Today’s contrarian sector – European Banks

This is likely in the “not yet” category, but it is something that I’m paying a little more attention to than most, namely the big European banks.

With the EU reacting to its poor energy policies by enacting demand restrictions, there will surely be further reverberations going forward in terms of the continent’s heavy industry. This will have spin-off impacts in terms of the credit that is extended to various corporations that are sensitive to energy input costs, and creating a whole financial cascade. Who ever thought that negative interest rates would actually have real consequences?

With that said, I’ve looked at various European banking entities, and just doing the most superficial analysis. Numbers are market cap (US billions), P/E, P/B and historical dividend yield.

UK
LYG: Lloyds Banking Group – 33 / 6.6 / 0.57 / 3.9%
BCS: Barclays PLC – 31 / 5.1 / 0.38 / 2.8%

France
BNPQY: BNP Paribas – 57 / 5.6 / 0.49 / 8.5%
SCGLY: Societe Generale – 18 / 7.0 / 0.28 / 8.0%

Germany
DB: Deutsche Bank – 17 / 5.4 / 0.25 / 2.7%
CRZBY: Commerzbank – 8 / 4.9 / 0.28 / 0%

Italy
ISNPY: Intesa Sanpaolo – 33 / 8.8 / 0.51 / 7.0%
UNCRY: Unicredit – 19 / 25.6 / 0.30 / 3.9%

Spain
SAN: Banco Santander – 39 / 4.6 / 0.44 / 4.6%
BBVA: Banco Bilbao Vizcaya Argentaria – 28 / 4.6 / 0.62 / 11.3%

Scandinavia
NRDBY: Nordea Bank (Finland) – 34 / 10 / 1.1 / 16.7%
DNBBY: DNB Bank (Norway) – 29 / 9.9 / 1.17 / 5.6%
SVNLY: Svenska Handelsbanken (Sweden) – 16 / 7.4 / 0.89 / 6.8%

Other notables
UBS: UBS Group (Switzerland) – 55 / 7.0 / 0.97 / 1.6%
ING: ING Group (Netherlands) – 32 / 7.8 / 0.62 / 4.0%

Note that all of the institutions above have international operations and hence they are not entirely exposed to the risks of their domestic markets.

Let’s compare this to Canada (market cap is in billions of USD):

Canada
RY: Royal Bank: 130 / 10.8 / 1.8 / 4.2%
TD: Toronto Dominion: 118 / 10.7 / 1.6 / 4.2%
BMO: Bank of Montreal: 63 / 7.3 / 1.7 / 4.6%
BNS: Bank of Nova Scotia: 65 / 8.7 / 1.3 / 5.8%
CM: Canadian Imperial Bank of Commerce: 43 / 9.4 / 1.3 / 5.4%

One immediate observation is that Canadian banks have much larger market capitalization than their European counterparts. Indeed, looking at the global picture, the USA and China have the largest banks by market capitalization, while the largest European one is BNP, very much behind in the standings.

Needless to say, some of these European bank valuations look compelling at a glance. However, to do the proper analysis of these large (and for the most part, incredibly opaque) institutions, one has to have a grasp on whether their loan portfolios will actually perform and to get a sense of where the geopolitical risks lie. But overall, Europe is trading like a disaster at the moment for obvious reasons (they are a slow-moving financial train wreck happening at the present time) – if, for whatever reason, it is better than a disaster, there perhaps may be some gains to be had in the future from the current depressed levels.

Unfortunately I am not skilled enough to make a nuanced differentiated bet on any specific company above – there are tons of analysts working in the usual institutions that are properly able to gain an edge on which of the above will do better than the rest, but my suspicion is that at some point, an unsophisticated player like myself can probably generate some alpha by constructing an equal-weighted ETF of some of the components above.

I do think I have a better “home field advantage” with the Canadian banks above, but that home field advantage tells me to back off for better values in the future. As far as Europe goes, however, the time is likely closer to a reasonable value bet.

That said, you may wish to disregard anything I say on international bank stocks simply because it does not look like that my investment in Sberbank (a couple days before the sanctions hit) will be materializing anytime soon – my largest one-shot loss in my investing history, assuming it goes to zero (which it effectively is at the moment for non-Russian investors).

Late Night Finance with Sacha – Episode 21

Date: Wednesday August 31, 2022
Time: 7:00pm, Pacific Time
Duration: Projected 60 minutes.
Where: Zoom (Registration)

Frequently Asked Questions:

Q: What are you doing?
A: The summer is ending – some economic thoughts, quick performance review, and taking some Q&A. There should be a few minutes left for Q&A, so please feel free to ask them on the zoom registration if any.

Q: How do I register?
A: Zoom link is here. I’ll need your city/province or state and country, and if you have any questions in advance just add it to the “Questions and Comments” part of the form. You’ll instantly receive the login to the Zoom channel.

Q: Are you trying to spam me, try to sell me garbage, etc. if I register?
A: If you register for this, I will not harvest your email or send you any solicitations. Also I am not using this to pump and dump any securities to you, although I will certainly offer opinions on what I see.

Q: Why do I have to register? I just want to be anonymous.
A: I’m curious who you are as well.

Q: If I register and don’t show up, will you be mad at me?
A: No.

Q: Will you (Sacha) be on video (i.e. this isn’t just an audio-only stream)?
A: Yes. You’ll get to see me, but the majority will be on “screen share” mode with MS-Word / Browser / PDFs as I explain what’s going on in my mind as I present.

Q: Will I need to be on video?
A: I’d prefer it, and you are more than welcome to be in your pajamas.

Q: Can I be a silent participant?
A: Yes.

Q: Is there an archive of the video I can watch later if I can’t make it?
A: No.

Q: Will there be a summary of the video?
A: A short summary will get added to the comments of this posting after the video.

Q: Will there be some other video presentation in the future?
A: Most likely, yes.

Short term interest rates

Exciting times in Canadian government interest rates – finally seeing some yields again (2 year Canada government bond chart below):

Short-duration bonds are yielding higher than they were before the 2008-2009 economic crisis. The one-year bond is at 3.67% currently, and the two-year at 3.53%.

I’ve talked about this before, but one theory in finance is regarding the term structure of the yield curve in that the total returns is invariant to the term one invests in – e.g. if you invested in 1-year government bonds 10 times, the net result will be the same as if you invested in 1 10-year bond. Of course, practice is different than theory, but if one were to take this theory and apply it with the existing rate curve, it would suggest that the target rate is going to rise significantly higher than the so-called “neutral rate” which, according to the monetary policy report, is between 2-3% nominal. I’ll leave it up to the reader to decide on the validity of these financial theories.

In the monetary policy casinomarkets, the 3-month Bankers’ Acceptance Rate is currently at 3.46% and has crept up slowly in anticipation of September 7, 2022’s expected rate increase – the September futures indicate a 3.89% 3-month rate. I am not sure if this translates into an expectation of 50 or 75bps for the September 7 meeting, but either way short term interest rates are going up. The next meeting of the bank on October 26 is anticipated to have a 25 basis point increase as well.

All of this means that money is coming harder and harder to come by. Governments will find it much more expensive to borrow money, so I would look carefully at your portfolio for entities that are government-dependent.

The big risk continues to be that interest rates will rise further than the market anticipates – and it likely will if inflation does not reach the magical 2% target.

The US dollar wrecking ball

By far and away, the largest surprise for many has been the relative strength of the US currency to the exclusion of others:

Since most international trade is denominated in US currency, it means that for foreign countries engaging in commodity purchases and most other imports, the trade currency becomes that much more expensive to transact. This has an effect on their cost inputs (in addition to the core commodity prices themselves being relatively inflated). For example, when Europe wants to import LNG, not only do they have to pay an extremely bloated premium to doing so, but right now they are dealing with record lows of “99 Euro-pennies” being equal to one US dollar.

The US Federal Reserve as well is raising interest rates, so holding cash (or liquid short-term treasury notes) is no longer a zero-yield option: indeed, you can lend your money to the US government for a year and get 3.3% for it. Cash is once again becoming more valuable.

It was widely anticipated that with inflation and the US government printing massive deficits that the currency would sink like a stone – indeed, it has gone in the opposite direction as people are demanding US dollars, especially as asset markets depreciate, and credit stress becomes apparent.

The future course of action appears to be that there will be some sort of crescendo event where the US dollar will gain so much strength and then when things break somewhere, the US dollar will be sold off. I don’t know when this will be.

All I know is that being levered long in this environment is dangerous – especially as the existing consensus is that the fed will drop interest rates again in 2023 – what if they don’t because inflation is still running well above 2%?

Prices are formed on the basis of the sentiments of the marginal bidder and marginal seller. In the event that there is an instantaneous drop in demand and consistent supply, prices will drop and they will drop quickly. As interest rates rise and central banks continue to pull capital out of the bond markets, it is like taking oxygen out of the room. Initially, nobody notices. Then there is a point where people actually feel better, despite the fact that the oxygen level gets below where it can sustainably maintain your cognitive function. We’re probably at that point in the markets. Then finally, you start to lose your functionality entirely before losing consciousness.

I’ve used the market rally that began in July to pull out the weed-wacker and trim the portfolio a little bit and raise cash. If things rise from here, I’ve got plenty of skin in the game. However, the suffocating effect of rising interest rates is increasingly apparent. It will be very difficult to generate excess returns at present.

Yellow Pages’ peculiar share buyback

Yellow Pages (TSX: Y), a long-time holding of mine, announced their second quarter results a couple weeks ago.

There were some interesting highlights involved, namely that this quarter was the first quarter in a very, very, VERY long time where they had a sequential increase in revenues between quarters (albeit, the profitability of such revenues decreased as the mix had more lower margin revenues). This got very little recognition.

The actual cash generation figures have still been quite healthy, although this is the first full year where Yellow’s tax shield has whittled away to only partially offset their income. By virtue of making some seriously questionable past acquisitions (before the belt-tightening regime of the existing management) they are allowed to deduct a declining balance amount on their cumulative eligible property, which is better than nothing.

However, the highlight is what is essentially a forced share buyback:

The Board has approved a distribution to shareholders of approximately $100 million by way of a share repurchase from all shareholders pursuant to a statutory arrangement under the Business Corporations Act ( British Columbia ). The arrangement will be effected pursuant to a plan of arrangement which provides that the Company will repurchase from shareholders pro rata an aggregate of 7,949,125 common shares at a purchase price of $12.58 per share, which represents the volume weighted average price for the five consecutive trading days ending the trading day immediately prior to August 5, 2022.

The proposal requires 2/3rds of the shareholders to approve, but they already have consent from the three major shareholders (GoldenTree with 31%, Empyrean with 24% and Canso with 23%) to proceed. Minority shareholders (such as myself) are along for the ride, although because the buyback is proportional, no entity will have a different level of ownership after the transaction (restricted share units, options, etc., typically have clauses to reflect such special distributions).

At the end of June 30, Yellow had 26,607,424 shares outstanding. This works out to a distribution of $3.76/share.

The way I understand it, instead of the entire amount consisting of an eligible dividend, it will effectively amount to a sale of 30% of the stock, which means that the cost basis of such shares can be deducted against the proceeds of the sale (for most people, this will be a capital gain). If my understanding of the tax treatment is correct, then the tax burden of such a distribution will be significantly less than the typical special dividend.

However, in the letter to the three top shareholders, the following paragraph is in there:

The Company agrees that it shall designate the full amount of any dividend deemed to arise under the Income Tax Act (Canada) as a result of the acquisition of the Common Shares pursuant to the Arrangement as an “eligible dividend” pursuant to subsection 89(14) of the Income Tax Act (Canada) and the corresponding provisions of any provincial tax legislation pertaining to eligible dividends.

As those three entities own more than 10% of the common stock of the company, such a distribution would be tax-free if given to their CCPC subsidiaries if classified as such. I am not sure whether differential tax treatment is permitting. When the company’s management information circular comes out, reading the tax opinion will be educational as I have never encountered this ‘forced buyback’ in my investing life.