Monthly Archives: March 2015

Lloyds Banking Group (ISIN GB0008706128) – A potential interesting special situation within UK Banking (part 1) ?

Quick “Management summary”:

Within the large UK banking peers, only Lloyds banking Group offers a “pure play” Uk opportunity. There are a lot of negatives around UK banking in general and Lloyds specifically, but overall nothing which would “kill” the investment at this stage. Potentially, the current selling of the UK government and the visible turn around could present an attractive entry point for a turn around situation with kind of “catalyst” if Government at some point is finished and profit increases ex fines.

Following my Aldermore post a few days ago, I decided to have a closer look into the listed UK banks as the UK market looks structurally more interesting than most European ones. Overall valuations are pretty moderate. This is a table based on the most recent financial year:


Name P/B P/TB Leverage NIM Pers. Exp P/E
HSBC HOLDINGS PLC 0,88 1,03 13,17 2,08% 33,25% 12,5
BARCLAYS PLC 0,77 0,90 22,03 0,00% 43,52% #N/A N/A
ROYAL BANK OF SCOTLAND GROUP 0,71 0,82 17,46 1,83% 38,00% 101,2
STANDARD CHARTERED PLC 0,90 1,01 15,53 2,15% 37,02% 16,5
LLOYDS BANKING GROUP PLC 1,19 1,30 17,13 1,33% 28,40% 51,7

Looking at the list of banks, lets look quickly at the different players.


HSBC is by far the biggest player with the clear target to be one of the biggest players globaly, offering all services from investment banking to private banking, etc. Their UK business is a rather small part of the company, the biggest part of the business comes from Asia. Historically, HSBC has always been trading at least at 2x book value. The company has been involved in many scandals, the problems of the Swiss subsidiary and the secret bank account of the CEO are only the latest example. Overall, HSBC is much more a play on Asia than anything else.

2. Barclays

Barclay’s is in its core an investment bank with some retail businesses attached. They took over large parts of Lehman following the financial crisis. Barclay’s has significant revenues from card processing and African operations. As with HSBC, UK retail is not their main focus.

3. Royal Bank of Scotland

The creation of “Fred the Shred”, had to be bailed out by the British Government in 2008. The Government still owns more than 60%. Among others, RBS is obliged to dispose US subsidiary Citizen’s which I own as a “special situation”. RBS is (still) a full service bank, including investment banking and wealth management. RBS is still in the middle of restructurings, for instance just a few days ago they announced to drastically shrink Non-UK investment banking.

4. Standard Chartered

Although Standard Charteres is UK listed, it basically does not do any business in the UK. It is an international commercial bank active mostly in Asia and Africa. The CEO has been recently replaced and the share price has recovered. Historically, as HSBC, Standard Chartered used to trade at much higher mutiples.

5. Lloyds Banking Group

After the disastrous HBOS acquisition in 2008, Lloyds had to be bailed out by the British government. the Government still owns 23% and is in the process of selling down. As part of the reorganization, Lloyd’s IPOed TSB and scaled back the international business. Lloyd’s is an almost “pure play” UK bank with the largest share in UK business of all the players. After the spin-off of TSB, they still have on average ~20% market share which to my knowledge is pretty unique for a private bank in a Western country.

So LLoyd’s in principle is the only interesting “play” to invest into UK banking. But is it worth the effort to dig deeper ?

As always, the first step is: Try to kill the investment case

This is the list I came up with after reading the 2014 annual report plus some “well known facts” about banks:

1. Lloyds had to pay massive fines, among others for misselling PPI insurance, Libor fixing etc and there is more to come
2. The UK Government still owns ~23% and is selling
3. Uk banking is very unpopular in the public’s mind which is bad for business
4. UK bank levy has been extended
5. 3 officers get 21 mn in 2014 despite tiny profit, bonus for”underlying profit”
6. huge pension plan (funded, derisked)
7. UK housing is overheated
8. In the next financial crisis, all banks will crash again
9. Valuation is high compared to “peers”
10. They only pay a tiny dividend
11. Risk of UK election outcome and UK exit
12. The banking business model is dead

1. Fines/PPI

This is a quote form the annual report:

The Group increased the provision for expected PPI costs by a further £700 million in the fourth quarter. This brings the amount provided in 2014 to £2,200 million (2013: £3,050 million), and the total amount provided to £12,025 million. Total costs incurred in the fourth quarter were £700 million and as at 31 December 2014, £2,549 million or 21 per cent of the total provision, remained unutilised.

So they do have still a 2 bn GBP provision for additional claims. Overall, the PPI episode was clearly a major issue for them. But on the other hand, there is some reason to believe that we have seen the peak. I am no expert in this, but if the provision would be enough, we could see rapidly increasing earnings over the next 1-3 years. Reading through the annual report, it looks like that they should not expect any US fines and also most FX/Libor related fines should be closed. But there clearly remains a risk.

2. Government stake / selling

In December, the UK Government decided to “dribble” the stocks into the market and against a one time big sale. A few days ago they released that they had sold 1% down. This constant selling is of course not good for the shareprice. The “break even” for the Government seems to be 73,6 pence, so one could expect that they are constantly in the market for the time being. This is clearly bad for traders but not necessarily for long term investors.

Looking at the chart, it seems that there is a “lid on the price” at around 80 pence since more than a year:

Forced sellers or in this case sellers who don’t want to maximise their long term return are often moving prices into “non-effecient” areas. As we value investors know, price is not equal value. So the classic “share overhang we have here might be a reason to actually look deeper into the value of the stock as there is a good chance that without those sales, the share price could be higher.

3. Bad reputation

Banking in general and UK banks in particular are maybe one of the most hated companies at the moment. As I have written, many small players try to take advantage of this like Aldermore, Handelsbanken or Virgin Money. Plus, the UK banks lose most law suits as judges mostly side with the plaintifs. The question clearly is if this will hurt the big players all over and long term or if there will be winners and losers for the big players. My personal opinion is that LLoyds as a focused UK player is in a better position to turn around the image than for instance RBS, HSBC or Barclays who have other problems to solve. I will look at this later but in my opinion the main victims will be the “weaker” players, not Lloyds Bank.

Bad reputation on the other side can be interesting for an investor. When no one wants to touch a stock, it is usually more likely a value investment than if everyone is talking on cocktail parties on how great a company does.

4. UK Bank levy

As a direct result of the bad reputation, the UK government had introduced a bank tax (“levy”) as a percentage point of the full balance sheet after the financial crisis. Currently it is ~0,21% for the whole balance sheet amount, a very significant expense especially for banks which have a lot of non-Uk business (Standard Chartered, HSBC). There is clearly a risk that a socialist UK Government will keep or even increase the tax. On the other hand, corporate taxes in the uk went down a lot which kind of off sets this issue compared to non-UK peers.

5. Large bonuses 2014

Especially the CEO, Antonio Horta-Osorio made around 11 mn GBP in 2014 which caused some uproar in the UK press. However most of that was a result of a 3 year plan which vested this year. On the other hand, he turned down a bonus of 2 mn in 2012 and received most of his bonus in stocks which he pledged not to sell until the government is out. As management plays a big role at banks, I will need to look deeper into the CEO at a later stage. Comapring older annual rpeorts, they have dropped their initial target from 2012 to earn 12-15% ROE in the long term.

6. Large pension plan

To be honest, Lloyd’s pension plan is not only huge but GIGANTIC. The current DBO liability is 38 bn GBP not much less than the total core equity position. The bad news: The discount rate the use with 3,67% is pretty high, on the other hand, they have derisked the plan early. of the 38 bn assets, only 5 bn are equity. Additionally, they seemed to have actively closed a large part of the interest rate risk in 2014. This is the statement from the annual report:

The asset‑liability matching strategy currently mitigates approximately 89 per cent (2013: 54 per cent) of the interest rate volatility and 94 per cent (2013: 71 per cent) of the inflation rate volatility of the liabilities.

This was very fortunate or clever timing and might have spared them a couple of billions over the last few months. For pension plans, this is clearly best in class with regard to ALM. Nevertheless a big pension plan like this will eat up a lot of capital and risk bearing capacity for the company and is clearly a big negative factor.

7. UK housing is overheated

I am not an expert in UK housing, but my assumption is that they are better prepared than last time.

8. In the next financial crisis, all banks will crash again

As I have mentioned before, I do think the banking sector overall is much more stable than in 2007. the next crisis will come from somewhere else and the major victims will be other players.

9. Valuation is high compared to “peers”

Yes, at first sight it looks expensive, but in my opinion, Lloyds is already 1-2 years ahead compared for instance with RBS. The have cleaned up the organization and the portfolio

10. They only pay a tiny dividend

Compared to the 6% of HSBC, Lloyd’s tiny dividend looks ridiculous. However this could change quickly and Lloyds could become interesting for dividend investors.

11. Risk of UK election outcome and UK exit

Valid concern, however I tend to ignore such macro stuff. Rather I think it could be an additional explanation for a low valuation.

12. The banking business model is dead

Nope, I do think the “traditional” banking model is here to stay, at least for the banks who do it right.


Overall, I would not “kill” the Llyods investment case at this stage. The biggest issue for me is the gargantuan pension plan. Although it seems to be well-managed, it is still HUGE. In a next step, I will need to come up with a valuation or some idea about potential returns for Lloyds and have a closelook at management.

As a side remark: I do see that someone like Handelsbanken could capture market share, especially from guys like RBS or Barclays. A funny side note: Handelsbanken doesn’t even appear as competitor for Lloyds in their 2014 strategy update

Some links

The founder of Singapore has died at age 91. Great article from the Telegraph on his life and achievements.

MUST READ: Howard Marks on liquidity

A new investing blog called jnvestor with some pretty good write ups. Keep it up mate !!!

A very good post about market timing and “cash addiction”

Notes from the Daily Journal 2015 meeting with great quotes from Charlie Munger

Amazon with a direct attack on all cloud storage competitors

Finally, the Brooklyn Investor nicely wraps up the HeinzKraft case

Short cuts: Koc Holding, NN Group, Romgaz

Koc Holding

Koc releaed 2014 earnings already beginning of March. Looking at the presentation (there is no English annual report yet), one can see that despite the troubles, Koc showed a remarkably solid result with overall net income up 1% against 2013, although operating profit was down -6%.

I read the earnings conference call transcript as well. The major story was that Turkey was struggling in the first 6-9 months but following the oil price decline, things seem to have improved in the last 3 months or so. This confirms the general assumption that Turkey as a large oil importer should benefit from lower oil prices.

Management made a point that the largest subsidiary, oil refiner Tupras is expected to increase earnings significantly in 2015 as a 3 bn USD investment program will be finished and the refinery then will run on full capacity. Although Tupras had losses on inventory, Koc stresses that margins are independent of oil prices.

Koc clearly has suffered as well from their USD denominated debt, but other than many EM companies, they do have a “natural” hedge because of their large, foreign currency denominated earnings stream.

Almost exactly 6 months ago, I reduced my Koc stake by 2/3 as I was worried about Turkey in general and my bad experience with Sistema in Russia. Looking back, I have to admit that this might have been a typical “fast thinking” mistake. I actually do think that Koc is  a very good long-term investment if one believes in the Turkish economy. I am therefore inclined to increase the position again to around 2,5% of the portfolio, as I think that Koc with a P/E of ~10-11 is still good value, considering both, the quality of the company as well as the potential growth opportunity. The long-term downside in my opinion is relatively limited.

NN Group

NN Group had issued their annual report some days ago. Overall, earnings etc were unspectacular. However there was on extremely interesting sentence right in the beginning:

NN Group’s Solvency II capital ratio, calculated as the ratio of Own Funds (OF) to the Solvency
Capital Requirement (SCR) based on our current interpretation of the Standard Formula, is estimated to be in a range around 200% as at 31 December 2014. NN Group is considering to apply for the usage of a Partial Internal Model. The Solvency II capital ratio remains subject
to significant uncertainties, including the final specifications of the Solvency II regulations and the regulatory approval process.

This is remarkable in 2 ways. First, the Solvency II standard formula is relatively onerous so having 200% in the standard formulae is a good sign. Secondly, many competitors actually do not comment at all on their Solvency II ratios. Aegon for instance or more recently Talanx didn’t even give an indication. Swiss Life, which is not subject to Solvency II but the Swiss Solvency test (SST) also declined to give numbers.

One can of course interpret this in many ways but in my opinion, not communicating estimated SII ratios is much more a sign of weakness than anything else.

There is also a recent presentation to be found on NN website which clearly shows that their ALM matching in their big life Dutch company looks Ok. Plus they made a 200 mn EUR share repurchase (from ING) in February. Not a bad idea when the stock is valued at 0,43 times book. Overall, I am quite happy with NN despite the big fundamental headwinds for the industry. This is a stock I will invest more into when there is weakness in the stock price.


Romgaz issued preliminary numbers for 2014 as well. In my interpretation, they are incredibly good. Net income increased by +44%  to 3,72 RON, resulting in a P/E of ~9 even before taking into account net cash. Even better, the dividend will increase to 3,15 RON or roughly 9,5% yield at current prices.

As mentioned, Romgaz is pretty independent from market prizes for the time being as they are just starting to adjust to (higher) market prices.

In any other market, this should have had at least some impact on the share price, but for now the market seems to have ignored it completely. For fun, I ran a quick correlation analysis for Romgaz since the IPO. Romgaz has a pretty low correlation to the Romanian stock index with a value of around 0,45. It is however even less correlated to any European index. For the Stoxx 600 it is around 0,21. Interestingly for the Euro Stoxx Oil and Gas it is even lower at around 0,17.  As I do like uncorrelated investments a lot, this is a big plus for me.

Deutsch Bank started to cover Romgaz some days ago with a buy rating, although in my opinion with a pretty strange way of calculating the cost of capital.

Anyway, as a consequence of the great results, I increased my Romgaz position by around two percentage points to 4,2% of the portfolio at around 7,70 EUR per share.

UK Banking – A look at IPO Aldermore Plc (ISIN GB00BQQMCJ47)

Within my Handelsbanken mini series (part 1, part 2, part 3), I have identified their UK business as one of the potential value drivers. So it was a luck and coincidence that a few days ago, Aldermore PLc, a “start-up” UK Bank went public.

Aldermore itself was founded only in 2009 by a then out-of-job former Barclay’s Banker called Philip Monks. They tried to go public already last year but had to pull the IPO in October.

As I have mentioned a couple of times, an IPO prospectus is always a good opportunity to learn about business models in general and about competitors and the specific sector as well.

There are some interesting parts from the prospectus on the UK banking market:

A high number of mergers and acquisitions in the sector has resulted in sector consolidation (Lloyds’acquisition of HBOS being the largest as well as a number of smaller building society takeovers such as Santander’s acquisition of Alliance & Leicester and Nationwide’s acquisitions of Cheshire, Derbyshire and Dunfermline Building Societies). This has resulted in the UK banking sector becoming one of the most concentrated and least competitive in Europe according to a Treasury Select Committee report published in 2011.

The report concluded that the top five UK banks controlled 75 per cent. of total gross new lending in total mortgages, 85 per cent. of the personal current account market and 62 per cent. of the savings account market.

For a potential shareholder in a UK banking business stock, “most concentrated and least competitive” sound not that bad as it implies some pricing power.

Handelsbanken is mentioned as one of the few foreign players:

Although there are exceptions (e.g. Handelsbanken), more generally, foreign banks have exited or reduced their presence in the UK market. For example, ING exited their mortgages and savings business and stopped writing new business in Asset Finance towards the end of 2012 and the UK business banking subsidiaries of Irish banks have restricted lending.
Furthermore, UK banks have been forced to carry out major cost-cutting exercises, including centralising credit selection functions; in some cases, ring-fencing retail operations; and spending significant amounts to improve the performance and security of their IT platforms.
UK banks have also been significantly impacted by legacy issues arising from, for example, the mis-selling of PPI and swaps and from legacy and underinvested infrastructure. Since 2011, the total bill for litigation,fines and customer redress has been £28.5 billion, equivalent to two-thirds of the cumulative profits of the top five banks over this period
 Customer dissatisfaction in the UK banking sector has also risen. One effect of this, as discussed in a recent Oliver Wyman report, is an increased propensity of customers to review and switch banking provider

Similar to my argument for Handelsbanken, UK customers seem to be fed up with UK banks and are open for new entrants like Handelsbanken and Aldermore.

As a result of these factors, there have been a number of new entrants to the UK banking market. They have adopted a variety of models targeting different credit segments (i.e. retail, SME, corporate) and adopted different distribution models (i.e. branches, intermediary, direct). These include retail-focused branch-based banks such as Metro Bank and Virgin Money and required disposals under State Aid such as Williams & Glyn (currently part of RBS) and TSB (majority owned by Lloyds Banking Group). In addition, these are specialist lenders such as Close Brothers, Shawbrook, Bibby and Paragon, challenging the share of the UK banking market controlled by the incumbents in targeted lending segments.

Aldermore however has a complete different set up than Handelsbanken. They don’t run any branches:

Aldermore does not have a traditional branch network and as such does not have the significant costs associated with running such a branch network.

Instead they run Online/Broker/intermediary based business model, claim to avoid unnecessary costs for branches.

The Directors believe that Aldermore’s branch-free distribution model is better suited to the digital era,with the regional offices representing the physical footprint that Aldermore requires to service its SME customers. The absence of a large, under-utilised branch network enables Aldermore to distribute products and service customers more cost effectively

Interestingly, their actual cost income ratio 2014 is  60% vs. 53% at Handelsbanken. This might have to do with size (Handelbanken is 2-3 times bigger). So it is clearly not a “no brainer” to run an online bank only.

What I didn’t like about Aldermore:

– Intermediary model is not that easy. They don’t have direct client contact, clients are “owned” by brokers
– How do they cope in a downturn test if work outs are necessary and they don’t have client contact ?
– large potential bonuses for management
– targets for management are only EPS and Share price

They do state an explicit ROE ambition:

The Directors are targeting a return on equity of approximately 20 per cent. by the end of the financial year ending 31 December 2016.

Targeting is great, but having it included in compensation would be even better.

Could Aldermore be the same story like Admiral 10-15 years ago ?

I think that Aldermore differs in a very important way from Admiraml: It is not structured at as capital-light model, Aldermore keeps the risk on its balance sheet and will at some point in time need additional capital if they grow like this, which then will dilute shareholders.

Additionally, they are not active in the comparison space. I do think that in the long run will bite into their profitability as the comparison siteswill be able to charge them significant comissions for referals. In the insurance space, referral fees in many cases are already as expensive as sales commissions for agents.

A good reminder that not every new and online based financial company is “the next Admiral” is for instance Vardia, the Norwegian direct insurance newcomer. After explosive growth, out of the blue they had to announce a recapitalization recently. The stock price of course got hammered.


Aldermore is clearly riding the wave of disgruntled UK bank clients, but I would not invest there. I don’t see a real competitive advantage,at least not for now.
Valuation wise, the company trades at around 2,5x book value and 15 times earnings which is OK but not cheap. The biggest risk in my opinion is that with their aggressive growth, the might attract a lot of bad risks. Their long-term underwriting abilities will be tested in the next down turn for sure. Anyway, the Aldermore IPO clearly shows that there is room for smaller players in the UK and that there is a good chance for Handelsbanken to grow for quite some time.

Additionally i would argue that the UK banking sector still looks attractive compared to other countries. In Germany for instance retail and commercial banking is dominated by Government backed banks (Sparkassen) which have a built-in advantage of extremely low funding cost. The local UK market in comparison looks much better, especially as interest rates are still positive…..

Some links

Activist fund Marcato’s presentation on BNY Mellon including a good insight into the business model of custodian banks (h/t market folly)

Alpha Vulture blog with a valuation update of FFP Holding (Peugeot)

Must read: Sequoia Funds 2014 letter (h/t market folly)

“Appraisal Arbitrage” – An easy way to make money for sophisticated investors? (I don’t think this works technically in Europe/Germany).

A very inspring TED talk from Ricardo Semmler, previous CEO and owner of Brazilian SEMCO on how to run a company without (almost any) rules.

Some signs that the start-up boom might be peaking for this cycle. Another, much surer sign is when the CEO of a struggling coal based German utility goes to Silicon Valley for an inspirational vacation trip.

Short cuts: AS Creation, Fortum, KAS Bank annual report

AS Creation

As Creation is a stock I owned in the past. Last November I had quickly updated the case and written the following:

In any case, I don’t think AS Creation is interesting at the current level of 30 EUR. At a 2014 P/E of 15-20 (before any extra write-offs on Russia) there seems to be quite some turn around fantasy being priced in.

Just a few days ago, AS Creation came out with an anouncement. There will be no dividend and the loss for the year 2014 is 9,3 mn EUR, at the upper end of the communicated range. In parallel, the CFO left the company. The loss seems triggered by a 10 mn EUR FX loss and a 5 mn EUR fine in France. They did not give further details but one can assume that the German business wasn’t that great either.

In any case a good reminder that despite cheap fundamentals, not every “value stock” is good value.


Fortum is also a stock which I owned in the past. I sold them in autumn 2012 because I was not really convinced by the idea anymore.

Looking at the chart, we can see that Fortum has done OK since then, especially compared to like German utilities like RWE, which looked a lot cheaper back then:

Again a reminder that cheap doesn’t mean good. The even more interesting aspect is that a few days ago, Fortum finalised the sale of the Swedish power distribution grid to a consortium of pension plans and insurers for 4.4 bn EUR.

According to Reuters, the multiples were quite “Juicy” for the seller:

The deal values the network at around 16.6 times earnings before interest, taxes, depreciation and amortization (EBITDA), the same as for Fortum’s Finnish grid sale in 2013.

16,6 times EBITDA for a business which is quite comparable to my portfolio stock Electrica is an interesting price point. Clearly, you need to take some kind of discount for a recently privatized Romanian company, but I think it clearly shows what kind of prices especially pension and insurance companies are ready to pay. This makes me feel even better about the prospects of Electrica than before.

KAS Bank annual report

When I looked first at KAS Bank 2 and a half years ago, i was drawn in mostly by a very low valuation and the solid business model with a good “mean reversion” potential. that’s what I wrote back then:


KAS Bank for me looks like a very interesting opportunity within the banking sector due to the following reasons:

+ attractive specialist business model (custodian)
+ cheap valuation even based on current “bottom of the cycle” earnings
+ valuation depressed because of overall hostility against banks
+ low or no analyst coverage
+ reversion to the mean speculation a lot less risky than with normal banks as virtually no risk of dilution (even Basel III standards are met by a wide margin)
+ potential upside ~100% over the next 3-5 years plus dividends+ low correlation / beta good portfolio diversifier

The upside has realized much quicker than i thought. As of now, including dividends, the stock return +75%. So good analysis, great return ? Well not really. Actually, if I am honest, this was mostly luck as I made a big mistake or omission when i analyzed the stock: I did not look at the pension liability. And this despite the fact that I have written and warned quite often about pensions.

In Kas Bank’s case I have ignored that because the plan was funded. That was a mistake and I will show you why.

Looking into the 2014 annual report of KAS Bank, we can see that they made a nice 24 mn EUR profit this year, which includes the one time effect of the canceled German JV. However, total equity DEcreased from 213 to 194 mn EUR. As the 2014 dividend is around 10 mn EUR, the question is clearly: Where did the other 35 mn EUR equity go ?

The solution to this question can be found on page 52, in the Comprehensive Income statement: KAS Bank lost 52,6 mn EUR pre tax) because of the increase in its pension liability. 2014 has been a brutal year for pensions. The discount rate has been reduced significantly. In 2013 I didn’t pay attention, but KAS Bank used 3,9% which was on the very high-end of permitted rates for EUR. In 2014 they had to slash this to 2,2% (page 80). It gets even crazier if we look at the gross numbers on page 81. The gross DBO increase 105 mn EUR from 182 mn to 287 mn. Luckily, some of that increase could be countered by asset increases. From an overfunding of 40 mn EUR, the plan went to break even. What really surprised me is the duration of the plan with around 22 years. The problem for me is the following: Despite the current funded status, there is a significant amount of risk in the plan. The gross size of the plan is 1,5 times the equity of KAS Bank. The run a significant equity allocation (85 mn EUR or ~ 45% of KAS Banks Equity). So in a scenario with a stock market crash with continuing low-interest rates, KAS Bank would pretty quickly be forced to do a capital increase.

Additionally, the current environment is clearly not helping KAS Bank in its core business. A custody bank is always deposit rich which is a problem now. Another second level problem is mentioned on page 18:

Treasury income, mainly securities lending, decreased by 20% to EUR 11.4 million (2013: EUR 14.3 million). The lower income from securities lending was primarily due to a market wide liquidity surplus which decreased
the prices for securities lending services.

This decrease happened even before the ECB started pumping liquidity into the markets.

So overall, I have been very lucky so far. I didn’t take into account the pension liability in my first analysis and fundamentals got worse for the business itself. Nevertheless I made good money because i bought cheap enough. Optically, the stock still looks priced oK at P/B 1, trailing P/E of 7 and 5,6% dividend yield, but fundamentally, especially looking at ultra low interest rates for quite some time, KAS Bank is in my view now at fair value.

However, I didn’t want to stretch my luck too far and therefore I sold the whole position at around 11,50 EUR per share.

Handelsbanken (part 3) – where is the upside & valuation

As this turned out to be again a pretty long post, a quick “management summary” in the beginning:

1. I do think that Handelsbanken’s UK business represents a significant opportunity for long-term growth
2. Additionally, I think that well run banks are a good opportunity as banks are in general disliked and overall risks in banking have been greatly reduced
3. However, at current valuation levels, Handelsbanken is too expensive. I would be a buyer at around 350 SEK per share or ~-15% below current prices

After trying to “kill” the Handelsbanken investment case last week, now in my third post I will look at the potential upside.

From my side, there are 2 potential “catalysts” which COULD imply future upside, which are:

1. Significant growth potential in UK and Netherlands
2. (Relative) revaluation of the banking sector in the medium term

1. Significant growth potential in UK and Netherlands

If you read the Handelsbanken annual reports over the last few years, it is not exactly a secret that they have great success in the UK. This is a table I compiled from the annual reports which shows the development of the UK branches:

Branches Operating profit Total OP UK/total
2009 62 177 13727 1.29%
2010 83 417 14770 2.82%
2011 104 639 16563 3.86%
2012 133 1006 17108 5.88%
2013 161 1173 18088 6.48%
2014 178 1652 19212 8.60%

Since the end of the financial crisis in 200, Handelsbanken managed to increase operating profit in the UK 10 times and the UK business reached almost 9% of total operating profits in 2014.

Despite a higher cost/income ratio in the UK (~55%) vs the home market in Sweden (~33%), profitability as measured by ROE is already at the same level. Opening bank branches is clearly a cost factor, so one should expect cost income ratios to even go down in the UK over time.

Gross margins in the UK are clearly higher than in Sweden. In my opinion, this has two possible explanations: First, overall interest rates are higher in the UK which makes it easier to charge more. Secondly, most of the competitors (Barclay’s, HSBC, Lloyd’s, TSB) have large legacy portfolios and need to earn margins on new business.

The big question is: can Handelsbanken continue to grow and how big could this become ? One clear driver of the growth is that UK customers are fed up with their local banks. Most of them needed bail outs (RBS, Lloyds, TSB), damaged their reputation by aggressively selling questionable products and/or tax evasion etc. (HSBC’s Gulliver with his Swiss bank account as a last example).

Handelsbanken’s market share in UK so far is tiny. I tried to collect some numbers. In this 2011 report for instance, Handelsbanken didn’t even show up. This is how market shares for instance looked for personal account:

Normally, as in many industries, size does have advantages also in retail banking. Advertising for instance are expenses which scale well. In the UK however banks with large market shares face strong headwinds as outlined in this article. Interestingly, Lloyd’s with its leading market share has a cost-income-ratio of currently around 67% and this number has improved a lot over the last year. So it’s quite interesting to see that the “dwarf” Handelsbanken is already much more efficient than the big guys.

Overall, without having examined the UK market in more detail, I do think there is room for Handelsbanken to expand and reinvest capital at attractive rates for some time.

Personally, I like the organic growth of Handelsbanken a lot. In general I find that especially in the early stages, organic growth is often undervalued. Stock investors prefer often fast growth via acquisitions. You can book a lot of accounting special effects etc. and increase EPS per share much quicker. As we have seen often however, the risk of M&A deals is a lot higher and more often than not, those deals backfire and sometimes even sink the acquirer.

In the UK for instance, recently spun-off TSB has already been approached by Spanish Bank Sabadell for a potential take over a few days ago. This is of course a quick way to add a lot of branches but also a much more risky one.


Netherlands for Handelsbanken is a comparable small market. with currently 20 branches (up from 18 in 2013), the business grew by ~17%. In principle, I think the situation could be similar to the UK. a lot of the dutch banks have big legacy issues and need to earn margins. However at the moment I would look at the Netherlands as an option and not as something to actually take into account when valuing Handelsbanken.

2. (Relative) revaluation of the banking sector in the medium term

I have quickly touched this topic in the two other posts already. Banks are generally considered as “bad investments” by most participants in the stock market. This is clearly justified if we look back the last 10 years or even longer. Whereas a company like Nestle is considered a safe and promising investment at a P/E of around 23, banks are considered a pure gamble even when the trade at fractions of those multiples.

For me, this is both, a lesson in how to look at historical data and a potentially big structural investment opportunity. Let me explain why.

The main arguments against banks is that they are highly leveraged and too risky. The risk is both individual and systemic (Lehman scenario). In my opinion, the systemic risk component has been greatly reduced by what happened since the financial crisis. A lot of mechanisms have been created to prevent a second event like the run that happened in 2008/2009. For me the most important are:

– collateralization of derivatives
– bank resolution systems both national (e.g. SOFFIN) and on international level
– clear commitment and mandates of central banks
– significant increase in capital requirements internationally

For current shareholders of large legacy banks, this is not very funny at the moment. Whereas most non-banks pay dividends and buy back shares like crazy, banks have to raise capital and postpone dividends in order to shore up their capital. And clearly, in many of the mega-banks, there is plenty of toxic waste on the balance sheet to justify low valuations.

On the other hand, this creates in my opinion great opportunities for players like Handelsbanken which have little toxic waste on their balance sheet and are run efficiently. The systemic risk for those players has become a lot smaller as a potential bankruptcy of one of the old mega-banks will most likely have only little effects on other banks in the future.

The individual risk of a classic and disciplined lending bank in my opinion is relatively limited if it is run by the right people. I do not think that a conservatively run bank is riskier than any other business. I know this is a somehow controversial standpoint but to me, a standard banking business model looks a lot less complex than for instance a multi national branded consumer goods company. For me this kind of blind distrust in the banking business model creates a very interesting opportunity.

Yes, banking in general will be much more dull in the future, but als a lot safer.

The second issue I want to touch quickly is the issue of historical data. Yes, historically, banks look like terrible investments because many of them have been wiped out in the financial crisis. I cannot prove it statistically, but I think banks are also the reason why suddenly low P/E and low P/B strategies seemed to have stopped working. The now favored metric by many “data miners”, the EV has the advantage that it automatically filters out any financial company. But looking into the rear view mirror is not always the best way to make investment decisions. If you would have been a stock investor after WW II, you might not have ever invested into German or Japanese shares because they have been wiped out. But a World War luckily does not happen every 5-10 years and neither does a full-blown financial crisis.

I think that there is a good chance that due to the pressure of capital markets, in the future, returns for banks could be relatively a lot better than they have in the past, assuming that the basic banking model is here to stay. The market will squeeze banks so much that those who remain will earn good ROEs again at some point in the future. And good banks will earn very good ROEs.

Valuation exercise

There are many ways to evaluate companies. I prefer simple ones. For banks, I consider ROE and P/B as the most important factors which drive long-term returns, so a valuation model should focus on those metrics.

To have a starting point, I make the following assumptions:

– ROE will improve to 15% over 5 years (from currently 12,4%) and will stay there (15 year average is 16,5%)
– P/B will remain constant at 2,1 (15 year average is 1,7)
– Divdend payout will be 25% and handelsbanken will be able to reinvest at the above assumed ROEs

The following table translates this into a simple IRR calculation:

Current Price book 2,1                    
ROE 15%                    
ROI 7,1%                    
    1 2 3 4 5 6 7 8 9 10
Book Value 200 218,8 240,1 264,4 292,1 323,9 360,4 400,9 446,0 496,2 552,0
ROE 12,5% 13% 13,50% 14% 14,50% 15% 15% 15% 15% 15% 15%
EPS 25 28,44 32,41 37,01 42,36 48,59 54,05 60,13 66,90 74,43 82,80
Implicit P/E 16,8 16,2 15,6 15,0 14,5 14,0 14,0 14,0 14,0 14,0 14,0
Retention ratio 75% 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75 0,75
Dividend   7,1 8,1 9,3 10,6 12,1 13,5 15,0 16,7 18,6 20,7
Target Price   459,4 504,2 555,2 613,5 680,2 756,8 841,9 936,6 1.042,0 1.159,2
NPV CFs -409 7,1 8,1 9,3 10,6 12,1 13,5 15,0 16,7 18,6 1.179,9
IRR 12,9%                  

Under those assumptions, Handelsbanken would be trading at 1.160 in 10 years time and returning me 12,9% p.a.

Now comes the interesting part: If I would want to see my 15% p.a. which I normally require, I would need to change assumptions. First I could move the purchase price down from 409 SEK. In my model, I could pay 342 SEks per share and get my 15% annual return. I could also increase my P/B multiple to 2,6 to get my 15% or I could increase the ROE to 21% after year 6 to get 15%. To be honest, both, the multiple expansion and the ROE increase seem much to aggressive to me.

So the question clearly is: Is 12,9% potential return enough or should I insist on 15% ? With the 10 year government rate in Sweden at 1%, the 12,9% would indicate a potential equity premium of 11,9% which is far more than one would normally expect from the market. On the other hand, no one knows what long-term interest rates will be in 10 years time, so betting fully on today’s low rates is also not the best solution.

This return is also driven by the assumption that Handelsbanken can continue to reinvest 75% of their profits at attractive ROEs. In Handelsbanken’s case, I don’t think that this is unrealistic. However if they could for instance only reinvest 60% and pay out the rest in dividends, then the expected return would drop to 10,7% p.a.

Anyway, for now, I would not feel comfortable investing at the current stock price level.


At the end of this mini-series, it has become relatively clear to me that Svenska Handelsbanken is really a great company, a true “Outsider” in regard to its business model and culture. Additionally, I do think that they have good growth opportunities in UK, which allows them to reinvest capital for some time to come attractive ROE’s.

In general, I believe than well run banks are one of the few potential bargains left in the market as investors hate them and do not see the greatly improved fundamentals of the financial “plumbing”.

Nevertheless, I do think that Handelsbanken does not fulfill my return requirements as the current price seems to have priced in some of this growth already. Unfortunately i was very slow in discovering Handelsbanken., as I could have bought them at an attractive only a few months ago. Nevertheless, I will keep them as my prime candidate on my watch list. I would love to add this “Outsider company” to my long-term value portfolio.

But again, patience is important. another positive aspect of this exercise is that I know now much better than before what I am looking for when I analyze a bank.

Some links

Barry Ritholtz interviews Cliff Asness (AQR) (audio only)

A good post on success factors for spin-offs

How to make 68,6% p.a. with a French Life Insurance contract

Damodaran with everything you need to know about the “New Tech bubble”

If you are interested in off-shore oil drilling, check out the official report on the Macondo desaster.

Why Ikea from Sweden is so sucessful selling the same furniture all around the world.

John Hempton from Bronte on why he likes Rolls Royce (the engine maker)

Sitting on cash as a market timer can lead to “cash addiction”

A deeper look into Svenska Handelsbanken (With a little help from Warren Buffett)

This is the follow up post on my first post where I compared Handelsbanken to Deutsche Bank.

Whenever I start to look at a company more seriously, I do a quick Pro/con list, starting with the Cons first in order to cool down my desire to quickly buy a stock:


1. It’s a bank
2. Avg P/E over the last 15 years has been ~11 compared to 17 now (so historically expensive)
3. current P/B at 2,0 is higher than 15 Year average (1,7)
4. current price/tangible book at 2,2 vs. 15 year average at 1,95
5. Almost 100% more expensive (P/B) than most European banks
6. high exposure to potentially “frothy” Nordic real estate markets
7. significant amount of capital market funding (deposit to loan ratio clearly below 0)
8. past performance also due to "Luck" of not being active in Southern Europe, many Nordic banks look good, especially Swedish banks
9. threat of continued technological change (online banking, peer-to-peer lending, etc.)
10. analysts are extremely negative, significantly below all peers (on Bloomberg, from 33 analysts, only 1 has a buy, 16 holds, 16 sells). Handelsbanken is Number 600 of analyst consensus in the Stoxx 600.
11. we are current in a frothy stock market environment and the stock chart looks aggressive

Let’s look into more detail into these issues.

Re 1: It’s a bank

Many value investors stay away from banks, mostly due to the 2008/2009 crisis where former highly regarded banks (Lehman, Bear Stearns;WaMu, Countrywide) basically disappeared over night. On the other hand, Warren Buffett’s single biggest stock investment is a bank, Wells Fargo at around 27 bn USD for their ~10% plus stake.

One of the great things about Buffett is that he usually explains what he does. Wells Fargo is not different. He actually explains it in his 1990 annual report.

He starts explaining why they don’t like banks in general:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.

So this is pretty clear statement from Buffett: If you buy a bank, buy a good one.

Let’s look at the next paragraph:

With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another – Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: “I’m no genius,” he said. “I’m smart in spots – but I stay around those spots.”)

He clearly invested in the people running the bank. That somehow contradicts other statements from him where he claims only to invest in businesses which could be run by idiots. Anyway, the second learning is: Buy good banks with good management..

Let’s look next, why and when he bought:

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled – often on the heels of managerial assurances that all was well – investors understandably concluded that no bank’s numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

As we have seen the 2008/2009 financial crisis, Buffett seems to like buying banks especially in crisis situations where they sell really really cheap. This somehow also contradicts the first paragraph. Clearly Buffett prefers to buy cheap if he has the chance.

In the following part, we can clearly see how far Buffett’s thinking went those days:

Of course, ownership of a bank – or about any other business – is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic – the possibility of a business contraction or financial panic so severe that it would endanger almost every highly leveraged institution, no matter how intelligently run. Finally, the market’s major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

Interestingly, real estate prices look expensive in 1990, even before the big 20 year boom. He then gives us a hint how he actually puts numbers on risk:

Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank’s loans – not just its real estate loans – were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

In any case this did not deter him from buying Wells Fargo and they have been a great investment for him. Just for fun, I checked out the performance of Wells Fargo since 01.01.1990. Including dividends, Wells fargo made 15,6% p.a. since then, that is even 2% p.a. better than Berkshire returned for its shareholders in the same time period !!!!

Re 2: Avg P/E over the last 15 years has been ~11 compared to 17 now (so historically expensive)

This is clearly an issue. As we have seen above, buying banks at distressed prices is much more fun. One counter argument is that current margins at Handelsbanken are also below their historical means. If you assume mean reversion for instance to the 10 year average net income margin, than this would lead to an overall average valuation level. So no reason to worry here but it is clearly not a bargain either. On the other hand, Wells fargo for instance would have been a great investment for Buffett in any case as long-term for such a great company the entrance point has less relevance.

Re 3. current P/B at 2,0 is higher than 15 Year average (1,7)
Re 4. current price/tangible book at 2,2 vs. 15 year average at 1,95

Similar to 2, both measures look expensive compared to the past. “Normalized” the look better but clearly not a bargain.

Re 5. Almost 100% more expensive (P/B) than most European banks

This doesn’t worry me much. As Buffett mentioned, you should buy “good banks” not weak banks below book value.

Re 6. high exposure to potentially “frothy” Nordic real estate markets

Here we can use Buffett’s sample calculation:

At the end of 2014, Svenska had around 1.114.000 mn SEK property loans. If we assume 10% of them defaulting with a loss of 30%, we would end up with an expected loss of ~ 33.000 mn SEK. Compared to the net income of 15.000 SEK for Handelsbanken in 2014, this would mean a loss 2 times their annual profit. Not as comfortable as Wells Fargo back then, but US Banks in general have higher margins. On the other hand, there are no “no recourse” loans in Scandinavia, so one could assume that the stress scenario might be lower.

Re 7. significant amount of capital market funding (deposit to loan ratio clearly below 0)

The dependence on capital market funding was the major problem for banks in the 2007/2008 crisis. Now however, the situation has turned. With negative rates, many deposit rich banks have huge problems because you can’t really charge your retail customers for deposits (yet) but you “earn” negative rates on excess deposits. For Handelsbanken, this is much easier because they don’t have a lot of excess cash on the balance sheet. So in the current environment, this is actually an advantage.

Ee 8. past performance also due to "Luck" of not being active in Southern Europe, many Nordic banks look good, especially Swedish banks

That is absolutely true, however Handelsbanken long-term ROEs etc. are the best even within this Group.

Re 9. threat of continued technological change (online banking, peer-to-peer lending, etc.)

This is a very interesting aspect. Many banks here in Germany are closing branch after branch, whereas Handelsbanken aggressively expands by opening new branches. Their focus on branch banking is clearly counter cyclical and I am not sure how this will work out long-term. I do think that there will be continued demand for “In person” bank services but I have no idea to what extend.

Re 10. analysts are extremely negative, significantly below all peers (on Bloomberg, from 33 analysts, only 1 has a buy, 16 holds, 16 sells). Handelsbanken is Number 600 of analyst consensus in the Stoxx 600.

This is actually a big plus from my side. I own other stocks (Admiral, TGS) which score equally poorly in analyst’s ratings. In my personal opinion, analysts mostly run their ratings on a top down approach. They start with the sector and if they don’t like the sector, most companies within that sector will get bad ratings. Very often in a next step they then rank companies badly which look “expensive” compared to similar companies. They almost never look a more specific aspects. A relatively expensive company like Admiral in a tough sector will get a bad rating, non withstanding any long-term significant competitive advantages etc.

For me, badly rated companies in tough industries but with long-term competitive advantages are one of the few corners of the markets where I can find value. So this would be a clear plus for Handelsbanken as a potential investment.

Re 11. we are current in a frothy stock market environment and the stock chart looks aggressive

Looking at the chart, it is quite interesting how the stock price accelerated despite the bad analyst ratings:

looking at the shareholders list one can see that US funds seem to like the stock and buy into it, especially Capital Group, T. Rowe Price and others. Skandinavian funds rather seem to be more cautious. Personally, I am also hesitant buying into such a chart, but int theory one should better ignore it as this could be very similar to “Anchoring” a very common behavioural bias.


Looking at the “Cons” which I have identified int he first step, I don’t see a deal breaker against investing. However, the current price level is rather “fair” than cheap. This could be justified if there would be a clear upside with regard to growth and/or growing profitability.

As the post got quite long already, I will look into the upside potential in a separate post which should hopefully follow soon.

Short cuts: Admiral, KAS Bank, NN Group

Some quick updates on preliminary numbers form 3 of my financial stocks:


Admiral released “preliminary annual” numbers yesterday. EPS declined slightly which was not a big surprise. My take aways at a first glance:

– UK car still tough, UK comparison some issues due to competition, however cycle might turn in 2015
– slowing growth in Italy

+ Italy at break even, break even in Spain expected for 2015
+ US growing strongly
+ Intenational comparison sites profitable

The CEO letter is again a must-read for anyone who is interested in Admiral and/or insurance. These guys are really different.

KAS Bank

Kas Bank came out already a few days ago with a press release on preliminary 2014 numbers. EPS almost doubled to 1,65 EUR due to the already mentioned one time effect. “Normal” earnings would have been around 0,74 EUR per share.

On the negative side, KAS Bank’s equity has been siginficantly reduced by an increase in the pension liability due to lower discount rates. Additionally they announced that they will expense 5 mn or so p.a. of the one-time gain as “investments”. Top line income acually fell but they were able to cut costs quicker. Overall, if low or negative rates will remain for a lnger time, the upside potential of KAS Bank now seems to be limited.

NN Group

Finally, NN Group came out with their 2014 results already 4 weeks ago. As with any life insurance company, they are quite difficult to interpret. What I found quite intereting is the fact that they said that their Solvency II ratio under the Standard model is 200%. Normally, most internal models show much higher solvency ratios than the standard model. In my opinion. NN Group remains the best (and only !!!) European Life insurance company to invest in despite the overall extremely difficult environment.

In any case, I will need to analyse all cases in more detail once the annual reports come out, especially with regard to KAS Bank and the pension issue.

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