value and opportunity

Many value investors are of the opinion that banks are not investable. Either because they say the business is too complex or because they think banks are doomed anyway. Maybe due to the overall low valuations of banks, I get regularly requests on writing about how to value bank,s so at least some people seem to be interested. The greatest value investor of all obviously has no problems with investing into banks. Wells Fargo is the biggest position of Buffett at around 26 bn USD and he holds various other bank assets like the Bank of America Warrants.

A few days ago, a good friend recommended me to look at Handelsbanken from Sweden as an example how a well run bank should look like.

I had never looked at them before, mainly because they were always relatively expensive. A quick look at the stock chart indicates that somehow Handelsbanken escaped all the troubles that other banks experienced over the last decades:

With a P/E of 17 and a P/B of ~2,0, Handelsbanken is also one of the most expensive ones.

The question is of course: Why do they seem to be succesful when everyone else fails ? Part of the answer is clearly that they are based in Sweden and their main activities are in the Nordic countries, which were relatively unharmed both, during the financial crisis and the Euro crisis. On the other hand, Handelsbanken performed a lot better than other Nordic banks, so it is interesting to look at them what they are doing differently.

The good thing is: they explain it very clearly in the annual report how they do business. Following are some points which I think are important to explain Handelsbanken’s success and as a contrast I will compare it with Deutsche Bank just to have a benchmark.

1. Simple organizational structure

Handelsbanken seems to have a very simple organizational structure. This is how they describe it themselves:

Handelsbanken is essentially organised on a geographical basis. Like all companies with more than one customer and one product, we have to deal with matters of product responsibility, customer responsibility and
function responsibility. We’ve made things simple for ourselves by establishing a geographical organisational model, with one manager being appointed for each area of operations. An area of operations is a well defined geographical area, for example a town, a local authority, or part of a city. This manager has full responsibility for all the Bank’s business in this well-defined geographical area.

So let’s look how Deutsche Bank explains its structure in the 2013 annual report:

Following a comprehensive strategic review, we realigned our organizational structure in the fourth quarter 2012. We reaffirmed our commitment to the universal banking model and to our four existing corporate divisions. We strengthened this emphasis with an integrated Deutsche Asset & Wealth Management Corporate Division that includes former Corporate Banking & Securities businesses such as exchange-traded funds (ETFs). Furthermore, we created a Non-Core Operations Unit. This unit includes the former Group Division Corporate Investments (CI) as well as non-core operations which were re-assigned from other corporate divisions.

As of December 31, 2013 we were organized into the following five corporate divisions:

Corporate Banking & Securities (CB&S)
Global Transaction Banking (GTB)
Deutsche Asset & Wealth Management (DeAWM)
Private & Business Clients (PBC)
Non-Core Operations Unit (NCOU)
The five corporate divisions are supported by infrastructure functions. In addition, we have a regional management function that covers regional responsibilities worldwide.

We have operations or dealings with existing or potential customers in most countries in the world. These operations and dealings include:

subsidiaries and branches in many countries;
representative offices in many other countries; and
one or more representatives assigned to serve customers in a large number of additional countries.

So which bank do you think is easier to manage ? Clearly a rhetorical question. One of the big advantages of the Handelbanken structure is that there are clear responsibilities. With a Matrix (or Cube) structure like Deutsche, responsibilities are less clear. Why does Deutsche do this ? Well, in large financial institutions, having a “Global HEad of anything” title usually means big bucks, so everyone wants to be a global head of something. The more dimensions on an org chart, the more glabel head and the more bucks.

Handelsbanken mentions somewhere else that this structure is in place since more than 40 years, so it seems to work.

2. Decentralised decision making

Handelsbanken stresses several times that decision-making takes place at branch level:

Every branch of Handelsbanken is led by a manager who is solely responsible for all operations in his/her branch’s local area of operations. The branches’ independence gives them a very strong local presence, with long-term customer relationships. In addition, short decision paths make it possible to adapt more quickly to various changes in local markets and make the most of new business opportunities.

This goes as far as basically requiring staff to live in the same city of the branch where they work in:

Our staff almost always live in the town where their branch is located. In this way Handelsbanken also reflects the community in which it operates.

Another interesting aspect of this is their credit approval process. Of course, large loans are approved by the board but this feature is in my experience unique:

The largest credits are decided by the Board’s credit committee, or by the entire Board, where cases are prepared by the Central Credit Department. However, no credit application may be processed in the Bank without the recommendation of the branch manager.

In many cases, the most disastrous loans were originated and executed at very high levels of a bank. I never heard f a credit approval process where a brnach manager can veto the bank board. I guess this increases the quality of loan decisions dramatically.

3. Moderate salaries, no bonuses & long-term employee participation

This is a quote from the compensation part of the annual report (page 60):

Remuneration to the CEO and other Executive Directors is paid only in the form of fixed salary and pension provisions, and also customary benefits such as a company car. Following a special decision by the Board, Handelsbanken can provide housing as part of the remuneration. No variable remuneration is paid, nor are there any agreements on severance pay.

So no bonuses, no “golden parachutes” for board members. On the same page we can read this:

cides on the size of the final amount. Variable remuneration occurs to a very limited extent, and only within Handelsbanken Capital Markets and the British subsidiary, Heartwood. Nor is variable remuneration paid to the Bank’s management or to any employee who makes decisions on credits or limits. Employees who, alone or together with others, are entitled to decide on credit risk, market risk, liquidity risk, commodity risk, currency risk or interest rate risk limits, as well as employees who, by deciding on credits or product terms and conditions, can affect the Bank’s risk profile, can have only fixed remuneration.

This, in my opinion is VERY VERY SMART. I haven’t seen this anywhere else but the purpose is clear: This works as a strong incentive not to blow up volumes and short-term profit by extending loans to bad credits which is very easy for a bank.

On page 206 one can find interesting information about the profit participation scheme “Oktogonen”. This is the relevant passage:

Every year but two since 1973, the Board has decided to allocate part of the Bank’s profits to a profit-sharing scheme for employees. The funds are managed by the Oktogonen Foundation. Allocations are subject to the Handelsbanken Group achieving its goal of higher return on equity than a weighted average of comparable listed Nordic, UK and Dutch banks. If this is satisfied, one third of the extra profits can be allocated to the employees. The allocated amount is limited to ten per cent of the dividends to shareholders. If the Bank reduces the dividend paid to its shareholders, no allocation can be made to the foundation. All employees receive an equal part of the allocated amount, regardless of their position and work tasks, and the scheme includes all employees in the Bank’s home markets. In recent years, employees in Hong Kong, Luxembourg, Poland, Singapore and Taipei have also been included. 98 per cent of the Group’s employees are now covered by Oktogonen.

The profit-sharing scheme is long-term, as payments cannot be made until the year the employee turns 60. One of the fundamental concepts in managing the foundation is that the funds are invested in shares in Handelsbanken. For many years, the profit-sharing foundation has been one of the Bank’s largest shareholders, and Oktogonen has two representatives on the Handelsbanken Board. Thus, the employees are also able to influence the Bank at Board level.

Again this is very unique. Each employee gets the same amount allocated. It is very long-term, opposite to many of the “phantom share” programs of other companies and turns employees into long-term shareholders of the bank, thereby aligning shareholder and employee interests.

All those policies clearly influence compensation levels. I think the Swedish culture plays its role too. Anyway, the result is the following for the CEO:

The CEO’s remuneration and pension terms In 2014, the CEO of the parent company, Pär Boman, received a fixed salary after conversion to pension amounting to SEK 11.2 million (11.3). His other salary benefits amounted to SEK 0.3 million (0.2). External fees for serving on the boards of other companies on behalf of the Bank have been paid to the Bank.

11,2 mn SEK is around around 1,2 mn EUR. If we look at Deutsche Bank’s compansation report from 2013, we can see that even the lowest paid baord member took home 5 mn EUR. As Deutsche Bank somehow requires 2 CEOs, they spend in total arund 17 mn EUR on ther 2 CEOs, around 15 times the amount of the Handelsbanken who seems to cope quite well with doing the CEO job alone.

Just comparing the two stock charts, it is pretty to see which shareholders got the better “bang for the buck”:

At least Deutsche Bank is thinking about a change. This is from the 2013 report:

Additionally, Deutsche Bank recognizes the need for cultural change in the banking sector and aspires to be at the forefront of this change. Compensation practices are under review, and client focus and teamwork are being emphasized to complement our performance culture, entrepreneurial spirit and cultural diversity.

Well Deutsche Bank, how about reading the Handelsbanken annual report ? Maybe you could start with looking at real numbers and not made up stuff like.An example from a 2014 presentation on strategy from Deutsche and how they compare themselves against their 15% ROE target:

Core Bank adj. IBIT(2) EUR 8.4 bn, equivalent to pro-forma post-tax RoE(1) >11%

In real numbers, they achieved ~1% ROE in 2013, but 11% “Core bank adjusted IBIT” just looks better.

Maybe it is a little bit unfair but just by looking at the Deutsch Bank CEOs

and the Handelsbanken CEO

I would have a strong preference whom to trust with my shareholder’s money….

4. Organic growth

This is how they describe their growth strategy:

For Handelsbanken to achieve and retain high profitability, growth is also necessary. Handelsbanken grows primarily by opening new branches in locations where it has not previously had operations. In this way, Handelsbanken grows customer by customer, branch by branch. This organic growth model means that Handelsbanken can achieve growth, coupled with low risk and good cost control.

Organic growth is slow and cumbersome, M&A is fast and sexy. However, one doesn’t have to be a genius to see that most acquisitions in the financial industry are an absolute disaster. Almost all of the big M&A players of the past are either finished (RBS, Fortis, BMPS) or suffering (ING, Commerzbank, Deutsche).

This relates to the previous point: If you are a manager with a huge pile of short-term options, it is only logical to go for fast and sexy as the associated volatility automatically increases the value of your option.. If your bonus is however tight up in a company share account and you have to wait until you are 60, you might prefer slow but steady.

From a growth perspective, their success in UK and the Netherlands looks interesting. Both are big markets and if Handelsbanken can replicate their success from the Nordics, this could be interesting.

5. Risk taking: Credit risk only, no market risk

This is from page Page 13 of the annual report:

The Bank’s business model focuses on taking credit risks in the branch operations. The objective is therefore to minimise other risks, such as market risks. Position-taking in theBank’s business operations is only accepted in customer-driven transactions, and only within strictly defined limits. Handelsbanken also seeks to reduce all macro risks, in order to have a business model that is independent of fluctuations in the economy.

Again, very boring. Looking at Deutsche Banks Risk position, we can clearly see that market risk dominates credit risk. At least for now, it doesn’t seem to pay off for the shareholder.

6. Derivatives

WB called Derivatives “Weapons of Mass destruction”. If you look at page 120 at the Handelsbanken report, we can see that derivatives on a nominal basis are around 200% of the balance sheet, with the gross “fair value” being below 5% of the balance sheet.

At Deutsche Bank in comparison, the gross market value of derivatives (assets and liabilites) is far above 50% of the balance sheet. The nominal amount is a mind boggling 35 times the balance sheet.

I think this huge difference is a direct result of not taking market risks. This simplifies a lot.

Summary:

Some readers might be disappointed that I will not come up with a quantitative formula of how to value a bank. But in my opinion, the most important factors in order to find out if a bank is a good long term investment is comapny culture and incentives.

Comparing a highly succesful bank like Handelsbanken with a less succesful Bank like Duetsche Bank clearly shows that the success of Handelsbanken can be found in the DNA of the people working there and running the place.

As with many other businesses, long term orientation seems to be key. The problem with banking is that it is very easy to quickly grow your business in the short term. A bank at the end of the day is in the business of selling money and if you sell a 100 EUR Bill for 90 EUR, you will soon do a lot of business. Bank accounting makes it possible to pretend for some time that you sell the 100 EUR bill for 110 EUR, but this usually stops working at some point in time.

I am not saying that Deutsch Bank is a badly run bank. At least they managed to do without government assistance. They even could be a good short term rebound opportunity. But long term in their current shape they will be an inferior investment compared to Handelsbanken despite being a lot cheaper.

Why ? Because at “normal” banks like Deutsche Bank there is no alignment between shareholders and employees. Employees and managers will do anything to look good in the short term and don’t care about the long term because they can always move to the next bank. Shareholders are effectively writing cheap options to the benefits of management without getting any compensation.

Handelsbanken in contrast shows that a well run bank with good management and alignment can be a great investment in the long term even with financial crisis, negative yields etc. I would call Handelsbanken even an “Outsider company” as they are doing things quite differently from other banks which seems to result in some significant competitive advantages.

Additionally, simplicity and regionality in my opinion is a big competitive advantage for banks. Most banks still dream from the “integrated model”, but with all the regulation around, a simple, regional and nimble business model looks superior. All my bank investments follow that rule with KAS Bank being a Dutch custody specialist, Gronlandsbanken being a simple S&L, Van Lanschot a Dutch Private/Merchant bank and Citizen Financial as regional US player.

“Buying cheap” with banks is mostly not a very good idea as shareholders often get massively diluted through regulatory required capital increases. Paying for quality in the long run is maybe the better and safer option.

So in the end, analyzing banks is not that much different to analyze any other company as the mentioned issues are relevant for any long term investment.

My biggest regret with regard to Handelsbanken is that I haven’t looked at them earlier when they were cheaper. On the other hand, one should maybe not compare Handelsbanken with other banks but with other “high quality” companies like Atlas Copco etc. Compared to them, they still look cheap. If I would be required to invest in large caps, Handelsbanken would be my first choice for the financial sector. For my Small cap portfolio, Handelsbanken could be also a potential investment but I will need to dig a little bit deeper into them.

But this is something for another post….