Interestingly, while looking at AerCap, I always almost automatically compared them to Llyods Banking Group. In the old days I might have bought both shares but as I limit myself to 1 new position (or one complete sale) per month I had to make a decision and it went to Lloyds. My previous analyses can be found here: part 1 & part 2
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So after my first look into David Einhorn’s long pick AerCap last week, I want to follow up with some more detailed analyis in a second step.
By the way, a big “thank you” for all the qualified comments and Emails I got already after the first post, that’s the best return on investment on a blog post I can get !!!
The book value story growth
This was for me one of the core slides of Einhorn’s deck:
I mean you don’t have to be a genius to understand this: A company which trades near book value and compounds 20% p.a. is pretty much a no brainer. However, if I look at the developement of book values for financial companies, I always look at both, stated and tangible book value per share.
In AerCap’s case, the comparison looks interesting:
| BV per share | TBV share | |
|---|---|---|
| 2006 | 8,83 | 8,3493 |
| 2007 | 11,18 | 10,6041 |
| 2008 | 13,04 | 12,4083 |
| 2009 | 14,79 | 14,3448 |
| 2010 | 14,82 | 14,3798 |
| 2011 | 15,26 | 15,0608 |
| 2012 | 18,72 | 18,5592 |
| 2013 | 21,32 | 21,2334 |
| 2014 | 37,04 | 16,174 |
| CAGR | 19,6% | 8,6% |
| CAGR 2006-2013 | 13,4% | 14,3% |
This table shows two things: Before the ILFC transaction, stated book values and tangible book values were pretty much the same and compounding around 13% p.a. Still pretty good but clearly not 20%. In 2014 however, with the ILFC deal something interesting happened: The book value per share doubled but tangible book value dropped.
The ILFC deal
So this is the right time to look into the ILFC deal. The two main questions for me are:
a) why did the book value per share increase so much ?
b) why did tangible book value per share actually decrease ?
This is how AerCap presents what and how they paid for ILFC:
So AerCap paid the majority of the purchase with own shares, 97,56 mn shares valued at 46,49 USD. Issuing new shares always has an impact on book value per share if the issue price is different from the book value. Let’s look at an example:
We have a company which has issued 100 Shares at 50 EUR book value per share and 100 EUR market value (P/B =2). So the total market value is 10.000, total book value is 5000. If the company now issues another 100 Shares at 100 EUR market value, we have 200 shares outstanding and 5000+10000 = 15.000 EUR total book value. Divided by 200 stocks we now have 75 EUR book value per share or a 50% increase in book value per share for the old shareholders. So issuing shares above book value increases book value per share automatically.
In AerCap’s case, it worked more or less the same way: AerCap had ~113 mn shares outstanding with a book value of around 21,30 USD per share. So issuing 97,56 mn share at a steep premium at 46,49 of course increased book value per share dramatically. The transaction alone would have increased the book value to ((113*21,30)+(97,56*46,49))/(113+97,56)= 32,97 USD per share or an increase of ~50%.
So how is this to be interpreted ? Well, clearly it was a smart move from AerCaps management to pay with its owns shares at such a nice price. On the other hand, one should clearly not mistake this a a recurring kind of thing. I would not use the historic 20% p.a. increase in ROE as expectation for the future but rather something like 13% or so in the past.
Intangibles
After looking into how much and in what form AerCap was paying, let’s look now what they actually got:
Yes, they got a lot of planes and debt. Interestingly they assumed more debt than book value of the planes. Altogether they did get a lot of intangible assets. All in, AerCap bought 4,6 bn intangibles which is around 80 mn more than equity created through the new shares. So at the end of the day, one could argue that the new shares have been exchanged more or less 1:1 against intangible assets.
The largest part of this is a 4 bn USD position called “Maintenance rights intangible” which for me is something new. This is what they say in their 20-F filing:
Maintenance rights intangible and lease premium, net
The maintenance rights intangible asset arose from the application of the acquisition method of accounting to aircraft and leases which were acquired in the ILFC Transaction, and represented the fair value of our contractual aircraft return rights under our leases at the Closing Date. The maintenance rights intangible asset represents the fair value of our contractual aircraft return right under our leases to receive the aircraft in a specified maintenance condition at the end of the lease (EOL contracts) or our right to an aircraft in better maintenance condition by virtue of our obligation to contribute towards the cost of the
maintenance events performed by the lessee either through reimbursement of maintenance deposit rents held (MR contracts), or through a lessor contribution to the lessee. The maintenance rights intangible arose from the application of the acquisition method of accounting to aircraft and leases which were acquired in the ILFC Transaction, and represented the fair value of our contractual aircraft return rights under our leases at the Closing Date. The maintenance rights represented the difference between the specified maintenance return condition in our leases and the actual physical condition of our aircraft at the Closing Date.For EOL contracts, maintenance rights expense is recognized upon lease termination, to the extent the lease end cash compensation paid to us is less than the maintenance rights intangible asset. Maintenance rights expense is included in Leasing expenses in our Consolidated Income Statement. To the extent the lease end cash compensation paid to us is more than the maintenance rights intangible asset, revenue is recognized in Lease revenue in our Consolidated Income Statement, upon lease termination. For MR contracts, maintenance rights expense is recognized at the time the lessee provides us with an invoice for reimbursement relating to the cost of a qualifying maintenance event that relates to pre-acquisition usage.
The lease premium represents the value of an acquired lease where the contractual rent payments are above the market rate. We amortize the lease premium on a straight-line bases over the term of the lease as a reduction of Lease revenue.
This sounds quite complicated and for some reason part of the sentences seem to have been duplicated. If I understand correctly, they assume that the underlying value of the aircraft is higher than the book value of the acquired planes. To be honest: I do not have any clue if this is justified or not.
However, as those intangibles are significant (more than 50% of book value), the case gets a lot less interesting for me. Intangibles created via M&A activity are in my experience always difficult, especially if it is esoteric stuff like this. It’s also a big change to the past of AerCap. Historically, they were carrying very little intangibles.
Funding cost & ROE
This was Einhorn’s prospective ROE calculation:
One of the key assumptions is a 3% funding cost. So let’s do a reality check and look at the expected pricing of AerCaps new bond issue. This is from Bloomberg:
Aercap $750m TLB Talk L+275, 99.75, 0.75%; Due April 30
By Krista Giovacco
(Bloomberg) — Commits due April 30 by 12pm ET.
Borrower: Flying Fortress Holdings LLC, a subsidiary of AerCap Holdings and International Lease Finance Corp., largest independent aircraft lessor
$750m TLB due 2020 (5 yr extended)
Price Talk: L+275
OID: 99.75
Libor Floor: 0.75%
Call: 101 SC (6 mos)
Fin. Covenants: Max LTV test
Existing Ratings: Ba2/BB+ (corp.); Ba1/BBB-, RR2 (TLB)
So AerCap is funding at a spread of 2,75% vs. LIBOR. With the 10 year USD LIBOR at 2,00%, funding would be way more expensive than the 3% assumed by Einhorn. Maybe the fund floating rate, but then the whole company would rather be a bet against rising interest rates than anything else. On a “like for like” basis without structural interest rate risk, I don’t think AerCap will generate a double-digit ROE at current spreads.
Business case & competitive environment
Within the comments of the first post, some people argued that the company is not a financing company but that the access to Aircraft is the value driver. Buying cheap aircraft from manufacturers and then selling (or leasing) them with a mark-up to clients then looks like some kind of Aircraft trading business.
For me however there is one big problem with such a business model. Retailing or wholesaling any merchandise is then most attractive as a business when 3 criteria are met:
– there are a lot of suppliers
– there are a lot of clients
– you can create a competitive advantage via physical distribution networks
In AerCap’s case, the biggest problem is clearly that there are not that many suppliers but only 2, Boeing and Airbus. Both don’t have much incentive to let any intermediary become too large so they will most likely encourage competition between Aircraft buyers.
Secondly, as far as I understand, there is no physical distribution network etc. behind AerCap’s business. So entering the market and competing with AerCap in the future doesn’t look so difficult for anyone with access to cheap capital.
Clearly, as in any opaque trading business, an extremely smart trader can always make money but it is important to understand that at least in my understanding there are no LONG TERM competitive advantages besides the purchase order flow from ILFC.
That the barrier to entry the business is not that high is proven by no other than Steven Udvar-Hazy the initial founder of ILFC and his new company Air Lease.
IPO’ed in 2010 and now the company is already a 4 bn USD market company 5 years later. Interestingly, AIG sued Air Lease in 2012 because they
were able “to effectively steal a business,” and reap a windfall at the expense of ILFC, the world’s second-largest aircraft lessor by fleet size. It described how some employees, while still working at ILFC, downloaded confidential files and allegedly diverted deals with certain ILFC customers to Air Lease, before leaving to join that firm. The companies are in the business of buying aircraft and leasing them to commercial airlines all over the world.
So to me it’s not clear what AerCap actually bought. It seems the “secret sauce” of ILFC seems to have been transferred to competitor Air Lease already. Interestingly, the lawsuit was settled a few days ago at a sum of 72 mn USD. I found that quote from Udvar-Hazy interesting:
“I want to make it clear that there is no secret sauce in the aircraft leasing business,” Hazy told analysts on a conference call. “ALC’s success is a result of a strong management team with extensive experience and solid industry relationships.”
Summary:
My problem with AerCap is the following: The financial part of the company, which I feel that I can judge to a certain extent, does not look attractive but rather risky to me. The Aircraft “buying and trading” segment on the other hand seems to be the more attractive part but for me too hard to judge in a reasonable way.
So for the time being, this is clearly not an investment for me. To look further into AerCap, two things need to happen: First they need to regain their investment grade rating and funding cost will need to drop to the 3% that Einhorn is assuming and secondly, there should be a clear impact on the share price from a potential sale from AIG.
In the current market environment clearly anything can happen and a multiple expansion could bring nice profits but personally, in a direct comparison I prefer the LLoyd’s case.
Thanks to a stock forum I discovered that John Hempton from Bronte is issuing a monthly letter for his Australian fund (H/T qed1984). The last one about China is brilliant.
An interesting article about a Whistleblower at Halliburton with some insight into the arcane world of “revenue recognition”.
Charlie Rose 30 minute interview with Ginni Rometty, CEO of IBM
Q1 report of Centaur, the US value fund run by Zeke Ashton
Must read: Roddy Boyd exposes US pharmceutical company and stock market darling Insys Therapeutics which seems to be literally “killing it”
A couple of presentations from the Ben Graham Centre 2015 Conference
Finally interesting research from German StarCapital on country by country valuations adjusted for differences in the underlying industry sectors
A friend forwarded me the latest presentation from “guru” David Einhorn where his main long pick was AerCap, an Airplane leasing company.
To shortly summarize the “Long case”:
– AerCap is cheap (P/E 9)
– they made a great deal taking over IFLC, the airplane leasing division of AIG which is several times AerCap’s original size
– they have great management which is incentivized along shareholders
– The business is a simple and secure “spread business”
– major risks are according to Einhorn mostly the credit risk of the airlines and residual value risk of the planes
There are also quite obvious reasons why Aercap is cheap and trades at lower multiples than its peers:
– share overhang: AIG accepted new AerCap shares as part of the purchase price and owns 45,6%. They want to sell and the lock up is expiring
– following the IFLC/AIG transaction, the company was downgraded to “Non-investment grade” or “junk” and has therefore relatively high funding costs compared for instance to GE as main competitor
What kind of business are we talking about?
Well, Airplane leasing is essentially a “special purpose lending business” without an official bank license, one could also say it is a “shadow bank”. What Aercap essentially does is to loan an airplane to an airline.
In order to make any money at all, they have to be cheaper than the simple alternative which would be the airline gets a loan from a bank and buys the airplane directly. As Airlines are notoriously unprofitable and often thinly capitalized, they often need to pay pretty high spreads even if they borrow money on a collateralized basis.
As any lessor funds the plane mostly with debt, the cost of debt is one important factor to make money compared to competitors. It is therefore no big surprise that GE with its AA+ Rating is the biggest Airplane leasing company in the world and that ILFC thrived while AIG was still AAA and had comparably low funding cost.
Airplane buying is tricky business
A second aspect is also clearly buying power. Planes have to be ordered many years in advance and the two big manufacturers want to be sure that they are getting paid. I assume a reliable bulk buyer gets better access to the most sought after planes and maybe even better prices. Prices for planes at least in my experience are notoriously intransparent. Nobody pays the official list prices anyway. I found this interesting article in the WSJ from 2012.
When Airbus and Boeing Co. announce orders at the Farnborough International Airshow this week, they will value the deals based on the planes’ catalog prices—which no one pays. Airline executives, when pressed for details, will probably say they got “a great deal.” But actual terms will remain guarded like nuclear launch codes.
The aviation industry’s code of silence on pricing is notable in this era of information overload. Thousands of people world-wide are involved in airplane purchases, yet few numbers spill out. That yields much mystery and speculation.
Discounts are large:
But there are ways to estimate the range of discounts. An analysis of public data by The Wall Street Journal and interviews with numerous industry officials yielded this: Discounts seem to vary between roughly 20% and 60%, with an average around 45%. Savvy buyers don’t pay more than half the sticker price, industry veterans say. But deal specifics differ greatly.
But no one wants to talk about it:
One reason for the secrecy surrounding all this, say industry officials, is psychology: Less-experienced plane buyers like to think they got a bargain and don’t want to be embarrassed if they overpaid. The safest approach then is silence. More-seasoned plane buyers also know that bragging about discount specifics would anger Airbus, Boeing or other producers and hurt the chances of striking a sweetheart deal again.
Clearly, as a large “quasi broker”, Airline leasing companies seem wo have a chance to make some money in such a intransparent market. But it is really hard to pin down real numbers. It reminds me a little bit about how you buy kitchens in Germany where the system is pretty much the same. Everyone gets a discount, but no one knows what the “true” price looks like.
But this also leads to a problem:
With the current funding costs, AerCap would not be competitive in the long run. Let’s take as a proxy the 10 year CDS spread as a proxy for funding costs and compare them across airlines and competitors (more than 50% of AerCaps outstanding debt is unsecured):
| 10 year senior CDS | Rating | |
|---|---|---|
| AerCap | 215 | BB+ |
| Clients | ||
| Air France | 96 | |
| Singapore Airlines | 105 | A+ |
| Southwest | 109 | |
| Lufthansa | 195 | BBB- |
| Thai Airways | 240 | |
| Delta | 256 | BB |
| Emirates | 257 | |
| Jet Blue | 362 | B |
| Competitors | ||
| GE Capital | 72 | AA+ |
| Air Lease | 175 | BBB- |
| ICBC | 194 | A |
| CIT | 229 | BB- |
So purely from the funding cost perspective, AerCap at the moment has a problem. Someone like Air France could easily fund a loan for an airplane cheaper than AerCap, so cutting out the middle man is basically a no brainer and even the smaller competitors could easily under price AerCap when they bid for leasing deals. On top of that, a lot of non-traditional players like pension funds and insurance companies want some piece of the action, as the return on investments on those leases are significantly higher than anything comparable. Even Asset managers have entered this market and have created specific funds for instance Investec.
AerCap does have a positive rating outlook, so there is a perspective for lower funding costs. Just to give an indication of how important this rating upgrade is: On average, 10 year BB financial isuers pay 2,4% p.a. more than BBB financial issuers at the moment. The jump from BB+ to BBB- will not be that big but it would increase the investor universe a lot for AerCaps bonds.
The biggest risk for AerCap
So although I am clearly no match for David Einhorn (*), I would argue that the biggest risk for AerCap is not the residual value of the planes or the credit quality of the Airlines but quite simply the refinancing risk. AerCap has to fund a significant amount going forward and if for some reasons, spreads move against them, they will be screwed. Just a quick reminder what happened to ILFC in 2011:
Credit-default swaps on the company climbed this month as global stocks tumbled and speculative-grade debt issuance all but evaporated. The cost reached as high as 663 basis points on Aug. 11, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts have held at prices that imply ILFC’s debt should be rated B2, according to Moody’s Corp.’s capital markets group.
However if they manage to to get an investment grade rating and lower their funding cost, then it could be an interesting investment as funding is cheap and they do have access to a lot of new and sought after aircraft. Again, borrowing from Warren Buffett, with any leveraged company, management is extremely important.
And one should clearly compare AerCaps valuation and risk/return to banks and not to the currently much higher valued corporates. AerCap is much more similar to a bank than anything else. This general valuation disconnect seems to be also one of major reason why GE announced the massive reorganization just 2 weeks ago. However, as far as I understood tehy will keep the leasing business as this is unregulated.
Summary:
Although I slightly disagree with the risk assessment of Einhorn’s case, I still think AerCap could be an interesting case and is worth to dig deeper. I don not have a problem investing into financial companies and I do like those “share overhang” situations. However, I will need to dig deeper and especially try to figure out how good AerCap’s management really is.
(*) I did disagree with David Einhorn already once with Dutch Insurer Delta LLyod which was Einhorn’s long pick of the year 2011. Overall in this case I would put the score of MMI vs. Einhorn at 1:0 as Delta LLoyd did not outperform.
TGS Nopec is one of my larger position which I bought back in November 2013 when oil (WTI) was still trading at ~100 US and the world looked great for oil and oil service companies.
In the meantime, as we all now, the oil price fell substantially since 2014 and especially oil service companies were hit hard. In contrast to other oil service companies however, TGS share price has decoupled from oil to a large extent as we can see in the chart:
This is especially interesting as 2008/2009 for instance, TGS lost almost -70% when oil crashed back then. Almost always when I discussed TGS with other investors, the argument was like this: TGS is a great company but the price has to fall at least -50% or more as it did in the past. Well, for now they are holding up pretty well.
2014 annual report
Anyway, the 2014 annual report can be found here
I would recommend anyone to read the annual report, at least the one page letter of the CEO, which in very clear words describes how TGS operates.
The highlights from my side:
– EPS dropped significantly from 2,59 USD to 2,09 USD per share
– however there were several negative one time effects included (around 65 mn USD or 60-65 cents per share).
– interestingly they make no effort to adjust those one time effects. You won’t find adjusted numbers anywhere in the report. I like this VERY MUCH.
– Operating cashflow actually increased by 10%
– Operationally, the Americas were doing very well in 2014. Asia was growing strongly but deeply negative
– payroll costs increased by ~10% in 2014
– they are still committed to invest counter-cyclical into new data by taking advantage of low charter rates for ships
Overall, they way TGS operates, 2015 will not look good from a P&L perspective, as they expense a lot of their investments and sales might take a little bit longer than usual. However if the past is any guidance for the future, in 2-3 years time the investments will then turn into nice profits down the road.
Q1 2015 update
A few days ago, even before the official Q1 report, TGS issued a Q1 update press release. They reduced significantly the expected net revenues for 2015 as E&P companeis are delaying their projects. Additionally, they announced a significant cost cutting program:
The Cost Reduction Program will position the company for the more challenging seismic market caused by the significant drop in oil price. A key element of this program is a reduction of more than 10% of TGS’ global workforce effective from April. Restructuring charges of approximately USD 4 million will be booked in Q2 as a result of this Program. The company expects annual cost savings of approximately USD 10 million as a result of the Cost Reduction Program.
Interestingly, this 10% reduction seems to off set the salary increase in 2014. At first, the market seemed to be shocked and the stock lost around -20% intraday but since then things have recovered. Maybe the recommendation change from Goldman has lifted the stock. This is what Goldman wrote last week (via Bloomberg):
(Bloomberg) — Offshore seismic market set for structural changes as oil producers rationalize costs, optimize upstream portfolios and concentrate on efficiency, Goldman says in note dated yday.
Goldman: multi-client segment has strongest outlook; data acquisition will continue to face challenges with at least six vessels needed to leave market to achieve balance
TGS raised to buy vs sell, is best-positioned in new oil order; co.’s library has highest N. America exposure which should remain most attractive onshore area
Strong financial position can sustain div.; selloff post 1Q creates buying opportunity
So it seems that this time, TGS does get better credit for their countercyclical business model than in 2008/2009. Maybe investors have learned actually a little bit since then ?.
In any case, from my side, TGS is a clear long-term core investment. Although the industry is very difficult, TGS is very good company with strong competitive advantages. Oil companies must replace their reserves,the demand for seismic data is not going away. Maybe it gets postponed a little bit ut they don’t have a choice. Without replacing reserves, atraditional E&P will not valued as going concern but as a run-off which much lower multiples.
Even with the reduced forecasts, TGS is still very profitable and who know what opportunities show up if some of the competitors get deeper into problems.
The Brooklyn investor looks at the JPM annual report and Loews
David Einhorn’s presentation from the Grant’s Investment Conference 2015
A new White Paper from AQR called “Fact, Fiction and Value Investing” (h/t Valuewalk)
Frenzel & Herzing look at Greek company Metka
Is Google the next Microsoft ?
Some interesting thought about the issues in Turkey
And finally, Hedge Fund billionaire Paul Tudor Jones wants to change capitalism
This is the follow up post to the first post on Lloyds Banking group 2 weeks ago.
By chance, I just saw this research note from Investec which perfectly sums up all the reasons why Lloyds is not a favourite of investors at the moment:
Bloomberg) — Lloyds cut from buy on concern about outcome of U.K. election, probability of a “raft of negative one-offs in 2015” and on U.K. govt plans to exit its 22% stake, Investec says in note.
Says Lloyds has “sensibly’’ signalled it will call all remaining Enhanced Capital Notes
That should speed-up negative fair value unwind of GBP0.7b
There could also be extra charge if Lloyds pays any premium
January PPI redress costs for bank industry rose to 14-month high of GBP424.5m
Planned sale of TSB to Sabadell means deconsolidation in 1Q, that could mean charge of GBP0.6b
Sees U.K. govt stake reduced to ~20% by end June, with sale of govt shares accelerated after that, acting as drag on stock
U.K. May 7 election poses risks to banks with uncertainties over macro economy, another bank levy increase, restrictions on use of residual tax losses
Lloyds less vulnerable than peers over regulatory/conduct issues and less exposed to bank levy than other FTSE 100 banks
For me, this is actually a good sign that a lot of the short-term bad news is on the table. But let#s look at the company now.
Just as a refresher, the quote from Warren Buffett which I used already when I looked at Handelsbanken:
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.
Lloyd’s Management
So let’s look at Lloyds Management. The CEO, Portuguese António Horta Osório is considered to be one of the “best bankers” in the business. He was appointed in 2010 and lured away from Santander, where he build up Santander’s quite succesful UK subsidiary.
He became CEO in March 2011 but then something strange happened: He “disappeared” for around 6 weeks due to a “burn-out”. He cam eback however and actually did not take his bonus for that year.
But how can one determine if he is really a good manager? Well, a first step would be to look at videos and interviews. As an INSEAD alumni for instance a quite interesting inerview with him can be found when he still was in charge of Santander UK. There are a lot of speeches and interviews found on Youtube from him, for instance here or here. Despite his “slick” look, he comes across as a rather thoughtful person trying to restore some kind of trust into the banking industry.
But public appearance only is a part of management assessment. The more important aspect in my opinion is a very simple question: What does a CEO actually do and achieve compared to what he is promising. In Lloyd’s case, a few months after he started, the CEO presented a strategic plan which covered the years 2012-2014. The main features were:
– reducing cost by 1.5bn GBP with a target cost income ratio of 42-44%
– Statutory ROE of 12.5%-14,5%
– Core tier 1 equity ratio > 10%
If we look at the latest presentation from March, we can see the following “score card”:
– cost was reduced by 1.4bn, but cost income ratio was 50%.
– Tier 1 ratio 12,8% —> fully met
– Statutory ROE: not met, it wasn’t even mentioned
Overall, Orosio delivered on the cost side but failed to increase the “other income”. Additionally, he clearly underestimated all the PPI, Libor scandal fines etc. but this is outside of his control. One thing which annoys me a little bit that they basically dropped the ROE measure from their reporting. The are now reporting non-sensical numbers like “return on risk weighted assets” which IMO is a “BS number”. For a financial company, ROE in my opinion is “THE” measure of success in the long run and nothing else.
So overall, I would give “good” marks to Horosia. I do think he is a great “operator” and maybe one of the bank “cost cutters” in the industry, but maybe not the one to create a lot of new business opportunities.
If we compare Lloyds for with RBS which was more or less in the same situation, financial markets seem to think that Lloyds has done better:
Valuation
As always, one has to make assumptions for any kind of valuation exercises. For banks, I like to keep it simple:
I Estimate a target P/B multiple, target ROE and target retention ratio to come up with a potential return calculation. In Lloyds case, I assume that 12% ROE is a reasonable target to be achieved within the next 4 years. Other than for Handelsbanken, I think that Lloyds can only reinvest 25% at those rates and will pay out 75% of earnings.
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | ||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Book Value | 65 | 66,3 | 6791% | 6961% | 71,5 | 73,7 | 75,9 | 78,2 | 80,5 | 82,9 | 85,4 |
| ROE | 8,0% | 9% | 10% | 11% | 12% | 12% | 12% | 12% | 12% | 12% | 12% |
| EPS | 5,2 | 6,46 | 6,79 | 7,66 | 8,58 | 8,84 | 9,11 | 9,38 | 9,66 | 9,95 | 10,25 |
| Implicit P/E | 80,76923077 | 13,0 | 11,7 | 10,6 | 12,5 | 12,5 | 12,5 | 12,5 | 12,5 | 12,5 | 12,5 |
| Retention ratio 25% | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 | 0,25 |
| Dividend | 4,8 | 5,1 | 5,7 | 6,4 | 6,6 | 6,8 | 7,0 | 7,2 | 7,5 | 7,7 | |
| Target Price | 84,0 | 79,5 | 81,4 | 107,3 | 110,5 | 113,8 | 117,2 | 120,8 | 124,4 | 128,1 | |
| NPV CFs 10 Y | -79 | 4,8 | 5,1 | 5,7 | 6,4 | 6,6 | 6,8 | 7,0 | 7,2 | 7,5 | 135,8 |
| NPV | -79 | 4,8 | 5,1 | 5,7 | 113,7 | ||||||
| IRR 10 year | 11,5% | ||||||||||
| IRR 4 year | 14,1% | ||||||||||
| Div. Yield | 5,77% | 6,41% | 7,05% | 6,00% | 6,00% | 6,00% | 6,00% | 6,00% | 6,00% | 6,00% |
If my assumptions would turn out to be correct, over a 10 year period, Lloyds would return around 11% p.a. Not bad but worse than Handelsbanken. Selling after 4 years however would lead to a return of 14% which I find quite Ok. The difference comes from teh fact that I assume relatively low “compounding” which I think is realistic.
Other considerations
What I do like about the risk/return profile is the fact that there is a kind of “soft put” at 0,736 GBP. This seems to be the break-even of the UK Government. I assume that if the price would move below that, they will lower their sales volume or stop sales altogether as they want to show a “profit”, which should support the stock price at that level.
I think there could also be an interesting effect with regard to index weights. I am not sure how often index providers refresh their weights for instance for the Footsie, but there is most likely a time lag between the UK government selling and the index providers adjusting the weight. I know that for instance the DAX is only reweighted once a year which would then, in the caso of LLoyds would suddenly increase the amount to be bought by the index funds.
Summary:
Summing up the two posts, I would look at Lloyds the following way:
+ Lloyds look like solid UK bank which has cleaned up its portfolio and will return respectable returns going forward
+ The bank is run by a good operator which will decrease costs further
+ The UK Governemnet selling down and overall negative sentiment towards UK banking could explain an undervalutation of the stock
+ fundamentally I find UK banking attractive as there is significant concentration and interest rates are still high enough to make money
+ profits and dividends will improve significantly over the next 2-3 years
+ Threat of new entrants lower than for the other large peers due to low costs
– there is not a lot of growth potential in the stock as the market share is so high already
– short term nagative surprises/charges possible
In its current form, Lloyds is clearly not a growth/compounding story but rather a 3-4 year “special situation”. It similar to my 2 other “forced IPO” or “forced sales” investments Citizen’s and NN Group.
So overall, I find it a quite attractive special situation. Banks in general are one of the last truly “cheap” sectors and I do think that Lloyds has most of its problems behind it, especially compared to its large UK peers. So despite the relatively high valuation, I do think Lloyds is one of the most interesting situations with large UK and European banks at the moment.
Due to my position limitation however, this will get on the “queue” for the time being and decide by the end of the month if to buy, unless the price woul ddrop significantly. My buying limit would be around 79-80 pence/share.
Looks like that the 3rd Romanian stock gets finally listed in London: Fondul Proprietatae (h/t valuewalk)
Good (partial) interview with the guys of Boyles Asset management
Wertart has a post on French Microcap Microwave Vision
The UK Value investor with a great analysis on what went wrong with his Balfour Beatty investment
FT Alphaville has some issues with Greak stock Follie Follie
And finally the MUST READ: Credit Suisse Global Investment Return Yearbook 2015 (h/t Meg Faber) with, among other, some very interesting 115 years (!!!) historical data on industries
Time to admit a mistake: Thanks to reader Roger, I found out that my table showing the tax benefit in the “discovery of slowness” post has some major errors. This was the table from the post:
| turnover/year | Total gain AT | p.a. AT | in% of max |
|---|---|---|---|
| 1 | 1024% | 8,4% | 35% |
| 2 | 1735% | 10,2% | 60% |
| 3 | 2061% | 10,8% | 71% |
| 4 | 2284% | 11,1% | 79% |
| 5 | 2363% | 11,3% | 82% |
| 6 | 2444% | 11,4% | 84% |
| 7 | 2529% | 11,5% | 87% |
| 8 | 2616% | 11,6% | 90% |
| never | 2896% | 12,0% | 100% |
Well, as always, what looks too good to be true isn’t true and now, you will not reap such large enefits by extending the holding period only a few years.
The mistake was that I actually did not calculate a full sale at each intervall but only a partial one. If I calculate the effect of a full sale, the table looks like this (with hopefully fewer mistakes):
| Avg. holding period | Total | P.a. | In % of total |
|---|---|---|---|
| 1 | 1024,3% | 8,4% | 35% |
| 2 | 1068,5% | 8,5% | 37% |
| 3 | 1112,8% | 8,7% | 38% |
| 4 | 1232,0% | 9,0% | 43% |
| 5 | 1201,2% | 8,9% | 41% |
| 6 | 1245,0% | 9,0% | 43% |
| 7 | 1361,3% | 9,4% | 47% |
| 8 | 1558,9% | 9,8% | 54% |
| never | 2896,0% | 12,0% |
It’s very easy to see that only the 1 year and 30 year number were correct, but in between the benefit of a longer holding period accrues much slower than in the initial version. The strange behaviour in the 4-6 year range is due to my arbitrary cut off at 30 years.
Holding your stock on average 8 years vs. 1 year still gives you 50% advantage after 30 years but it doesn’t look that spectacular. And to be honest: What fun it is to have for portfolio fixed for 30 years to gain the full “magic of compounding” before tax?
That led me to another thought: What is the impact if you manage to hold at least a certain percentage of your assets for along time ?
Again a very simple table to illustrate the effect and again hopefully with only a few mistakes:
| % 30 year vs. 1 year | Total | p.a. | In % of total |
|---|---|---|---|
| 0% | 1024,3% | 8,4% | 35% |
| 10% | 1211,5% | 9,0% | 42% |
| 20% | 1398,6% | 9,4% | 48% |
| 30% | 1585,8% | 9,9% | 55% |
| 40% | 1773,0% | 10,3% | 61% |
| 50% | 1960,1% | 10,6% | 68% |
This table shows under the initial assumptions (12% p.a., 30% tax on realized gains), how a portfolio develops consisting of one sub portfolio with 30 year holding period and the other with annual turnover.
The results are interesting if compared to the first table: Even if you manage to hold only 10% of your assets for a really long time, this is equal to increasing the total holding period of the portfolio to 4-6 years.
So a small percentage of very long holdings really can create quite a nice benefit after tax, even before transaction cost etc. Intuitively I was trying to achieve something like this by defining a “core value” sub portfolio but I didn’t focus that much on long holding periods yet.
So what now ?
This is what Roger commented:
If they are relevant for you and your investment strategy (as your article suggests) I would suggest to revisit your calculation.
At least for me it would be quite annoying to change my investment habits due to an important insight from a calculation and later having to recognise that calculation was obviously wrong.
Well the good news is: Holding stocks longer is still positive even with the corrected numbers. But more important was this part of the original post:
Secondly, and even more important, being slow in my opinion is the best defense against any kind of behavioural biases.
I think this holds true in any case and the tax effect is just a niece side effect. I hope that the major “behavioural” benefit from this rule will be better investment decisions and the ablitity to hold winners for a longer time. If I look into my personal portfolio, a disproportionate amount of “alpha” comes from my long term winners, not from my rather short term special situations kind of investments. And rather nothing on average from short term “spontanious” trades.
I don’t think that I have to sacrifice anything by limiting myself to one position change per month.
Even more, since I decided for myself to slow down which I did already a few months ago, oddly enough I feel more relaxed overall with regard to the markets and my cash position. I have to admit that I used to pressure myself to come up with many new ideas before actually drilling deeper into existing ones. Especially right now, with a lot of annual reports coming out, I used to feel some stress in the past. This year I am actually quite relaxed. As I already know what I do in April (buy a fund), I now have a lot of time and leisure to prepare a potential transaction in May.
Just a quick reminder: this will be the last monthly update, from now on I will switch to quarterly updates.
Performance
In March, the portfolio gained +2,1% against +3,6% for the Benchmark (Eurostoxx50 (25%), Eurostoxx small 200 (25%), DAX (30%),MDAX (20%)). Year to date, the score is +11,5% against +20,2% for the benchmark. Since inception, the portfolio is up 104,3% vs. 73,3%.
Major winners were TFF (+19,6%), Drager (+8,4%), Hornbach (+6,5%) and Thermador (+6,0%). Losers were Ashmore (-7,1%), Van Lanschot (-6,4%) and TGS (-4,3%).
Overall, performance was again behind the benchmark but with around (2,1/3,6)= 58% of the upside fully in line with the current allocation of the portfolio with regard to cash and beta of the investments.
Portfolio transactions
In line with my self-prescribed “slowness” I only made one position change this month: The full sale of my KAS Bank position in mid march. Within my existing positions, I added to my Romgaz stake following the good results.
Cash and “cash similar” positions are now at around 27%, a pretty high percentage but maybe not too bad going forward. So far of course, the conservative approach has cost me a lot of performance, but the year is not over yet. The current portfolio, as always can be found under the respective portfolio page.
Comment “Should an active investor give money to a money manager ?”
I am currently preparing my first investment into a fund actively managed by someone else. For me, as an active investor, this is quite unusual, so far I have only invested in ETFs in order to gain exposure to sectors or directly into stocks and bonds. The big question here is of course: Why should I pay management fees for someone doing the same stuff that I actually enjoy doing myself ? So for myself a tried to rationalize the decision a little bit and came up with 5 criteria which are important to me for trusting my hard-earned money with someone else:
1. The manager has to be trust worthy
2. The manager should have most of or even better all his money in the fund
3. the manager has a different skill set than oneself or just better skills or access to different assets
4. The manager should still be “hungry”
5. The fund manager is not only in for the money
6. The investment vehicle should be a “fair” structure
Interestingly, those criteria are not that different from investing into a stock, but let’s look at them one by one:
1. The manager has to be trust worthy
This sounds more easy than it is. In order to know if someone is trust worthy, you either know someone really well or there is a long track record of this person proving that she/he will always act what in German we would call “in Treu und Glauben” or in English as a true Fiduciary of one’s money. In a standard asset management organisation, this cannot be taken for granted. In many large asset management companies, the main target is not performance but management fees and not the performance of the money invested.
One of the worst cases would be investing into someone where you know that this guy is “bending the rules” somewhere and hoping that still everything would be ok with your money. With Bernie Madoff for instance, many people thought that he was making the nice and easy money in his “hedge fund” by scalping and front running his customers on the trading side of his business and thy were OK with it. Without accusing him in any way, Bill Ackman for me would be also a questionable character. Both, with Herbalife and Valeant he is “bending” the rules to his advantage, how do you know that he will never does the same within his investment vehicles ? I think this is clearly the area where one should never make the slightest compromise.
2. The manager should have most of or even better all his money in the fund
This is something which is especially important if there is a performance component in the fee structure. A performance fee is essentially an option and the value of any option increases with volatility. If a portfolio manager however has invested all his money in the fund, he will think twice about maximizing only the option value…..
3. the manager has a different skill set than oneself or just better skills or access to different assets and the investment process is transparent
Sounds pretty obvious but is still worth thinking about. If I invest in a value investing strategy, this only makes sense if I am sure that the manager does have skills that I don’t have. This could be either very deep research and a concentrated long-term portfolio or access to markets/assets which I don’t have as a private investor. in any case this requires that the manager is transparent on what he is doing at that an investor understands the investment process. Fundholder letters or even better “manuals” are a big plus here.
4. The manager should still be “hungry”
The typical story in investment management goes like this: Manager starts small fund, has great returns, nobody is interested at first. After 3-5 years of great returns, fund gets onto the radar screen of large investors and grows quickly. Performance drops as investment style cannot easily be scaled up and/or investment manager cares more for his Ferrari collection. In any case, I think it is more interesting to invest in the early phase than in the later phase despite a potentially higher fee percentage.
5. The fund manager is not only in for the money
That sounds strange at first, why should a money manager not be in for the money ? What I mean here is that there are a lot of people in the investment management business who see this as the fastest way to make a lot of money. In my experience, those people are generally not good money managers in the long-term. The really good ones are those who actually like what they are doing and do it because its their passion. Those guys will go the extra mile and read annual reports on week ends and in their vacation because they don’t consider it as work.
6. The investment vehicle should be a “fair” structure
As I am an individual investor I would for instance have a problem with a structure where I pay upfront commissions or custody fees that an institutional investor would not pay. Also, if I plan to invest long-term, I would not want to invest in a structure where other investors could hurt my returns by either putting in a lot of money on a daily basis or pulling their investments at any time. As a long-term investor, I would need to be sure that also the others are in for the long-term and no “hot money” can disturb the investment success.
It makes also a lot of sense to look at other investors in a fund vehicle. It is an advantage if other investors are known and reliable.
Those are the 6 criteria which are important for me for trusting my money to someone else. Of course this is no guarantee that the investment will perform well, but at least the risk to the downside is limited to a certain extent if all criteria are met.
More on the specific fund investment will come in a later post this month.
value and opportunity 