Yesterday, the new 13F filing for Berkshire Hathaway (NYSE:BRK.B) came out and for the most part, I wasn’t really surprised. Warren Buffett trimmed some of his holdings but increased his stake in Wells Fargo (NYSE:WFC), Johnson & Johnson (NYSE:JNJ), and a new holding in Bank of New York (NYSE:BK).
The new position in Bank of New York is really interesting to me. I have had this theory for a while now that asset management/trust banks would become attractive going forward because of their large fee income businesses.
See, for a long time, most banks operated on this 80/20 model where 80% of revenues came from interest activities (loans) and 20% came from fees (overdraft, credit card interchange, debit card interchange). But that’s changed a bit with the Durbin Amendment which is scrapping the debit card interchange fee from banks. Most bankers have publicly said that they will be figuring out new ways to make up the lost income — most likely by charging customers for things that they take for granted (free checking).
The other model though, might be to acquire financial institutions that are driven primarily by fees. There are a few ways to do this. A bank could acquire wealth management firms that are within their geography — BBVA did this when they came to Houston. Or they could acquire a trust bank, which typically has the income structure split closer to 65/35 than 80/20. We saw one of these acquisitions when M&T Bank (another Berkshire Hathaway holding) acquired Wilmington Trust in an immediately accretive deal.
So where exactly does Bank of New York fit into all of this?
Bank of New York is regulated as a bank but actually derives most of its income via fees. It acts as a custodian for financial assets. As a result, Bank of New York can charge asset management fees to clients, typically at a percentage of AUM. Plus, it can also charge clients on a per transaction basis – so if you expect an increased level of volatility going forward, then the bank should do quite well. This is a great business to be in and throws off a lot of free cash flow when times are good.
The only thing that concerns me about Bank of New York is the company itself. The business they are in is great and should have excellent prospects for the future, but historically the bank’s own results have been less than spectacular. To illustrate, look at BoNY’s EPS since 2000 versus Wells Fargo:
Those earnings seem pretty weak, which makes me wonder about BoNY. At the same time, they have engaged in M&A over the last 10 years, which might have hurt earnings growth — especially if there were integration costs and dilution. Maybe Buffett is expecting some kind of shift in operations, much like what happened with Coca-Cola when he invested.
I’d suggest taking a deeper look at trust banks and banks that have some kind of non-interest fee stream that makes up a greater than 20% portion of their business. This looks like a really fruitful area for some of the bigger banks to do deals and might be beneficial to investors.
In a recent article Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.
I. Investing based on mean reversion will be less compelling
II. Risk on/risk off fluctuations in sentiment will continue
III. Tail hedging becomes more important
IV. Historical benchmarks and correlations will be challenged
V. Less credit will be available to sustain leverage and high valuations
Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.
However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.
Anne-Louise Fogtmann has a good take down of what Montier said at the conference. Montier outlined his own views which I thought were interesting, particularly on cash:
Seven “immutable laws of investing” apply, Montier argued, as they have in the past:
-Always insist on a margin of safety.
-This time is never different.
-Be patient and wait for the fat pitch.
-Risk is the permanent loss of capital, never a number.
-Be leery of leverage.
-Never invest in something you don’t understand.
With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” A few of his specific calls: Government bonds have no return potential; emerging markets look overvalued; and in a world where both bonds and equities could be too expensive, cash becomes a much more attractive investment, even when the yield is near zero. Not only is cash a better inflation hedge than bonds (it’s a zero duration asset), it can act as a store of value during periods of deflation.
The market’s had a pretty good run lately, making most equities more expensive for value investors. The dynamic between cash and equities is a really interesting one for us because we tend to hold portfolios that are more concentrated. Other investors might have the kind of allocations which allow them to replicate the movements of your typical indicies, but value guys tend to take a 5% to 10% position approach. This makes our allocation decision a bit more difficult. There’s a big difference between re-creating an index versus putting on 10% positions in full value/expensive stocks. This is why, for concentrated investors, it makes sense to shift to cash rather than equities. At the same time, there are pockets of value scattered throughout the market. While no one sector seems to offer compelling valuations, I have been spending most of my time analyzing select companies in industries ranging from energy to insurance.
Montier’s point about emerging markets being expensive is one that resonates with me. Take the case of Brazilian banks Bradesco (NYSE:BBD) and Itau (NYSE:ITUB). Both are priced richly at over 4x book value, but are generating high returns on equity (32% and 40%) implying an 8-10% return. If we dive deeper into the financials and analyst estimates, we can see that much of this is being driven on the prospect of loan growth. Brazil has a rapidly growing middle class and most people expect that financial services firms will be able to profit from that growth.
I agree that a developing middle class should be able to help the banks. In theory, as the banking sector in Brazil becomes more formalized, citizens should be depositing more money into banks and using them for payment transfers. That should lower the cost of funding for Brazilian banks. Plus, Bradesco and Itau are targeting for insurance income to make up 25% of their earnings in a few years. These are truly financial services supermarkets and I could see that part of the equation working out. But analysts are modeling loan growth at rates of 30% annually. I just don’t know if Brazil can sustain such growth levels. You could make the argument that much of the growth could be going to consumers, not commercial enterprises, but to me that kind of lending is much more difficult. At least when a bank loans to a business, the credit analysts can give a business a good scrubbing and have the business’ assets used as collateral. Consumer lending is an entirely different beast. They could try to increase the amount of mortgages on their books, but the problem there is consumer demand might not match up with supply, you might end up creating a mini-housing bubble.
To me, emerging markets at this point have a lot of things going for them. I do expect the BRIC countries to do well over the long term. But as a value investor I just don’t think you will get the margin of safety that you are looking for. Everything has to go right for them to warrant such high valuations. Buying right now is akin to being a trend follower or momentum investor. I have a list of great companies in BRIC countries that I usually check every other day. The way I figure it, given the way the global economy is going — any heightened level of volatility might trigger a pull back and make some of these companies a bargain. For now, you might be better off analyzing large caps with emerging market growth exposure. Those businesses still seem to be trading at attractive valuations.
My friend Miguel Barbosa continues his interview with Alice Schroeder (Part 2 and Part 3). Here is an excerpt:
Miguel: What was it like being the world expert on Berkshire Hathaway?
Alice: I thought that it would be interesting to our retail brokers and to a limited number of institutional investors. I knew that a lot of people on Wall Street were indifferent to Warren Buffett and some even disliked him for one reason or another.
What I didn’t expect was that the new role would become huge, but it did, because, until that time, Warren had been so inaccessible. The New York Times ran a front page business section story “The Oracle of Omaha Taps a Medium on Wall Street.” For a while I had 3 people answering the phones. I can’t tell you how many phone calls just never got returned; it was like a wildfire. Thankfully, it calmed down after a few weeks.
Berkshire was a very interesting stock to follow, especially as you began to really understand it and its most important elements. Shortly after I began my new role, Warren made a series of acquisitions in the late 1990’s and early 2000’s. There was, as there still is, a fascination with the minutiae of these companies. But it seemed to me that the most important part of what he did resembled a factory-like process. What interested me was the factory.
After parsing through bank earnings one thing that sticks out is non-performing loans (NPL) remain high. Tracking NPLs and more particuarly NPL inflow rates will help you determine the amount of problematic loans coming into the pipeline. In any recovery you should see this number decline sequentially and from 4Q09-2Q10 that’s exactly what you’ve seen across most banks. But results from 3Q paint a different picture particularly in one region.
A closer look and you’ll find that Southeastern banks or banks with heavy exposure in the Southeast are starting to see the rate of inflows increase. On surface you may not be able to spot the NPL trends as a majority of these banks have disposed NPLs through sales or a transfer to held for sale which skew the inflow calculation.
Let’s take a look at some of the Southeastern banks that have reported 3Q results:
Regions Financial (NYSE:RF) which has $133 billion in assets and banks in the southeast saw NPL inflows of $1.4 billion compared to $900 million last quarter. The inflows were primarily due to income producing commercial real estate (CRE) and land/condo/single family loans. A quick glance shows at the end of 9/30/10, RF had $3.372 billion in NPLs, down from $3.473 billion last quarter. Taking the difference plus adding back charge-offs of $759 millions gives you $658 million in NPL inflows and implies a solid deceleration given last quarter’s NPL inflows of $900 million. But RF also transferred to held for sale $1 billion in troubled assets which they marked down $233 million skewing the inflow calculation. The actual inflow rate is closer to $1.4 billion when you consider the $658 million inflows + $1 billion in troubled assets – $233 million mark.
SunTrust (NYSE:STI) with $175 billion in assets saw NPL inflows increase to $296 million from $188 million in 2Q.
BB&T (NYSE:BBT) which has $157 billion in assets saw NPL inflows increase to $693 million from $505 million in 2Q excluding troubled asset sales which would make the inflows worse. 50% of BBT’s loan portfolio are comprised of commercial loans.
All three of the banks above saw NPL inflows decelerate from 4Q09-2Q10.
Synovus (NYSE:SNV) mainly a Georgia bank with $31 billion in assets saw NPL inflows increase to $422 million from $339 million after adjusting for the disposition of $172 million in trouble assets. This was the first increase in 5 quarters.
BancorpSouth (NYSE:BXS) with $13.6 billion in assets and banks around the Gulf had NPL inflows increase to $133 million compared to $115 million. BXS had no troubled asset sales.
Whitney Holding (NASDAQ:WTNY) a Louisiana bank with $11.5 billion assets saw NPL inflows improve but announced that it will sell $180 million in troubled loans and reclassify $100 million in additional NPLs to held for sale in 4Q10.
You are seeing inflows pick up in a few banks in the mid-west as well but it is not as widespread as it seems to be in the Southeast region. There could be a few reasons:
1. A slowdown relative to the rest of the US
2.Inflows continue to improve at the bigger banks(ex-C as numbers remain skewed due to their asset disposition strategy) most likely due to having a diversified footprint and loan portfolio. A good amount of improvement is also coming from card portfolios which most regionals tend to avoid. Typically regionals have higher concentrations of commercial, CRE, and mortgage loans which continue to struggle.
3. Banks are finally owning up to their losses.
I am not implying this is a trend and that we’ll see NPLs skyrocket but I do believe NPLs will remain relatively high and we’ll continue to ebb and flow from these levels for quite sometime. It’s a metric worth monitoring.
These days Alice Schroeder gets a lot of hate for her biography The Snowball, about the life of Warren Buffett. It’s still my favorite Buffett biography because it gives you the most in depth view of his early life as an investor. People complain about all the pages dedicated to his personal life, but if you really want, you could just skip through those parts. You’d still end up with more information than what’s in the Lowenstein book.
My friend Miguel Barbosa of Simoleon Sense has an interview with Schroeder and it’s worth a read, especially for people who are interested in insurance. Also, Schroeder is featured in The Confidence Game which details Bill Ackman’s short selling campaign against MBIA.
Miguel: This reminds me of James Grant indicating a great way to make a name is to follow unpopular paths and recommend shorts.
Alice: In a normal market, it is tough to be the naysayer, but the past few years have been a heyday for shortsellers. With so much hedged money, there’s also far more demand for diverse opinions today. In general, though, the human race is biased towards the positive. You have to be optimistic to go through life.
There’s also some interesting research that shows that people who speak out critically are viewed as smarter than those who give only uncritical applause, even though they are less liked. In the long run, the price of popularity is paid in respect.
Miguel: Two things I wanted to go back to; first your experience as a regulator and how this taught you how games are played; and second, you mention the importance of being skeptical. Is this an inborn trait or can analysts, investors, and others develop this trait (if so how)?
Alice: We may have a natural bent one way or another, but it is very strongly shaped by experience. As just one small example, when I worked on the E&Y transition team, it was fascinating to see first-hand the amount of friction, wasted time, and lost energy that inevitably occurs in a merger integration. And this was quite a successful merger. So you can imagine how skeptical the experience made me of projected “acquisition synergies” in deals I later covered or took part in on Wall Street.
My experience in regulation was also immensely useful in this respect. It exposed me to dozens of people lobbying for an outcome. This is a side of human behavior that we see much less often as an analyst or investor. Try as they might, people aren’t putting their best foot forward when they’re lobbying you; they’re putting their greedy foot forward. Also – and I have never said this before in an interview — being in the presence of a blonde has an interesting effect on some people. It can get tedious to be underestimated, but has its advantages. Certainly, it raises one’s skepticism.
I thought the bit about getting exposed to regulation was really interesting. I feel as if investors who come from a regulatory background have a good edge for analyzing financial stocks. Todd Combs, Buffett’s latest hire has that kind of a background and he has done quite well for himself.
My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via the school library. I read everything I could and now I'm here, writing out my thoughts and investment ideas.