Last Thursday’s Brexit vote led to a historically nightmarish day in the financial markets:
- Indexes across the globe were down between 3-10%.
- The British pound dropped from a high of $1.50 to $1.32, before finally recovering to $1.37, down an enormous 9% for the currency.
- European banks stocks were down between 15 and 20%.
- S. stocks and especially financials were punished as well, as fear pervaded across the globe.
If you felt anxiety or concern as these events unfolded, that would make you like every other person that owns equities, funds, or is otherwise engaged in the global economy across the world. It is totally natural and in today’s society where you have 24/7 access to news coverage and everyone is clamoring for ratings, these types of events get magnified to a level where you can be forgiven if you were surprised to see the sun rise again on Saturday.
With this said, it is important to understand that the Brexit is much more of a political issue than a financial issue.
U.S. exports to the U.K. make up about 0.7% of U.S. gross domestic product and those exports aren’t going to stop as a result of this decision. Below I’ll provide a balanced picture of the opportunities and risks, and explain why we are positioned the way that we are.
Short term panic, not long term damage
The Brexit vote is the most conclusive evidence that across the globe we are seeing a resurgence of nationalism of the greatest veracity since the end of World War 2. It is important to note that global markets functioned quite effectively prior to the EU and I don’t expect the EU to completely unravel by any means. It seems more likely that eventually, cooler heads will prevail and constructive changes can be made to make the EU more attractive for its members. Remember in the United States, the Articles of Confederation were filled with many problems that necessitated the Constitutional Convention, which lead to the rise of a more effective national power.
The process will take many years to unfold so the immediate impact will likely be confidence related, more than anything financially substantive.
It isn’t as though the UK will be defaulting on its debts, or that all trade between the island Europe will come to a halt. I certainly don’t want to minimize the impact of the UK leaving though for both Europe and the island. Clearly, concerns will shift towards other countries such as Italy, which might believe they can find greener pastures on their own. This wasn’t necessarily unexpected though no matter which way the Brexit vote went. Worry about global political issues will have you keeping your money under a mattress, which is a big reason why it is so important to focus on individual companies and work your way up from there.
The T&T outlook
At T&T Capital Management (TTCM), we have been underweight on European equities. Realistically this area might be getting quite a bit more interesting after the selloff and this underweight could change. The biggest impact that the Brexit will have on our portfolios is that the lack of confidence in global growth could further delay interest rate hikes, which would be of benefit to financial stocks. Very few people expected many rate hikes in the first place and while they would be helpful, low interest rates help areas such as mortgage origination, bond issuance, etc. The potential disruption to the European banking sector could open up opportunities for the big U.S. banks, which we hold positions in to pick up market share.
While stocks across the globe plummeted on Friday, the actual impact on earnings, book value etc., for the vast majority of our positions is minimal to non-existent depending on the position.
Not all bad
Friday’s upheaval marred what had been a fantastic week for the banks. Through the close of Thursday’s trading, the SPDR S&P Bank exchange-traded fund (KBE) had rallied 4.1%. This rally was a result of a combination of optimism on the economy, the Brexit vote, and the Federal Reserve’s bank stress test. After the close on Thursday the stress test results came out and the results were even better than expected, pushing most banks up another 2-3% after hours. All of this was for not in the short-term though as Friday sunk all ships! That same index was down a whopping 7.2% on Friday.
These types of short-term market swings are noise. Ultimately, what drives stock prices are fundamentals and earnings.
There is no doubt in my opinion that earnings are going to be quite strong for the big banks, leading to higher book values and capital ratios. After the close of Wednesday’s trading this week, we will get the results of the CCAR process in which the banks find out if their requests for stock buybacks and dividend raises are approved. This should be a major catalyst.
Banks such as Citigroup (C), are overly capitalized and are generating $15-18 billion of additional capital per year. Ultimately, this money will go back to shareholders.
On a company with a market capitalization of only $118 billion, these capital returns will be massive, likely leading to much higher stock prices. These returns are occurring despite the current low interest rates!
Strong margin of safety
Speaking of the Federal Reserve’s stress-test, the results showed that in the draconian worst-case scenario used by the Fed, the 33 banks tested would still have nearly twice as much capital as required (8.4% versus the required 4.5% tier 1 common equity ratio.)
This means that the banks could withstand a potential loss of $385 billion of bad loans and still be far stronger than they had been prior to the Financial Crisis!
Keep in mind that this stress-test basically implied a severe depression scenario, which is not in the cards. Instead, we will see tens of billions of profits from the big U.S. banks this year and probably more next year, and the year after.
To give you an idea of how far the banks have come, look at Bank of America (BAC). Liquidity has gone from $100 billion to $400 billion over the last 10 years. Tangible common equity, which is the highest quality form of capital, has improved from $60 billion to $160 billion. The company made about $16 billion last year and has a market capitalization of only $133 billion. Total equity is $262.776 billion! Remember assets minus liabilities equals equity. That is what it means to be buying dollars for 50 cents. Where else in the market do you find these opportunities? This isn’t 2011 when the banks still had to build capital to meet new requirements and where changes to the business model would create massive upheaval. We now have leaner, more efficient, and safer institutions than we have had in many decades, if not ever!
Their grass is not greener
Would we be safer owning utilities, which were one of the few areas that were actually up on Friday? This no growth industry trades at 20.61 times earnings and has a P/B of 1.88. Debt is being increased to finance dividends and the yield is relatively low historically for the sector at 3.27%. The banks will be dramatically growing dividends, while utilities will have a much tougher time. Legacy coal, nuclear, and even natural gas are facing more headwinds than in the history of the industry. This is forcing companies to acquire one another to diversify. In addition, companies are having to compete with federally-subsidized clean energy solutions. This could result in huge risks, which are unappreciated given current valuations.
This is why it is so important to look at investing as a long-term activity, as opposed to getting caught up in emotion or short-termism.
Financials growth is consistent
As long as our key financial investments continue to grow book value and dividends, the stock prices will follow. There is nothing in the short to mid-term horizon that should prevent that from occurring. Even after all of the challenges presented to the sector over the last 10 years, these companies have consistently grown book values, and finally we will see the dividends follow suit since capital levels are so high. The last part of the equation is investor sentiment and how it impacts valuations. What prices are investors willing to pay for a dollar of book value and a dollar of earnings? Currently, as banks are seen as pariahs by many, the willingness to pay a fair and appropriate business value on earnings and capital is quite limited. This won’t last forever and it never has! In my opinion, dividend increases will be the straw the breaks the camel’s back leading to values more representative of intrinsic value, as cash speaks more than anything right now. While stock buybacks at discounts to tangible book value are more attractive in my opinion due to the accelerated tangible value creation, in today’s low interest rate environment, dividend increases will not be ignored for long.
Risks of long-term permanent losses of capital are exceptionally low as these companies are safer than ever and the return potential is extraordinary.
Predicting the timing is a fool’s errand but we’ll keep reporting the facts as they arise! As always, if you have any questions or if I can help in anyway, please don’t hesitate to call me at 805-886-8140.