Imagine I told you nothing about two different companies except their historical long-term earnings power (net income through the cycle; return on assets/equity %, etc) and capital structure (equity/total assets, debt/total capital, etc). I then told you they were both financial companies dependent upon access to capital markets for funding – making them somewhat comparable (both spread lending businesses but against different types of assets) if not exactly the same. Conceptually, could you come up with a valuation framework that seemed consistent with what the market was telling you?
Here is company A. Over the last 12 years this company has grown earnings (net income) at 15% per annum (per below). During the financial crisis earnings fell 20% year over year – pretty incredible for a financial company! – but bounced back within two years to new highs:
Clearly a good deal of this growth was accomplished through acquisitions (note the step function higher in earnings from 2014-15), but importantly asset-level returns (as measured by RoA %) and capital structure (as measured by equity % of total assets) has not really changed much over this long period of time – which is why RoEs have remained remarkably steady in the 10-13% range in recent years:
So, this company is earning essentially the same returns on its underlying assets (whatever they may be) as they did back in 2008. Pretty consistent, right? And while absolute earnings have declined the last few years, because asset- and equity-level returns have not changed much, the company must have been reducing the size of their balance sheet and returning capital – and indeed, when we look at book value per share, this has continued to grow (compounding at 16% per annum over the long-term, essentially in line with net income):
Now let’s look at Company B. Clearly this is a much larger company to begin, but unlike Company A, this company saw much more downside volatility during the financial crisis – earnings fell 70% YoY – although they bounced back faster, and to new highs (again, it looks like a large acquisition hit the business). Much like Company A, earnings appeared to plateau 4 years or so ago and have not advanced in absolute terms since. It should be noted the scale of earnings growth is also lower (Company B grew at a 9% CAGR vs Company A at a 15% CAGR):
Let’s look at the asset-level metrics and capital structure for Company B:
While the 2008-2009 volatility in asset-level returns is notable, for the most part RoA has been pretty stable in the 1.1-1.2% range, as has the equity ratio (around 10-11%). The salient point – other than the outsized volatility exhibited during the GFC – is of course that the asset level return is much lower in absolute terms, and thus the required leverage to earn decent RoEs is so much higher (10% equity ratio or so for company B vs 20%+ equity ratio for company A). As you might expect, book value for Company B has compounded at a far lower rate – commensurate with the much slower growth in net income – and has only grown 8.4% CAGR over this time, or basically half as fast as Company A (admittedly Company B is a dividend payer whilst Company A is not, an important distinction but one that does not change the dynamics here meaningfully in this case).
To summarize, then: based on an extremely long-term record (12 years, spanning the pre- and post-financial crisis period), we can conclude the following:
- Company A generated near-double the earnings growth of Company B and compounded book value at near-double the rate (15.5% vs 8.5%);
- Company A saw much less downside earnings volatility during the financial crisis (20% vs 70%);
- Company A manages more than double the asset level return over the long-term, and thus
- Company A operates through the cycle with half the leverage of Company B (21% equity ratio vs 11% equity ratio).
All else equal, wouldn’t you think Company A would earn a far superior multiple (of book or earnings or whatever) to Company B?
And the winner is…
Pulling back the curtain, Company A is Aercap (AER), the world’s largest aircraft leasing company; and Company B is Wells Fargo (WFC), one of the world’s largest commercial and retail banks. Here is how each entity is valued by the market, first on a NTM P/E basis (going back over the last 12+ yrs):
Now let’s look at P/B:
As you can see, barring a very brief period in 2014 when P/B parity was almost achieved AER has traded at a very large and consistent discount (around 5 turns on average P/E, currently 3 turns) – despite the hard evidence of many, many, many years of superior financial (and operating performance).
How do we explain this? To be clear, this is much less about WFC (honestly I picked it somewhat randomly, I could have made the same argument with most any other listed financial). And of course, there are many other differences in these two businesses (access to capital, etc) that affect how these two assets should be relatively priced. But my contention is much more about AER and the way the market has perceived it over a very long and successful history, and I thought the comparison to a bank like WFC, even a spurious and simplistic one, provided some insight.
Normally, the market rewards consistency of performance; or it rewards consistency of growth; or it rewards consistency of capital returns. AER has aced all three of those tests for its entire listed history as a company: AER generates earnings well in excess of its cost of capital; it has grown earnings well ahead of the market; it didn’t lose money in the financial crisis (!); and it has returned a huge amount of excess capital. Yet it appears the market doesn’t care one iota.
Furthermore, AER is not a small, under-covered stock: it has a $7bn+ market cap; it is incredibly liquid (trading >$50mm/day); it is listed on the largest stock exchange in the world (the NYSE); and it is covered by a large-ish number of sell-side analysts (at least 7). Frankly, it is not at all cheap for any spurious, non-fundamental reason. Rather, it seems to me that in AER’s case (and really most all the aircraft leasing space), the market simply perceives the riskiness of the business model to be many, many degrees greater than the long-term record would suggest.
And this to me is a real conundrum, because the market – as I understand it – is meant to be at least semi-form efficient (ie, it should value assets more or less correctly, most of the time). In this understanding, there are rewards to be had through demonstrated execution, and consistent performance over time (as the market pays up for businesses with a track record of success) – but in AER’s case the opposite appears to be happening (the business is getting de-rated more over time despite exemplary performance and lower risk today than at any time in its history).
Luckily there is a self-correcting mechanism, and one AER is pursuing today: buying back all its shares from Mr Market on the cheap. AER has retired >40% of its outstanding shares over the last 5yrs, and is on track to retire another 8-9% of the company this year as well. If the public markets never accord the value to the company it deserves, I fully expect the company to be taken private – either by strategics (a Japanese bank with a structurally low cost of capital?), or perhaps by astute management, once the float is de minimis in a few more years. Or maybe – if the valuation discount continues – sooner? For what is the point of putting up numbers, quarter after quarter, year after year after year, and yet permanently suffer from an unfairly high cost of equity? This is a financing business, after all…
Disclosure: long AER
(PB: I didn’t discuss the fundamentals of aircraft leasing in this post, but it is something I have discussed previously here and here; alternatively, this blog post by a respected peer goes into some detail as to why AER is interesting as well).