March 2021 Newsletter
How Much is too much of a Good Thing?
We look at our International All-Cap Value strategy with a little bit of disbelief these days. Nearly half of the strategy is now invested in Financials. Our process has led us to a shocking result. When you lean as heavily as we do on bottom-up fundamental research, there can be some surprising results in the eventual portfolio construction. It’s as if we started testing different types of cheese, and in the end, made a 12 cheese pizza. You can’t but help wonder how they all fit together, and if the process hasn’t led to too much of something.
When we began the strategy in November of 2017, Financials were roughly 35% of the portfolio. So it’s not as if we have come from de minimis exposure to a wildly exaggerated position (it’s currently 47%). The composition of the Financials exposure in late 2017 was quite different. There were a few niche operators in Europe, Emerging Markets, and Canada, in addition to some large Japanese banks. The Japanese banks obviously bring a long history of underperformance, but the other financials that we owned were accustomed to very decent returns within their businesses. Fast forward a few years, and the current strategy has quite a different composition of financials. European banks have entered the Ballina picture in decent size.
We can understand if you feel like you’ve already read what we are about to write. The investment case for European banks has been made for a decade now, with no success. Undercapitalized, overbanked and starved of returns and growth have justified the “Waiting for Godot” type feeling for those that must cover European banks. For example, German Sparkassen, typically owned by local municipalities, account for roughly a 1/3 of the retail and business lending markets in Germany. While bank branches decline in the country, the number of new Fintechs grows. This partly explains why we actually have yet to have a German bank pass our screens. We can pick on Germany, but this is not just a German problem. We hold the large franchise European bank exposures with a healthy degree of caution and skepticism. Most of the European Banks are just not Buy and Hold it forever candidates. We would be ready to exercise our sell discipline. Semiconductors have been a very tough, cyclical sector in the past. More recently, some investors made great profits by calling a turn where well placed Semiconductor companies were going to have a time in the sun[1]. We would love to make a comparison between Semi’s and European banks, but there isn’t one to be made. European banking will remain tough business.
Global Financials (IXG) vs All Country World Index (ACWI) Next Twelve Months P/E
Our approach to financials is that we remind ourselves that we like cash. Since it is inappropriate to use standard cash flow analysis to value financials, we tend to lean on dividends. Specifically, we work to find the dividends we believe the financial company can and “would” support on normalized earnings. We emphasize “would’” because in some cases, companies demonstrate over a decent timeframe that they just aren’t that comfortable with the payout ratios that other companies in their sector support. In these cases, we won’t assume the frugal company comes around to the same thinking as their peers.
With future cash dividends as our focus, what do we like in Financials?
Investec PLC (INVP) – 2bn GBP market cap
Potential Dividend Yield (Normalized Dividend / Today’s share price) : 12%
We’ve owned Investec PLC since the inception of our firm. It would be fair to describe it as disappointing, but enchanting. The South African business is the enchanting piece, but of course you can’t think of that without recalling that South Africa has been scoring own goals on it’s economy for some time. The UK piece has been disappointing, but we are hopeful that the turnaround will bear fruit. Exceptional long term value did open up on INVP from the COVID downdraft in the share price (the stock halved in about a month), and we added to the stock aggressively. Our Sum of the Parts indicates that we don’t have to pay much of anything for the bits we don’t like all that much (UK Specialist Bank, Investment Portfolios), to get meaningful upside for the stock. See below. Proof that INVP is not always cheap is evident in the current 40% discount to the five year average Price to Tangible Book value. Our assumption for Normalized DPS would result in an 12% yield on the current share price.
Banca IFIS (IF) – 600mm EUR market cap
Potential Dividend Yield : 17%
We purchased IF for both of our strategies in September of 2018. The Specialty Finance lender in Italy has a remarkably profitable history, given that it operates in a difficult market. The reason for the good profits is that IF are specialized in Non Performing Loans and lending to SME’s in shorter duration segments such as factoring and leasing. This hasn’t mattered as much in recent years, as the stock market has moved IF’s valuation basically in line with that of a traditional Italian bank that has branches, mortgages and loads of Italian Government bonds. When it comes to dividends, like other European Banks, IF has been prohibited from paying them during the Pandemic. But this has not stopped IF from providing for their 2019 and 2020 dividends. IF was profitable in every quarter of 2020 despite the pain that Italy experienced economically. Our assumption for Normalized DPS would result in a 17% yield on the current share price. Cash is a big part of why we like IF so much. We also find that there is little reason for a group with the track record and resilience of IF to trade at almost 2/3 discount to the five year average Price to Tangible Book Value.
(1) EU weighted average is from Q2 2020
Great Eastern Holdings (GEH) – 10.6bn SGD market cap
Potential Dividend Yield : 3.7%
We purchased GEH in January of 2020. The Singaporean Life Insurance Group has a very long record of stability and profitability. The debt to capital has declined in recent years, and stands at a very low level of 5-6%. Book value per share has grown in nine of the last ten years. The brand is the 6th strongest in Singapore, and #1 in Singapore Insurance, according to Brand Finance. GEH is a stable company, and the equity trades with low volatility as well, which we like. We are also attracted to the fact that just one broker covers GEH, and that they have very reasonable expectations for the company. Given the safety and security of GEH, it wouldn’t be realistic for the potential dividend yield to be over the moon. And it isn’t, at less than 4%.
GEH Embedded Value History
Bank of Ireland (BOI) – 4.1bn EUR Market cap
Potential Dividend Yield : 5.8%
We purchased BOI in May of 2020. It was obviously a scary time, and given the market movements, the BOI investment has worked out well to this point. BOI is the oldest, and leading bank in Ireland. They have been moving forward with a strategic plan to improve profitability (see their progress pre pandemic below), which includes exiting some segments. COVID lockdowns have been stringent in Ireland, and therefore it is not clear what the damage will be to consumers and businesses that are all too familiar with debt crises. We firmly believe that Ireland will come out of this better than the rest of the EU, and BOI is uniquely positioned with the strongest asset quality in the market. Our conviction is strengthened from the evidence that investors have become much more realistic on their expectations for BOI. A few years ago, when sellside models had to plug in the numbers for the years 2021 or beyond, they would start with figures for Net Income of circa 1bn EUR. Today, the estimate for 2022 Net Income is 455mm EUR. We believe that BOI can easily beat the latter figure. Beating the higher figure, even without the Pandemic, would have been a stretch. BOI also trades at a meaningful discount to its five year average Price to Tangible Book (0.5x vs 0.7x). In many ways, the BOI story is very standard for what we see in the Financials we are currently attracted to. The expectations are modest, and the valuation discount is just too significant.
Societe Generale (SG) – 16.8bn EUR Market Cap
Potential Dividend Yield: 5.5%
We purchased SG in May of 2020, so much the same as with BOI, the shares have done well for us. However, the comparison with BOI is a poor one. SG is in pretty bad shape (see ROE’s below). Capitalization and asset quality are decent. But the core of it’s operations have been under managed for a long time. We find that French companies can sometimes find it hard to come to grips with the reality of their new environments. However, once commitment is taken for a strong strategic direction, the results can start to improve. We believe we’re at the point where the supertanker that is SG has “just” started to turn. We probably will not see meaningful evidence in results until at least 2023. But significant decisions are being made with a sense of urgency on underperforming segments such as French Retail Banking and Global Markets in 2021. As with GEH and BOI, we take comfort from evidence that expectations have meaningfully moved down for SG. It wasn’t that long ago that Net Income forecasts for a given fiscal year were in the range of 4-5bn EUR. Current Net Income estimates for 2023 Net Income are 3.2bn EUR. Everything helps. While we do not believe that SG will anytime soon pay as much in dividends as the 2.2 EUR per share they paid in 2018, we do believe the Normalized Dividend per share would result in an 5.5% yield on today’s share price. It will require the utmost patience for us to stick around for SG to achieve that kind of result.
Source: Factset
This is just a small section of Ballina’s Financials exposure, although some of our highest conviction names are here. Four banks mentioned here “could” be considered European banks. However, we believe that only one, SG, has characteristics of what one thinks of when they consider the weaknesses of European Banks. It took the depths of COVID financial despair to draw us deeply into European Banks. We will, as always, use our selling discipline if any of our Financials show evidence that the problems are far bigger than the entity can deal with. Much of the market discount for Global Financials has had more to do with the excitement and potential in other parts of the market. We don’t like the risk associated with overpaying, so we find ourselves with nearly half of the International All-Cap Value Strategy invested in Financials. What should be apparent from the stocks discussed herein is that there is no prevailing sector view for Financials. Each investment case is made to stand on it’s own. We’ll have to use our best monitoring skills to ensure we best handle this exposure moving forward.
Strategy Performance
International All-Cap Value returned 4.88% (gross basis) in March 2021 versus 1.87% for the benchmark. Year to date performance was 13.03% (gross) versus 4.48% for the benchmark.
Global Small Cap Value returned 1.63% (gross) in March 2021 versus 1.68% for the benchmark.[2] Year to date performance was 9.08% versus 9.11% for the benchmark.
Top Contributors and Detractors
International All-Cap Value’s top contributor in March was Bank of Ireland (“BOI”). The Irish Banking stock gained 21.5% as speculation swirled about the exit of NatWest from the Irish banking market. There was also the news of a scandal at Davy Stockbrokers, an Irish bond and equities sell side firm. These developments point to a consolidating and complex market in Ireland that will remain tough for small players. The top detractor in March was Joyy Inc,, which declined 20.4%. March was a tough month for Chinese internet stocks, as larger players like Tencent dealt with stronger regulation at home, and selling pressure from large holders in the United States.
Global Small Cap Value’s top contributor in March was Vistry Group Plc. The stock returned 30.7% in March, as the UK Housebuilder gave a very bullish outlook for 2021 and beyond with their annual results. The top detractor in the strategy for March was Joyy Inc. The Chinese Social Media player declined 20.5%, as it was caught in the crossfire of greater regulation and selling pressure for the larger stocks in the sector like Tencent in the month of March.
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. The information contained herein is not investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
[1] From March of 2001 to November of 2013, the SOXX ETF was flat in terms of Total Return. Since that time, the return has been more than 500%. [2] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)