AerCap Holdings NV (ISIN NL0000687663) – How good is Einhorn’s new favourite ?

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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.

Update: TGS Nopec Annual Report 2014 and Q1 2015

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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.

Some links

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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

Lloyds Banking Group Special Situation investment – Management & Valuation

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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.

Some links

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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 – but still slow investing …

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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.

Performance review March 2015 – Comment “Should an active investor give money to a money manager ?”

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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.

Investment Strategy update: The Discovery of Slowness

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The discovery of Slowness

The last book  I read was a German novel called “The Discovery of Slowness” (in the English Translation) from German writer Stan Nadolny.

The book is a ficticious story about a real person, the famous English explorer John Franklin.

In the book, John Franklin is an extraordinarily slow person who has a rough start into life as a kid. He always needs a lot of time to answer questions or react to things happening. During his life, this weakness turns into a strength. More than once, his slowliness and deliberate long thought process leads to a superior solution compared to the “first impulse”.

For instance once, after their ship goes under, he and his comrades find themselves themselves stranded on a flat corall bank. Whereas his fellow sailors start shouting for help etc., he directly starts to build a platform in order to survive the high tide and thereby saves all his comrades. When he was asked later why he did this he says “As I am so slow, I have to start early”. In another situation, a ship under his command gets in into a storm in the Arctic seas and is at risk to get destroyed by Icebergs. His men start to panic and want to get away. He takes his time and finally contra-intuitively stears the ship into the solid ice as this is the only safe place in a storm and they survive.

During his life, he turns his weakness into a strength by preparing himself extremely diligent for any unforseen problems. As it turns out, good preperation is almost always better than fast reaction time. He is calling this preparation a “system”. One of the core pillars of this system is to have an organization run by two person: One “fast” one for the daily work and a “slow” one for the really important decision.

Despite the book being a good read itself (kind of a Forest Gump story with a Victorian English setting), the more I read the more I had to think of investing and Warren Buffett in particular.

Compared to today’s financial technology (Twitter, High Frequency Trading etc.), Warren and Charlie look as slow as John Franklin in the book. They are so slow that they actually missed the whole first dot.com bubble and many other hypes. However, by creating Berkshire as a permanent investment vehicle and holding a big cash pile, they prepared themselves well for any kind of troubles.

Both have stressed themselves the advantages of being slow many times, either Charlie with his “sit on your ass investing” or Warren’s “Punch Card”. From the outside I would even say that they employ the “Franklin system” to a certain extent. Warren seems to be the fast guy and Chalrie is the one who makes the big changes, like steering Warren to “great” companies many years ago.

For many investors, including myself, this often sounds counter intuitive. Real time stock prices, twitter feeds, mobile phone trading etc. enable us to do everything real time, so why should we care what those old farts say ?

Well, one aspect of this a pretty tangible one: Capital gains tax. In Germany, as a private investor, you pay around 30% capital gains tax. For fun, I made a quick table with the following assumptions:

– Underlying annual return 12% p.a.
– investment horizon 30 years
– Capital gains tax 30%

The following table shows the total return over 30 years depending on how often the portfolio is being “turned over”. So 1 means: The portfolio is turned every year, 5 year means 6 turns within 30 years etc.. These are the results:

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%

The results are logical but still striking: Over a thirty year period, if one turns the portfolio every year, the result is roughly 1/3 of a portfolio which remains constant over the 30 years. It is also interesting that the total result increase over-proportionally with every additional year of the average holding period. Already with a 4 year holding period one captures almost 80% of the total yield.

One remark: Please don’t confuse this withe an advice for dax driven investments. This is just to illustrate that slow portfolio turn-over has adnatages.

Secondly, and even more important, being slow in my opinion is the best defense against any kind of behavioural biases. The book was written well before Danial Kahneman’s famous book, but clearly shows that slow thinking leads to better decisions which is especially important in investing.

In the past, I have often reacted to quickly, which resulted either in selling too early or buying to quickly. Especially when prices move significantly within a short term, some behavioural biases like anchoring become very strong. Maturing as an investor in my opinion means among other things, to become slower.

However this is more easy said that done. A large part of the investment industry is hard wired to make investors trade as often as possible in order to generate fees. If you watch CNBC or read investment magazines, they always emphasize to buy or sell things now and not wait until it’s “too late”.

Consequences

As I have written in some of my comments, I am aiming to lengthen my holding periods anyway, but I still think I am too fast. For me, I have come up with 3 very concrete action items which should hopefully help me in becoming a lot slower:

1. I will limit my news feed to high quality sources. I will abandon high frequency stuff like Zero Hedge and Clusterstock

2. I will stop writing monthly performance comments and switch to quarterly

3. I will create my own “soft punchcard”: I will limit myself to either 1 new position or 1 complete sale of a position per month. Increasing or decreasing existing positions is still allowed.

A little explanation for point 3, as this is a real “hard restriction”: This means that at a maximum, I can “switch” 6 stocks a year into new ones. I have to sell one first in one month and buy the new one in the next. As I own on average 25 positions, this should translate over time to a holding period of at least 4 years, preferably more.

This will of course limit my choice to do for instance soem short term special situations, on the other hand I hope that this will further improve my investment decisions and focus better on the long term. I would love to have an brokerage account which would actually limit me on the number of trades I could do in a month.

Deeply discounted rights issues – Serco Plc (ISIN GB0007973794)

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Serco Plc, the British outsourcing company, used ro be a stock market favourite for a long time. Especially in the 2000s, Serco was able to increase its profit ~10 fold from 0,04 pence per share in 1999 to around 40 pence in 2012.

Then however, a little bit similar to Royal Imtech, problems and some scandals piled up and culminated in an accounting bloodbath for 2014. Serco showed a total loss of 2,09 pounds (!!) per share, eliminating pretty much all profits made from 1999.

After raising a smaller amount of capital last year, Serco announced a large 1:1 capital increase at a sharp discount in early March, the rights have been split of on March 31st. Serco wants to raise some 500 mn GBP with the majority being used to lower the outstanding debt (currently around 600-700 mn).

Looking at the stock chart, Serco shareholders have suffered a big loss, especially compared to competitor G4S which, despite relatively similar problems, has recovered well:

Normally, I would not look at a “turn around” case like Serco at all, but in this case it might be different. The difference is the new CEO, Ex Aggreko CEO Rupert Soames:

Soames surprised everyone in early 2014 when he left Aggreko after leading the company for 11 years and with great success. For anyone who has read an Aggreko annual report, one knows that Soames was not only a succesful CEO but also a very good communicator. I can highly recommend to read those reports as they are very interesting.

Before asking for shareholder money, he actually said that he will not take his guaranteed bonus for 2014 which I found was a very good gesture.

After enjoying the Aggreko reports I decided to look into the 2014 annual report and especially the “CEO Letter” from Soames to see what he has to say.

I was positively surprised by the openness how Serco’s problems were adressed, both from the Chairman and Soames himself. It is the classic tale of too much growth through acquisitions combined with a lack of integration and bad execution. Other than at Royal Imtech, it doesn’t involve outright accounting fraud.

One rarely gets to read such a good description of the problems of a company and the historic context (page 9 of a turnaround case. This is then followed by a clear change in strategy, namely to focus on Government services and get out of “private” contracts altogether. Overall the strategy section looked very well thought out and not unrealistic to me.

Further in the report, I found this interesting statement:

Historically, the key metrics used in forecasts were non-GAAP measures of Adjusted Revenue (adjusted to include Serco’s share of joint venture revenue) and Adjusted Operating Profit (adjusted to exclude Serco’s share of joint venture interest and tax as well as removing transaction-related costs and other material costs estimated by management that were considered to have been impacted by the UK Government reviews that followed the issues on the EM and PECS contracts). We believe that in the future the Group should report its results (and provide its future guidance) on metrics that are more closely aligned to statutory measures. Accordingly, our outlook for 2015 is now expressed in terms of Revenue and Trading Profit. The revenue measure is consistent with the IFRS definition, and therefore excludes Serco’s share of joint venture revenue. Trading Profit, which is otherwise consistent with the IFRS definition of operating profit,adjusts only to exclude amortisation and impairment of intangibles arising on acquisition, as well as exceptional items. Trading Profit is therefore lower han the previously defined Adjusted Operating Profit measure due to the inclusion of Serco’s share of joint venture interest and tax charges. We believe that reporting and forecasting using metrics that are consistent with IFRS will be simpler and more transparent, and therefore more helpful to investors.

This is something whcih I haven’t seen before that actually a company is going back from “adjusted” reporting to statutory which I find is very positive.

Another good part can be found later in the statement from the CFO (by the way another Aggreko veteran) regarding the implementation of ROIC:

A new measure of pre-tax return on invested capital (ROIC) has been introduced in 2014 to measure how efficiently the Group uses its capital in terms of the return it generates from its assets. Pre-tax ROIC is calculated as Trading Profit divided by the Invested Capital balance. Invested Capital represents the assets and liabilities considered to be deployed in delivering the trading performance of the business.

I always like to see return on capital as an important measurement for businesses and implementing this is clearly a great step forward.

Another interesting fact from the Renumeration report: Both new board members have significantly lower salaries than the old, outgoing board members. Soames has a 800 k base salary, Cockburn 500 k. both pretty reasonable numbers.

However the big problem for me is that I know next to nothing about the business of Government outsourcing. So for me it is at this time very difficult to assess how attractive the stock is and how long it will take to recover.

The current management is clearly a good one but I am not sure if the underlying business is a good one as well. Especially those long-term contracts do seem to contain significant risks. Page 50 and following pages in the report provides  a very good view in great on what can go wrong with long dated contracts. In many cases, Serco was locked into fix price contracts and costs went against them without having a chance to do anything about it.

On the other hand, the 1,5 bn write-off for sure is conservative and one could/should expect that it contains some “reserves” which might be released in coming years.

Deeply discounted rights issues in general

Another word of caution here: A couple of discounted rights issues I looked at in the past were actually not very good investments.

Severfield was a good one with around +50% outperformance against the Footsie since the rights issue in March 2013. KPN even outperformed the Dutch Index by ~+62% in the two years and Unicredit even more than 70%.

On the other hand, Monte di Pasci underperformed by -70% against the index since their rights issue  and Royal Imtech by -45%. EMAK finally performed more or less in line with the index over time after the capital increase.

So overall, the score of outperformers to underperformers would be 3,5:2,5. With Royal Imtech it was pretty easy to see that it would be difficult, as there was a significant accounting fraud involved. BMPS also looked like a big problem as the rights issue was to small and another one is in the making.

So the question is clearly: Is Serco more like Severfield/KPN or Royal Imtech ? For the time being I would rather look at Serco more positively, mostly due to management.

Not surprisingly, analysts hate Serco. the company has one of the lowest consensus ratings within the Stoxx 600. This alone is not a reason to buy, but at least might explain a potential under valuation. A final note: Soames might not be a bad choice for running a Government outsourcing company. His ancestry should ensure some viable contacts at government level:

Rupert Soames can just remember his grandfather, Sir Winston Churchill. His earliest memories are of playing cowboys and Indians with Britain’s wartime prime minister – and of not being allowed to attend his state funeral. He was six at the time and furious: “Watching it on TV was a very poor substitute,” he once said.

His family has long been part of the political establishment: his father Christopher was the last governor of southern Rhodesia, now Zimbabwe, who served in Margaret Thatcher’s cabinet and was also a European commissioner, while his brother Nicholas is a current Tory MP.

Summary:

Overall, the Serco case does look interesting. A brilliant management team is trying to turn around a troubled Government contractor with a transparent and plausible strategy. On the other hand, the business is a difficult one or at least I do not have a lot of knowledge about this sector so I need to digg more into it.

So for the time being, I will watch this from the sidelines and maybe try to learn more about this sector in general.

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

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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:

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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.

1. HSBC

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:

PPI
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.

Summary:

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

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