservative commercial banks around. It has never been “bailed out” or needed external support. Long-term focus and survival are always the main focus.
• The quality of credits is never neglected in favor of higher volume or margins.
• Selective in its choice of customers – high creditworthiness. Exposure to cyclical industries, for example shipping and oil, is kept to a minimum. The bank avoids participating in financing where there are complex customer constellations or complex transactions that are difficult to understand.
• Managed in an ethical way.
• Skin in the game: All employees have a significant stake in the bank via the Oktogonen Fund.
• Decentralized structure, bottom-up, not top-bottom: The branches and managers manage their own loan book. The decentralized structure and culture are the main reasons why I’m long. The culture is extremely difficult to replicate. Decentralization means quick response if borrowers face problems, those who work closest to the customer will make the most sensible decisions. The branches’ independence enables them to have a very strong local presence, leading to long-term customer relationships and getting to know the customer really well.
• The mutual fund division gains market share.
• Impeccable reputation, the bank scores consistently the best in its home markets. Because of this, it has low funding costs.
• In the long run the compounding effect makes sure the best-managed banks outperform the cheaper ones. Thus, I own Handelsbanken despite its trading at much higher multiples than for example Danske Bank.
• It’s trading at its lowest multiple in over a decade. Thus, I expect a 10-13% annual return over the next decade.
• However, banking is a competitive and slow-growing business. In addition, there is a headwind from low interest rates.

Good investments don’t have to be original or very exhaustive. I believe these five charts from Handelsbanken’s 2019 annual report summarize pretty well the advantages Handelsbanken has over its peers:

Svenska Handelsbanken: Historical return on equity and customer satisfaction.

Svenska Handelsbanken: Historical costs and credit losses.

The business:

In principle the business of a bank is pretty simple: You accept deposits at x% interest rates and lend these deposits to borrowers at a higher rate, and pocket the difference. If all goes well, this is of course a very profitable business. However, the problem is twofold: Competition is fierce, because banking is commodity-like, and sooner or later the bank will suffer losses in the loan portfolio. If the bank is leveraged, something which all banks are (more later), any losses backfire. The economy goes in cycles, and in good times many banks increase their risk, either on purpose or subconsciously. If there is no culture of prudence and long-term commitment, many banks face the stark reality of getting wiped out when the next recession inevitably comes.

Banking is a commodity-like business where it’s very hard to separate oneself from the competitors, just like in insurance, for example. Any competitive advantages must likely result from corporate culture, operating discipline, loss aversion and capital allocation skills. Furthermore, it’s the ultimate cyclical, leveraged and fragile business where a lot of the banks face serious financial difficulties during a recession.

However, even though it’s a competitive industry, the business is somewhat sticky: it takes time and effort for customers to change banks (switching costs), and usually for very little financial gain. The positive with banking is that it’s a durable business that is needed to grease the machinery of business.

Handelsbanken is one of the major commercial banks in Scandinavia. The banking market has consolidated during the last two decades and decreased the number of commercial banks, mainly due to M&A. I consider Handelsbanken, SEB, Swedbank, Danske Bank, DNB, Nordea and Jyske to be the major banks in Scandinavia. In some aspects, the banking market works more like an oligopoly. One of the reasons for consolidation, I believe, is efficiency, but just as likely due to increased regulation and scrutiny.

The table below summarizes some facts about Handelsbanken:

	Sweden	UK	Norway	Denmark	Finland	The Netherlands	Capital Markets
Income	21,664	6,476	3,832	1,713	1,315	675	440
Expenses	8,145	3,709	1,551	1,368	1,018	592	3,389
Operating profits	13,322	2,641	2,380	946	688	280	1,954
Return on capital	14.4	14.7	11.5	12.7	10.4	12.9
Branches	383	207	47	56	36	29
Profit per branch	35	13	51	17	19	10

The bank itself claims it has 46 years with better profitability than the average of peer banks in the home markets. Unlike its peers, the bank has never been “bailed out” or needed government support, not even during the Scandinavian banking crisis in 1992. The business model has proven successful during all business climates over the last 50 years (the current structure was implemented in the early 1970s). That is pretty impressive considering banking is a very cyclical and leveraged business.

The main competitive advantage:

I believe Handelsbanken has the best moat a business can have: their ingrained culture which is extremely difficult to replicate.

Every year, EPSI Rating – which includes SKI (Swedish Quality Index) – carries out independent surveys of customer satisfaction. For 2019 the surveys showed that Handelsbanken has more satisfied private and corporate customers than the average for the banking sector in all six of the bank’s home markets, just like previous years. In addition, the survey shows that Handelsbanken’s customers are significantly more loyal than the customers of their peers and that they give the bank’s digital services high marks. The fact that digital customer meetings are perceived positively is important for fostering long-term and strong customer relationships.

In a commodity-like business, it’s difficult to obtain any competitive advantages, but I believe Handelsbanken has a durable advantage in their culture because all employees have an interest in running the bank very profitably for the long-term – not the short-term. A good reputation – earning the respect of its customers – is a big challenge to overcome for every business and extremely hard to replicate. Just look at the US retail operator Costco: It’s no rocket science, but still no one has managed to replicate Costco’s model successfully (yet – and many have tried). I believe Handelsbanken’s conservative and decentralized structure gives them the upper hand for the foreseeable future.

Additionally, all banks have a regulatory moat: After the GFC in 2008/09 the workload/cost to open and keep customers has increased and thus “forcing” the smaller and less capitalized bank to be acquired. Regulation is always the enemy of the small business. For example, Handelsbanken’s costs of KYC/AML have risen from 0.3% of total expenses in 2017 to 1.2% in 2019. That equals 260 million SEK a year! Obviously, this does not include customers’ costs to provide documentation for transactions, etc. This is a huge cost for businesses and is of course ultimately borne by the end-user.

Worth mentioning is that the bank avoids the media, they like to operate without being in the limelight as a part of their strategy.

The graph below shows the outperformance of Handelsbanken over time:

10 000 invested 1.1.2000 returned, with dividends reinvested, this per 15th of April 2020:

• Handelsbanken: 177 000
• DNB: 71 000
• SEB: 55 000
• Swedbank: 36 000
• Danske Bank: 11 000

Perhaps not so distinct in the chart is the fact that Handelsbanken’s share price fell a lot less than the other banks during the GFC in 2008/09, thus recovering from a much higher price. From January 2008 to the bottom Handelsbanken fell 40% at the most, while the others fell much more: SEB 73%, Danske 78%, Swedbank 85% and DNB 65%. During the Covid-19 we see the same: Handelsbanken falls less than peers. However, in good times this means that the bank might underperform a little, but all in all the shareholders are rewarded for investing for the long-term.

At the end of the day, banking is difficult because of leverage, risk and black swans, and for an outside investor it’s difficult to fully understand the balance sheet and its risk. An outside investor needs to trust the management and its culture, and Handelsbanken has proven itself over many economic cycles. In the case of Handelsbanken the interests of the management, employees and outside investors are aligned:

Management and ownership:

The biggest shareholders are Industrivärden (10.4%) and Oktogonen Foundation (10.4%), both long-term institutional investors. Oktogonen is a pretty interesting institution as it was set up by the “father” of the current business philosophy, Jan Wallander. Oktogonen was initiated in 1973 to create incentives and long-term commitment for the employees. It’s a profit-sharing scheme for all employees, whether you are a clerk or a boss. The fund keeps all its assets in Handelsbanken shares, and the requirement for allocating shares to the foundation is that the bank must both get an acceptable return on equity and at the same time better than its peers. When an employee reaches the age of 60 the assets in Oktogonen need to be withdrawn, either as a one-time payment or over 2-20 years. I believe this is a much better incentive and compensation than options. Both in 2017, 2018 and 2019 there were no provisions for the Oktogonen fund because the board was not pleased with the performance, meaning many employees were disappointed, to say the least, but the board takes a tough stance, compared to many other banks that keep on handing out bonuses despite lackluster long-term performance (Deutsche Bank comes to mind). In recent years outside investors forced the board to allocate less to Oktogonen by demanding an additional requirement of an acceptable return on equity. Simply being better than competitors was not enough. (Provisions to Oktogonen for 2018 is under consideration).

Additionally, the board owns in total 67.6 million shares, almost 4% of the company. The reason is Fredrik Lungberg who owns 67.25 million shares (3.6%) via the investment firm Lundberg. Fredrik Lungberg is the son of Lars Erik Lundberg, the founder of Lundberg, and they have had a stake in Handelsbanken for a long time. Furthermore, Lundberg owns 11% of Industrivärden which again owns 10.4% of Handelsbanken. The chairman, Pär Boman, the former CEO, owns 126 000 shares of which 26 400 indirectly via Oktogonen.

The executives own a total of 285 000 shares, almost all indirectly via Oktogenen. This equals about 24 million SEK.

Capital allocations:

Because Handelsbanken is well capitalized, the common equity tier 1 ratio (CET1) increased from 16.8 to 18.5% in 2019, we can expect most of the net earnings to be returned to shareholders via dividends (and less via buybacks). Reinvestment opportunities are slim. The dividend has been rising steadily since 1995 except for 2008 when it was reduced by 20%. For 2019 it was left unchanged from 2018, but at the AGM it was decided to postpone the dividend until 2020 (see item 9):

 

This means the entire amount at the disposal, 5.5 SEK, should be carried forward to the next year (2020).

5.5 SEK per share equals a yield of 6.8% as of today, the highest level since 2009:

The payout ratio is only 65%, so I believe the dividend is pretty “safe” for next year, perhaps in the worst case it will be reduced, but not eliminated. However, a dividend should be of less importance because a shareholder can just as well sell shares to get “income” (I wrote an article about this some months ago).

As of today, the board has a mandate from the AGM to buy back up to 120 million shares. Previously the buybacks have been very modest, and it looks unlikely that any buybacks will be done during the Covid-19 crisis, despite the stock trading at the lowest multiples since the GFC in 2008/09.

Costs and credit losses:

Handelsbanken has lower overall operating costs (excluding credit losses) than peers, and during a crisis like today, the weakest banks get the most punches. For example, Danske Bank has seen its funding costs rise substantially, which means they need to dig deeper to serve their customers if they need extra borrowing. Handelsbankens main priority is to serve existing customers before taking on new ones.

As can be seen from the chart at the beginning of this article, the cost advantage has decreased over the last two decades. The other banks have increased digitalization and centralized operations, while Handelsbanken has stuck to its original structure with many branches (758 branches at the end of 2019). The branches have been the cornerstone of the deregulated structure where the manager is responsible for his or her own loan book. Handelsbanken’s response to the narrowing cost gap has been:

• Close some branches, the number has dropped from 850 in 2017 to 758 at the end of 2019.
• Closed all offices outside core markets.
• Close some products and services that were in low demand (fewer products).
• Focus on the most profitable products, the core market, which is lending and asset management.
• The new CEO has used the term “En enklere bank” (which means something like “simpler banking”).

Nevertheless, expenses are just one part of the total costs, and expenses have just rarely ruined a bank, but credit losses have. Handelsbanken’s very conservative lending practices have so far made the bank “immune” to huge losses:

The balance sheet and loan portfolio:

Banks are very difficult to evaluate because risks are complex and often dependent on counterparties and derivatives. Because of this, investing in banks might be very tricky. I often wonder if the banks really understand their risk exposure themselves! However, the balance sheet of Handelsbanken is somewhat easier to understand due to less potentially “toxic” items like for example complicated derivatives, swaps etc. During the Scandinavian banking crisis in the 1990s, the credit loss ratio peaked at 2.5% (peers at 9%). The same goes for the GFC in 2008/09: Handelsbanken peaked at a very modest 0.2%, while peers at 1.1%.

All banks are highly leveraged. In the annual report of 2019 on page 121 Handelsbanken has an interesting chart showing the liability side of the balance sheet:

The loan portfolio stood at 2 300 billion SEK at year-end 2019, compared to shareholder’s equity worth about 160 billion. The right side of the balance sheet shows the tiny equity compared to the liabilities. Leverage is the friend of prudent and conservative management, while an enemy of the reckless risk-takers: the equity can be wiped out pretty fast. However, the figure above overestimates the liabilities because there is a corresponding asset and the two might cancel each other out.

No other bank in the world has a higher rating than Handelsbanken in terms of bank ratings from Fitch, Moody’s and Standard & Poor’s. Moody’s has Handelsbanken at a2. Other Scandinavian banks are at a3 or baa2 (Danske Bank). This ensures the lowest funding costs compared to peers. Furthermore, the bank is funded to manage for at least 12 months under stressed conditions without borrowing any new funds in the financial markets.

The Scandinavian commercial banks have gradually shifted away from “risky” lending to businesses, to assumed less risky lending to real estate. There are several reasons for that, one of them regulation.

Handelsbanken’s lending is almost exclusively toward real estate: personal and commercial real estate with about 50% each, the latter including low-risk loans to housing co-operatives/associations. In addition, the growth toward public entities has grown more than private entities over the last few years.

The bank aims for the lowest LTV-value possible. Commercial businesses can never borrow more than 60% LTV, while private persons theoretically can borrow up to 100%, but that is of course rare. In general, those potential customers who want to borrow the most need to go to other banks than Handelsbanken.

Valuation:

Most bank stocks have taken a beating during the Covid-19 crisis, and so has Handelsbanken with a drop from over 100 SEK to around 79 SEK as of writing. This means Handelsbanken is currently valued at its lowest valuation for many years. The valuation has gradually contracted since 2015, despite the annual growth in book value (including dividends) at 13.5%, which is more or less the same CAGR since 2007 (see chart early in the article).

This is the price to book from 2009 up until today (April 2020):

Handelsbanken is currently trading around the book value, but not including the profits for 1Q2020.

Obviously the same goes for the P/E ratio:

Given no extra losses or provisions for 2020, it means you can buy the shares for an earnings yield of 11% (!).

Scandals:

Several Scandinavian banks have over the last years been involved in “scandals”, mostly related to money laundering in the Baltics: SEB, Nordea, Swedbank and Danske Bank come to mind. Handelsbanken has so far not had any issues, and that’s no coincidence, I believe. It all boils down to culture and a long-term commitment. Because of this, I believe they can gain market share in the future. (Handelsbanken never wanted to have much exposure to Eastern Europe, for many reasons, and this has turned out to be very smart.)

Handelsbanken sells products that are beneficial to the customer, not the bank. For example, structured and complex products have never been offered to “fool” the customers, but instead focused on selling simple mutual fund products.

Future growth:

Handelsbanken doesn’t do any risky M&A where corporate cultures collide and where synergies in general are too optimistic. Instead, all growth is organic. Handelsbanken is growing mainly because the branches are doing more business – with new customers and with existing customers with whom they have had a relationship for years. I believe that this is a viable strategy even in an increasingly digital future. Banking is a very mature business, but also a durable one: there will always be demand for deposits and lending.

Risks:

Even Handelsbanken can’t escape the gravity of low interest rates. This, and higher capital requirements from the regulators, indicate the times of 15% return on equity most likely is gone. Compared to 2008/09 banks are in much better shape today, and more capital makes banks safer, but less profitable. However, Handelsbanken has always had more capital than required.

Is P2P/crowdfunding a threat? I think it’s too early to tell, but I doubt so. Lending is a professional market, and most likely to stay that way in the future. I have dipped my toes in the P2P market, and my experience is that most investors should concentrate on the traditional stock market or real estate market.

Conclusion:

The valuation is at its lowest since the GFC in 2008/09, but Handelsbanken is better capitalized now than then, and additionally I believe the loan book is in better shape. Handelsbanken is, in my opinion, the best-managed bank in the Nordic region where the interests of outside investors are aligned with the managers/employees. I don’t expect any significant losses or provisions due to Covid-19.

Many banks are cheaper than Handelsbanken, but in the long run it pays off to invest in those who are managed the best because of the compounding effect, even though some cheaper banks might perform better in the immediate near future.

What kind of return can Handelsbanken deliver over the next decade? A lot needs to go wrong for this to be a bad investment. A dividend yield of 6.8%, organic growth at 2-3% and some multiple expansion should return about 10-12%. I think this is a pretty decent risk/reward for such a mature business. Furthermore, as of today, the share price is close to book value/equity/shareholder’s equity. It’s not unreasonable to expect the return on equity to be around 10-13% over the next decade, and if we add some multiple expansion into this the return is set to be pretty good, barring a financial crisis further down the line (which I believe the bank will survive in good shape).

 

Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.