Pixabay CC0 Public DomainCourtesy photo. Inflation Is Unusually Dormant… For The Moment
Data continues to point to the broadest synchronised expansion the world has experienced in more than a decade as advanced and emerging markets continue to gain momentum. Labour markets are recovering at a rapid pace and, although the unemployment rate in Europe is still above pre-crisis lows, in the US, it has reached a low of 4.1% and in Japan, it sits at just 2.8%. And yet, inflation is oddly muted. Indeed, the average inflation rate in the OECD countries is 1.5%, down from 2.2% in 2012 and well below central banks’ official target of 2%. How is this possible, also considering that the balance sheets of the four largest central banks have exploded to USD 14 trillion in assets?
The first explanation could be that the recovery has been slow. Growth rates are still below pre-crisis levels as investment, trade and, to a lesser extent, consumption have lagged. As for labour markets, in the US for example, one reason why the tight labour market has not led to a sharp acceleration in wage growth is that the fall in the unemployment rate is the result of a change in labour supply as a large number of baby boomers have retired, thereby reducing the participation rate. This has also impacted wage growth because the pay checks of retirees are likely to have been higher than those of entrant workers. Moreover, what really impacts inflation is unit labour costs and not nominal or real wage growth and the recent improvement in productivity has allowed unit labour costs to fall over the past year. Finally, although quantitative easing and ultra-low interest rates have succeeded to boost financial asset prices, they have failed to lift inflation. This is due to the extreme slack the financial crisis caused in the economy. Slack which today is far lower as economies have recovered.
An undeniable cap on inflation also comes from exchange rate variations. The dollar, for example, impacts headline inflation through its direct impact on commodities but it also affects core inflation which excludes energy and food. A rise in the dollar makes foreign imported goods cheaper, thus increasing competition for domestic producers which pressurises them to reduce prices. The 26% rise in the dollar from mid-2014 to end 2016 and the 60% drop in oil prices during that same period were therefore much to blame for the low level of prices.
More structural factors such as disruptive technologies and globalization have also played a role in capping prices. E-commerce companies, Airbnb and Uber have enabled more price transparency as well as an additional supply of goods and services for clients, thus leading to slower inflation. Worldwide integration has given firms the possibility to move their production facilities across borders at lower costs. However, does this benefit consumers or the firms’ profit margins? And although all these topics seem reasonable, research has shown only a reduced impact on inflation.
Surprisingly, the most important driver for inflation are inflation expectations. Surprisingly also, they are backward looking as they seem to be correlated with recent or coincident inflation. The most likely outcome therefore continues to be low levels in inflation. But let’s not forget that inflation is a lagging indicator. While the correlation between core CPI and GDP growth over the last twenty years is only around 5%, when GDP growth is lagged by six quarters, the correlation jumps to 80%. The stronger growth which started in the second half of 2016 should therefore start to impact inflation soon. Moreover, a further depreciation of the dollar or a persistent spike in oil prices are possible risks. Even though inflation has continued to fall below expectations, we could be reaching an inflection point and we may see inflation trend higher. Hopefully it will be at a controlled pace!
Pixabay CC0 Public DomainPhoto: elenlackner. WisdomTree Buys ETF Securities’ European Exchange-Traded Commodity, Currency and Short-and-Leveraged Business
ETF Securities has agreed to sell its European exchange-traded commodity, currency and short-and-leveraged business to WisdomTree Investments the Nasdaq-listed (ticker: WETF) and New York headquartered global exchange-traded product provider.
The business being sold comprises all the European operations excluding the ETF platform. The business being sold to WisdomTree has $17.6 billion of AUM spread across 307 products, including the flagship gold products PHAU and GBS. The business has a comprehensive range of commodity, currency and short-and-leveraged products and more than 50 dedicated staff.
WisdomTree and ETF Securities will work to ensure that integration is seamless and expect no change to the current high standards of service and operations experienced by our customers and partners.
The sale is subject to regulatory approval and is currently anticipated to close in late Q1 2018.
Graham Tuckwell, Founder and Chairman of ETF Securities, comments: “We are pleased to be selling our European exchange-traded commodity, currency and short-and-leverage business to WisdomTree and to become the largest shareholder in the company. I believe this combination creates a uniquely positioned firm which will flourish in the years ahead, continuing to deliver huge value for customers and stakeholders. ETF Securities has a strong cultural fit with WisdomTree as both firms have been built from scratch by teams who have worked closely together for many years and who show an entrepreneurial spirit in seeking to deliver innovative and market leading products for their customers.”
Mark Weeks, the UK CEO of ETF Securities says: “This transaction creates a leading independent global ETP provider which is well positioned to compete in the rapidly growing European ETP market. We have complementary expertise, product ranges and customer networks. We both continue to challenge the status quo to provide customers with a range of differentiated products. In this industry customers want and value firms like ours, which provide broader choice.”
Yerlan Syzdykov, courtesy photo. Venezuela On the Edge of a Cliff: Lets Be Cautious
A full Venezuelan sovereign default scenario would be one of the most complex events of its type and would require a large-scale restructuring, according to Yerlan Syzdykov, Deputy Head of EM at Amundi AM who does not see anuy rapid solution to the restructuring process.
What is your analysis of recent events in Venezuela?
President Nicolas Maduro recently announced the Republic of Venezuela’s intention to restructure all foreign debt, thus recognising the country’s current debt load as unsustainable. The nation missed a coupon for about $200ml and failed to make the payment by the end of a 30-day grace period, triggering the rating agencies downgrade to default. A meeting of the International Swaps & Derivatives Association will follow shortly to discuss whether a week- long delay on bond payments from the state oil company will trigger default-insurance contracts on those securities. We think Maduro’s move is part of a political game to increase his chances of re-election in 2018, and it follows an attempt to consolidate power by the regime, including sweeping victory in recent gobernatorial elections – despite a 21% approval rating at the time. With this political capital in hand, pushing bond payments further out, Chavismo1 now turns to the debt issue. To further delay and complicate the negotiation process, the Republic invited bond holders to Caracas on 13 November to begin restructuring negotiations. The meeting was chaired by Venezuelan Vice President Tarek El Aissami. Among the attendees was the Economy Minister Simon Zerpa. who also serves as CFO of PDVSA, the state oil company. Both Mr El Aissami and Mr Zerpa have been sanctioned by the US, which inhibits US persons participating in the discussion. No specific proposals seemed to have emerged from the meeting but government officials insisted they plan to continue to service obligations.
What is the market expecting for the near future?
The restructuring announcement changes the prevalent consensus towards both Venezuela and its related quasi-sovereign bonds. The market was expecting Venezuela to service into 2018 and then seek to restructure the Republic only. Now the market has begun to debate the Republic’s specific timetable and the range of potential outcomes. With Maduro in power, the range of outcomes is narrow. The market’s assessment of the probability of a transition, and therefore Maduro’s future, will be important drivers of bond prices. Maduro’s recent comments confirm that the Republic plans to include PDVSA and other Venezuela quasi- sovereign issuers in the restructuring programme. PDVSA and the electricity company Elecar collectively have $750m in coupon arrears on $66bn of outstanding bonds. It appears that the government is proposing to address these arrears collectively or concurrently with the Republic. The Republic may be attempting to protect PDVSA by going for a restructuring. Considering the complexity of the government’s position, the decision to restructure may reflect a desire to negotiate a more favourable outcome, which is unlikely, in our view.
What happens if Venezuela should default? A full Venezuelan sovereign default scenario would be one of the most complex events of its type and would require a large-scale restructuring. Only the Republic knows Venezuela’s total debt level, which is estimated to be around $150bn. US investors hold some 70% of Venezuelan hard currency debt. This introduces further complication to an already complex situation, given the prevailing US sanctions. Creditors include recipients of promissory notes, as well as those with material trapped capital – such as airlines. This creates a potential burden on the state through unresolved claims. It also contributes to uncertainty around bond servicing, as the total size of these claims is not widely known.
Who could come to the rescue?
We see quite limited options. Venezuela does have some assets, even though foreign currency reserves have declined in the past years. The country has an equivalent of $1.2bn in SDR2 reserves with the IMF, and around $7.7bn in gold. Further external support from Russia is also a possibility. The government could also negotiate an extension to several Chinese loans due at the end of this year. Venezuela getting further loans from Russia or China remains a low probability event, in our view. China is unlikely to bail out the government, having previously declined to revise the terms of a loan. The IMF enters the process facing a number of challenges. It is said to regret its role in the recent Greek bailout. At that time, the Fund was pressured to take a 30% participation, a transaction it says it now regrets. This may influence the Fund’s path of engagement with the Republic. The Fund enters the discussion with incomplete and outdated information. Venezuela had reduced contact with the IMF in recent years. The fund’s first challenge will be to develop a precise understanding of the situation – a goal that may take time to be achieved. Holdouts present a real challenge to any attempted restructuring or re-profiling of maturities. Another wildcard: in the US, a creditor with a court judgement is entitled to attach receivables, which means creditors could seize oil payments. As a result, the Fund might alter its traditional approach and attempt a more direct resolution. For example, the Fund might move to engage the market earlier by going for an early debt haircut; should it go down this route, we expect considerable scepticism. Lastly, IMF’s decision to support the restructuring and commit any funds to the country has a complex political dimension given antagonistic relationship between Venezuelian government and the US. Overall, we believe that the Venezuela story will persist for several years.
Where does the state oil company PDVSA stand in all of this?
PDVSA enters restructuring talks with c. $42bn in outstanding bonds, of which $29bn are USD-denominated. 2016 EBITDA has been estimated at $15bn compared with $66bn in 2011. The company currently operates 44 rigs, down from 70 a few years ago. PDVSA’s oil production is likely to have fallen below 2.0 mm bpd (barrel per day), (-11% YoY), as sanctions complicate oilfield equipment purchasing. PDVSA ships around 1mm bpd to service borrowings from China and Russia, as well as to service other political commitments made by the regime. This limits the amount of production available for debt servicing. PDVSA is a different legal entity than the Republic, hence an event that impacts the Republic doesn’t automatically impact the company (so called cross-default). The Republic’s intention may be to protect PDVSA and oil flows ensuring access to petrodollars. Sovereign bondholders, however, will immediately seek to attach those flows through legal remedies based on the legal argument of ‘alter ego’. Furthermore, it is unlikely that the IMF would allow the Republic to default while PDVSA continued to service.
Would you expect any spillover from the Venezuela crisis?
Contagion among EM is mitigated by a number of factors. Firstly, the possible default of Venezuela has been well flagged. In fact many investors believed Venezuela should have defaulted long time ago. Secondly, fundamentals in EM are currently generally strong and the spreads reflect a healthy macro background. Most countries are not overleveraged, and we see current account surpluses in many EM economies. Where there is a potential contagion is around US refineries. Venezuela supplies crude to many US refineries, particularly those around the Gulf. These refineries produce gasoline and are configured to take Venezuela’s sour crude. A slowdown in Venezuelan output could reduce US gasoline production, which might alter inflation or growth characteristics. While that is theoretically possible, at this juncture it does not look likely.
In Russia, some petroleum companies are invested in PDVSA (mainly Rosneft, but also Gazpromneft and Bashneft). There is also a reported miss on a payment to ONGC, the Indian state oil company. Were Venezuela would service its debt or restructure, the result would be immaterial given the relative size of the exposure for those companies. In an unlikely scenario of a blockage of the Venezuelan oil exports, US majors and oil servicing companies will have a negative but limited impact.
Do you see opportunities emerging from the crisis?
The timing and tone of the government’s proposals may have a material impact on discussions, successful or otherwise. PDVSA, as the country’s main source of hard currency export earnings, could give exposure to Venezuelan yields from a possibly advantaged position if an event occurred. Given the overall uncertainty, the complexity of both PDVSA and the Republic’s capital structure, and the unknown size of overall liabilities, it is too early to make a meaningful assessment of potential recovery value. An additional consideration is about alternative investment opportunities – if Venezuela’s interest rate spread continues to widen, it might pull investment from other, higher-risk debt issuers: the composition of return from EM could shift in character. Overall, we remain very cautious on Venezuela, we don’t see any rapid solution to the restructuring process, and we continue to look for tactical opportunities as they emerge with risk control as a priority for our investors.
Foto cedidaSimon Fox, Senior Investment Specialist at Aberdeen Standard Investments, courtesy photo. Aberdeen: “Diversification Across Funds Should Mitigate Market Falls"
Investors have to deal with both short-term volatility and downfalls risks. For Simon Fox, Senior Investment Specialist at Aberdeen Standard Investments, the adequate way to deal with this is to better diversify your portfolio. As he explains in this interview with Funds Society, at a difficult time for traditional fixed and variable income, he finds the most compelling opportunities through a range of diversifying assets, such as emerging market debt in local currency, investment in infrastructure and asset backed securities.
What does provide an ‘alternative’ approach to markets? Is it about looking for new sources of alpha or is it about protecting against risks?
Multi asset investing has evolved considerably since the Global Financial Crisis. Today’s investors are looking for a more explicit focus on their own objectives – such as a cash or RPI+ return; or maybe a consistent level of income. In the past a simple blend of stocks and bonds may have delivered decent returns, but not without significant volatility. Looking forward, historically low bond yields and challenging equity markets mean that even the returns achieved in the past look unlikely to be delivered in the future.
To address these challenges, we believe that investors should further diversify their portfolios. In particular, there are, today, a broader array of asset classes available and accessible to investors via UCITS regulated investment structures. Our Diversified Asset team seeks out fundamentally attractive long-term investments across listed equities, private equity, property, infrastructure, high yield bonds, loans, emerging market debt, asset backed securities, alternative risk premia, insurance linked securities, litigation finance, peer-to-peer lending, aircraft leasing, healthcare royalties and other asset classes.
Combining these asset classes in a diversified portfolio results in the attractive returns coming through in a much more consistent fashion than any one asset class in isolation. This approach is very transparent and does not rely on complex derivatives trades or our ability to trade in and out of markets over short-term horizons. This makes the approach easy to understand and robust to differing market conditions.
What are the main risks that you currently appreciate and how could alternative strategies help to mitigate them?
Investors have to contend with both the risk of short-term volatility and also the risk of failing to generate the growth (or income) that they need over the longer-term.
We believe that the right foundation for dealing with both of these is to better diversify the portfolio. As we have seen over the last few years, equity markets can, and do, suffer large drawdowns over short time periods – notably in the summer of 2015 and the start of 2016. By being more diversified, our multi-asset funds have experienced much smaller drawdowns through these periods; as such, they have also been able to compound positively as the markets have recovered.
And talking on risk, we could mention the low rates risk… do you see a bubble in fixed income? And could this bubble burst in some markets? How do you manage this risk in the funds? – Central Banks: what do you expect from Fed? Which will be the next steps of ECB? How do you manage all this issues in your portfolios?
When building our portfolios we make use of sophisticated optimization techniques and other quantitative modelling; but we also believe that it is important to consider the possible future risk scenarios that risk models won’t capture. Most recently we have assessed the possible impact of a North Korea/US conflict, a global pandemic and secular stagnation – as well as a rout in bond markets. While we regard it as a very low probability, there is nonetheless a risk that the US Fed is forced to raise interest rates rapidly over the next 12 months to deal with inflationary pressures and the prospect of a substantial fiscal stimulus. This scenario would see Treasury yields spike higher and equity markets fall. While our multi-asset funds would likely be down in this scenario, we would expect them to provide significant protection relative to a more traditional balanced portfolio.
Often this exercise throws up a call for some portfolio protection (put options, gold, etc) as minds become overly focused on the worst-case scenarios. However we remain of the view that the diversification across the funds should mitigate market falls to a large degree and that portfolio protection strategies are typically not cost effective. The recent reduction in equities is an example of our more preferred route to risk reduction especially when stretched equity valuations make the risk-reward trade-off less attractive. We currently have no exposure to traditional fixed income – either government bonds or investment grade credit.
Brexit: Which risks do you appreciate related to this process? Do you place the portfolios at a specific way in the run-up of Brexit?
At the start of 2016 – ahead of the UK referendum – we modelled a Brexit impact in our scenario analysis. In practice, the diversified and global nature of our portfolios, as well as share class specific currency hedging, meant that Brexit had little impact on our portfolios.
About Multi-Asset spectrum: in which segment do you see more opportunities of returns: in risk assets or in those assets with lesser risk?
Our asset allocation is derived from a longer-term outlook than many multi-asset funds, with a 5 year view of risk and return the main driver of our positioning. The chart below shows our current outlook for various asset classes. It highlights that traditional bonds – investment grade credit and government bonds – offer limited return potential (and, in some scenarios, limited diversification benefit). Equities still offer a premium over risk free assets, but this has narrowed over the last 6 months, notably in the US where valuations looked stretched on a range of measures. As such, we find the most compelling opportunities across a range of diversifying assets. This includes local currency emerging market debt (benefitting from good yields and strong fundamentals); infrastructure investments (which we can access through REIT-like investment trust structures); and asset backed securities.
Taking into account the environment of markets: do you consider necessary to reduce the expectation of returns or is still possible to obtain good returns with an alternative and multi-asset approach?
As can be seen from the chart above, our 5-year view is that traditional assets will under-perform relative to history. However, by being able to diversify the portfolio across a broader array of asset classes, we continue to believe that we can meet our long-term return targets for our funds while maintaining a volatility well below that of equity. Since inception our growth strategy has outperformed its Cash+4.5%pa return target, net of institutional fees, with a volatility of c.4.5%pa. Our ability to access a range of compelling opportunities stems from our ability to identify and access a broad range of asset classes in a liquid form. This is driven by the breadth and depth of resources we have across a range of investment specialisms.
Could you give us some examples of investments you currently hold in the portfolio? I mean some bets on relative value, for instance.
Within social infrastructure we have taken a couple of new positions recent months – adding Bilfinger Berger Global Infrastructure (BBGI) and International Public Partnerships limited (INPP). Both INPP and BBGI provide exposure to a large portfolio of Public Private Partnerships/Private Finance Initiative projects across the UK, continental Europe, Canada, Australia and the USA. These provide attractive, government-backed and largely inflation-linked long-term cash flows.
Within our special opportunities sleeve we have also made a new allocation BioPharma Credit. This holding provides exposure to a diversified portfolio of debt backed by the assets or royalties of biotechnology firms. Benefitting from the premium associated with specialist lending, Pharmakon Advisors are targeting an 8-9%pa return from a portfolio offering significantly different return drivers to other exposures in our Funds.
CC-BY-SA-2.0, FlickrPhoto: Eric Golub
. Why We Are In The Silver Era For Hedge Fund Strategies
Three years ago K2 Advisors, part of Franklin Templeton Investments, launched its first UCITS Liquid Alternatives fund, the Franklin K2 Alternatives Strategies Fund. At the time, some would have argued that the macroeconomic conditions were not favorable for certain hedge-fund strategies. While they haven’t for a number of years, but now this may be changing.
Monetary policy looks to be shifting in some countries, currencies are becoming more volatile and geopolitical risks have intensified of late.
“We think these fundamental elements could drive alpha opportunities for skilled hedge fund managers to capture. Many think that hedge-fund strategies are super-charged and high-octane. We would argue hedge-fund strategies are actually meant to be dull, with low volatility. But hedge-fund strategies can also provide diversification and long-term capital growth potential.” Says Brooks Ritchey, Senior Managing Director, Head of Portfolio Construction, K2 Advisors.
His team believes that low interest rates are often an overlooked factor in regard to hedge-fund strategy performance. Now, as US interest rates are making slow but steady strides upward from historic lows, they think certain hedge-fund strategies may be finding new opportunities to show their mettle.
“If the US Federal Reserve (Fed) continues to raise interest rates this year and next, we think it could cultivate an environment for certain hedge-fund strategies’ to flourish. Rising interest rates have historically been associated with lower cross asset correlations, creating more alpha opportunities for hedge funds,” adds Ritchey.
Additionally, K2 Advisors reminds us that rising interest rates have typically led to future periods of above average alpha, as represented by the Hedge Fund Research Index Fund Weighted Composite Index (HFRIFWI).
The illustration below shows a positive correlation between alpha and interest rates. The average level of alpha rose to the highest level at 14.07% during the measured period, where the US 10-year Treasury yield stood at 7.05%. Based on what we’ve seen in the past, they think hedge-fund managers could have the opportunity to capture that alpha, or outperformance, as US interest rates continue to rise.
For Ritchey, global geopolitical risk is another element that should drive a change in the landscape for hedge-fund strategies. On the back of recent geopolitical tensions, major currency spreads have widened, and historically wider spreads have benefitted hedged strategies’ alpha. “This is particularly noticeable within the Group of Seven (G7) economies, since they coordinate and attempt to manage major exchange rates in a way that leaves their currencies closely linked. As a result, we might not yet be in the golden era for hedge-fund strategies—the most-ideal environment for managers to capture alpha—but we could be approaching the silver era, where favourable opportunities are starting to appear.” He notes.
Allocating Toward Market Themes
Not all hedge strategies will fair equally as conditions change. K2 Advisors expects that the event-driven hedge-fund space, for example, may face headwinds as central banks globally begin to normalize interest rates. Event-driven hedge funds often seek to profit from merger-and-acquisition (M&A) corporate activity, which, in their opinion, could be diminished as interest rates rise. Global macro strategies, however, may benefit from rising rates. The global- macro space has seen an increase in trading volume over the last two months, and the firm anticipates this trend will continue.
“We’ve seen evidence that the current market landscape could become a nurturing environment for certain hedge-fund strategies, but we’re only just at the beginning and believe more opportunities could crop up during this silver era.” He concludes.
Pixabay CC0 Public DomainJosé Antonio Llaneza, courtesy photo. Principal To Acquire MetLife’s Pension Fund Management Business in Mexico
Principal Financial Group has signed an agreement to acquire full ownership of MetLife Afore, MetLife’s pension fund management business in Mexico, subject to regulatory approval. After closing, Principal Afore will be the fifth largest pension provider in Mexico in terms of assets under management.
According to CONSAR, the Mexican regulator, the main differences in their portfolios are that Principal has a larger allocation to equities and structured instruments than Metlife, which favors fixed income.
“As the middle class in emerging markets continues to grow, there is increasing demand for long-term retirement and investing products that enable individuals to retire with the highest pension possible,” said Roberto Walker, president of Principal International in Latin America. “This acquisition strengthens our commitment to Mexico’s pension market.” Giving them “additional scale, a larger distribution network and the capacity to better support its customers in Mexico with innovative advice and customized tools that help them achieve their retirement goals.”
Jose Antonio Llaneza, country head for Principal Mexico, added: “This acquisition demonstrates our continued commitment to invest in Mexico. Our focus remains on providing superior performance and counsel, while helping to educate people on the importance of increasing their contribution rate to their pension accounts.”
The purchase agreement between Principal and MetLife will be reviewed by Mexican regulatory authorities before closing, which is anticipated during the first quarter of 2018.
“The divestiture of MetLife Afore will allow us to enhance our focus on growing our leading insurance business in Mexico, where we are the number one provider of life insurance,” said Oscar Schmidt, executive vice president and head of MetLife’s Latin America region. “We are confident that Principal will provide our Afore clients in Mexico with access to quality resources and capabilities to help them achieve their retirement goals.”
BNP Paribas Securities Corp. and Credit Suisse Securities (USA) LLC served as financial advisors on the transaction to Principal and MetLife, respectively. White & Case LLP served as legal counsel for Principal and Nader, Hayaux y Goebel, S.C. for MetLife.
Pixabay CC0 Public Domain. Is it Possible for Value Investors to Find Opportunities in the Banking Sector?
A lot of fund value investors tend to avoid the banking sector altogether due to a number of reasons: a difficulty in understanding it’s business, the prolonged low interest rate environment, the lack of growth seen in credit, a poor market capitalization and a bad operating earnings trend. Despite these perceptions we are going to prove how an investment idea is possible to find in this sector with some banks that do have clear and sustainable competitive advantages or ‘moats’; especially strengthened in an increasing interest rate environment in the U.S.
Investment idea – Bank of the Ozarks
What would you say if I told you there was a commercial bank that has increased their earnings per share and its total assets by more than 2,000% in the last 20 years? It also boasts the highest quality of assets in the US and we managed to buy its shares below 15x its last twelve month earnings in September 2017?
I discovered Bank of the Ozarks 5 years ago, on a business trip to London while reading the American Bankers Association magazine in J.P. Morgan’s reception. I was so impressed by what I read about the bank that I began doing additional research and also came across its success story in other magazines, like Bank Director. In August this year, Ozarks was awarded for a 5th time in a row and for the 7th time running the number 1 bank in the US.
Bank of the Ozarks is a regional American bank founded in 1903 in Jasper, Arkansas with a market cap of USD 5269 million and 251 offices spread across 9 States in the U.S. Its main business is in loans servicing commercial real-estate development, office construction and other similar projects under the RESG unit or Real Estate Specialty Group. This division represents 80% of its total loan book of $15 billion dollars and is financed entirely from capturing deposits. Until this point it may seem like any other mortgage lending bank but what really makes Bank of the Ozarks an extraordinary bank?
1) Ultraconservative mortgage awarding policies.
The Real Estate Specialty Group (RESG) is made up of an experienced team of 107 employees of which 40 of them are in charge of origination. RESG works in the nonrecourse loans with a higher risk. In case of default, the bank only has collateral on the value of the property and the yield it generates to recover the loan. In exchange, these non-recourse loans are priced at a higher rate than the market.
So what does make Bank of the Ozarks different from other commercial banks?
It’s team of bankers in charge of origination are probably one of the main reasons with George Gleason, CEO since 1979, also heading the team and signing off each of the loans for the past 14 years. The bank is also very selective financing only certain properties and constructions in prime locations catering only to experienced customers with strong a solvency record. They even have the ability to almost transform a nonrecourse loan into one with recourse with their bad-boy carve-outs T&Cs in the event of default. Their experience and track record serve as testament to all these attributes. In the last 14 years, for example, they’ve only experienced losses on 2 loans (in 2009 and 2011) worth up to $ 10 million dollars from a total loan book of $15 billion! On top of this, the bank is always the only borrower in the senior trench of the deal, meaning they’re the least exposed in the capital structure of the loan and the borrower must ALWAYS put forward 50% of capital in advance. Another interesting fact working to the bank’s advantage can be seen in their average Loan to Value and Loan to Cost ratios. In the last few years, Loan to Value has declined to 42% and Loan to Cost to 49% after seeing highs of almost 70% around the time of the credit crunch. In today’s landscape, this could well be the most conservative loan book across the country. In June this year, George Gleason announced that he would dedicate approximately 75% of his time to the RESG division for the next two years, shortly before announcing the departure of Dan Thomas, longstanding RESG Chief Lending Officer.
Lastly, the conservative credit provision policy is clearly reflected in the quality ratios of their assets not only in their most recent filing but also consistently across their recent reporting history. As of 30th September 2017:
Allowance for LLS as % T.Loans = 0,55%
Non-performing loans as % T.Loans = 0,11%
Allowance for LLS as % NPLs = 650%
Loans and Leases past due 30days = 0,12%
Net charge-off = 0,09%
2) Seeking opportunity in its loan provision strategy for Commercial Real Estate and Construction – The Arkansas-based bank has only gone after niche markets that have experimented recent problems or difficulties where supply and demand is unbalanced. They therefore come against very few competitors in real estate lending projects ranging from condos, offices and hotels. Their most notable success can be seen in New York City where the bank has been capable of growing their volume of transactions very quickly from 2012, making it account for roughly 20% of the bank’s total loan book. This strategy has lead Ozarks to see a higher than market credit yield, as their interest margin increases at a faster pace than competition. Even the CEO himself defines their strategy the following way:
“What we have tried to do is sort of ignore the headlines to a great extent, I mean certainly you to have to take larger macroeconomic and market themes into account. But we have really tried to not let that drive our decisions, but instead to look at the supply demand metrics of each sub-market market and macro market and the relative competitive position of each product in the market and do a much deeper level of analysis on projects”.
3) Strong growth in Real Estate lending volumes.
Gleason expects to double the RESG business in the next 3 to 4 years and twofold in the following 7 to 8 years. It’s ambitions cover not only commercial real estate but also the expansion of other sectors including marine, SMEs and leasing. Their ambition is supported by their strong organic growth in a sector that is unlikely to grow organically.
In addition to this, there is also a strong inorganic component behind it’s success, after completing over 15 transactions from 2010. Each transaction has been accretive during the 1st year not only in terms of tangible value per share but also in their earnings per share.
The most interesting aspect of their organic and inorganic growth has been their unbeatable efficiency margin close to 30%, unseen in any other competitor, neither in the U.S. nor in Europe.
4) George Gleason, Bank of the Ozarks’ Chief Executive Officer (CEO). Management’s commitment and aligned interest to the company’s performance is exemplified in it’s CEO history. He bought a controlling stake in the bank in 1979 at a time when the total number of employees was 12, assets were $28 million and he was only 25 years of age. In 2003, he set up the RESG division with Dan Thomas commanding the team. Since 2010, Ozarks has completed 15 acquisitions becoming the largest bank in Arkansas and never allocate more than 50% of total purchase price to goodwill. Any investor, who would have co-invested with Gleason in the 1979 IPO, would have obtained a compound annual return of 22% including dividends when the average competitor has only seen a 4% return and the S&P 400 Mid Cap, a 10%. George harnessed his parents experience and began working at the early age of 5, when he was already in charge of set tasks within his father different businesses. Once he joined the bank, he founded and fostered a culture to motivate employees on a continual path of year-on-year performance, making sure they always felt were part of the company and also carried a sense of holding a stake in it. During this time and until today, George has managed to grow the profit in compound interest towards 19%, with a total return over its own funds and efficiency at the top of the sector.
Then why has its share price dropped by almost 30% from March’s all-time highs? There are 2 reasons behind this:
1) Muddy Waters Capital’s Short Selling note and skepticism over it’s Commercial Real Estate line of business. Muddy expressed concerned over the banks provision for loan losses, assuming it did not have enough cash to cover itself in the event of rising non-performing loans. It also believed it’s total off-balance sheet liabilities were becoming unsustainably high.
Answer 1) the provisions calculated by any bank are based on the quality of its assets. In Ozarks’ case, we are talking about one of the most high quality loan books, made evident by only experiencing losses on 2 of their transactions during the recent credit crunch. It’s average LTC and LTV of are healthily positioned at around 45%. What this means is that if a borrower would like to apply for a $100 million dollar credit, Ozarks
Answer 2) Even though the off-balance sheet liabilities add up to $11 billion dollars, mainly from their RESG side of business, most of these loans are senior, meaning Ozarks would be the last to provide funding for credit but the first to receive any repayment. The bank also demands collateral against the loan worth up to 2x the value of the credit. Tim Hicks, Chief Administrative Officer, showed no qualms when openly admitting that 92% of loan applications it receives are surprisingly rejected!
2) Dan Thomas quits as Chief Lending Officer of Ozarks’ RESG division. On the 28th July, Dan Thomas suddenly announced his departure from the firm forcing the share price into a sharp 12% decline.
Answer 3) Even though the longstanding Chief didn’t reveal his true motives behind leaving the company and despite the fact he was one of the masterminds behind the growth and the bank’s spectacular track record during his tenure, it may seem that George Gleason’s earlier decision and public announcement to commit a larger part of his time to overseeing the day to day operations of the RESG unit was not well-received by Dan. Despite these changes in senior management, we still believe the RESG unit is staffed with experienced, independent and long-serving employees equally capable of continuing on with the business alongside the CEO. For us, it would be far more worrying if we were to see the CEO suddenly leave. And how much have we paid for this extraordinary franchise? The average price paid was $43 per share and approximately 14-15x it last twelve month earnings. We estimate its intrinsic value at $66 per share, after applying a 21x price to earnings multiple for the next twelve months against a 15,5x observed multiple for the sector in the US.
And how much have we paid for this extraordinary franchise?
The average price paid was $43 per share and approximately 14-15x it last twelve month earnings. We estimate its intrinsic value at $66 per share, after applying a 21x price to earnings multiple for the next twelve months against a 15,5x observed multiple for the sector in the US.
As of today, we see a low probability in there being a recession in the US economy (at least within the next quarters) but despite this we would still apply a conservative approach and calculate an intrinsic value assuming that scenario were to take place. The resulting intrinsic value would therefore be $35 per share, placing it 18% lower than our average price paid. If it does happen to reach these levels, we would seek to increase are holding in this company. As a reminder, it is important to not only buy extraordinary companies but also not making a mistake in overpaying for them. Coca-Cola’s case in 1998 should serve as a reminder.
Appendix: Ratio definitions and quality of assets chart.
Allowance for LLS as % T.Loans are the provisions made to face any future losses.
Non-performing loans as % T.Loans are the unpaid loans with more than 90 overdue, where neither capital nor interest is paid off.
Allowance for LLS as % NPLs is the coverage ratio.
Net charge-off is the total unpaid debt by the company minus any recovered payments.
Pixabay CC0 Public DomainPhoto: stevepb. The Case For Fixed Income In The Core Of A Portfolio, Despite Low Rates
Bonds have long played an essential role as a foundational holding at the core of investors’ portfolios. Bonds and bond ETFs have the potential to offer income and stable returns that can offset volatility from a portfolio’s stocks.
But, in recent years, investors have struggled to achieve their investment goals amid low bond yields, especially from government bonds. The main cause? In response to the 2008 financial crisis, the U.S. Federal Reserve (and other central banks around the world) slashed interest rates to encourage economic growth.
While the Fed has since started to raise interest rates, they are still below historical averages. A low yield environment could be with us for some time because of several factors, including demographics (aging baby boomers have greater demand for bonds, potentially keeping interest rates low).
Beyond providing income potential it is important to emphasize that bonds and bond ETFs can play multiple roles in a portfolio.
These roles may include:
Recurring Income Stream No matter if an investor is looking to grow wealth or save for retirement, generating income in a portfolio can help get an individual closer to reaching an investment goal. Investors can receive interest payments at a regular cadence, typically monthly, quarterly or annually, potentially providing stable income and strengthening total return in their portfolio.
Stability of Principal In addition to receiving an income stream, bond investors receive the bond’s principal at maturity, assuming the bond is held to maturity and does not default. Repayment of the bond’s principal (a fixed amount) at a fixed time helps provide an investor with stability in their portfolio.
Potential hedge against risk Bonds and bond ETFs can offer a potential hedge against increased equity market volatility. Historically, bonds have been more likely to move in the opposite direction to stocks. For example, fixed income investors have increased their allocations to U.S. Treasuries during equity market sell-offs as a potential safe haven investment.1
Despite challenges that bond and bond ETF investors may face with yield and income in the short term, it is important to remember that fixed income investments can play a vital role as a foundational, long term holding, at the core of a portfolio.
While there are similarities between bonds and bond ETFs, there are also differences between the two investments. Investors should be diligent when researching the best investment vehicles for their portfolios. For example, individual bonds have set maturity dates while traditional bond ETFs do not. Bonds and bond ETFs may have different distribution schedules, despite tracking the same asset class, this may result in different income streams for investors. Individual bonds trade over-the-counter while bond ETFs trade on an exchange. Additionally, bonds and bond ETFs may create different tax liabilities and therefore investors may be subject to a variety of federal, local and/or capital gains taxes. Cost of ownership is another area where individual bonds and bond ETFs differ, bond investors may face a transaction and brokerage cost at the time of purchase whereas a bond ETF investor will likely pay both an expense ratio and transaction cost.
Get started building the core or your portfolio in Spain or LatAm.
Pixabay CC0 Public DomainShutterstock. Argentina: 116/583
Regularization / situation correction / normalization / tax pardon / repatriation / externalization of assets / fiscal disclosure / amnesty. Different names that mean essentially the same thing.
This is not an issue relating solely to Latin America. In the past, countries like Australia, Belgium, Colombia, Ecuador, Spain, the Philippines, France, Honduras, India, Ireland, Italy and Panama have implemented some kind of tax pardon/ amnesty program. Other countries, such as Denmark, Finland, Greece, Mexico, New Zealand, Norway, Peru, Portugal and Sweden, at one time or another, have also instituted relief schemes to normalize fiscal conditions.
Argentina concluded its own asset amnesty program in late 2016. Of a GDP of $583 billion, $116 billion worth of assets have been disclosed. The amnesty means an increase of approximately 12% of GDP to the economy’s tax base.
In the last 60 years, the country has sanctioned and carried out 20 of these amnesty programs with differing results. It is worth pointing out that they were all “for one time only”.
For many years, some citizens have sought a safe-haven for their capital abroad due to political, financial or security reasons. The results of this diversification, particularly in developing countries, could negatively impact the economy and increase the cost of private and sovereign financing. The effects of reduced tax collections are generally compensated by an increased tax burden with possible consequences for the country’s economic development.
I believe this repatriation of capital will have short, medium and long-term impacts. For now, the effects are unseen by most but they will become much more obvious in 2017 and beyond.
The immediate effects include: reduced debt cost, increased tax revenue, tax deficit reduction and possible credit risk improvements not only for the sovereign but also for private entities that need to access the local credit market and markets in stronger currencies than the peso. With this multitude of potential investments, building a capital market that allows financing in the local currency will be easier.
To be eligible for amnesty / repatriation, individuals must not only pay a special tax but they must also make payments on earnings from what they have declared so far. For example, 35% on earnings generated by their investments (excluding certain Argentinian assets, Brazilian and Bolivian sovereign debt). The way to avoid this cost is to have a portfolio invested in Argentinian bonds or sovereign bonds from the countries mentioned above or Argentinian provincial bonds that are also exempt.
In any case, there are side effects. For example, Argentinian bond portfolios are over exposed to local debt issuances making the portfolios undiversified.
In fairness, this success has been achieved in the midst of severe restrictions on non-declared assets abroad, with a local government managing to generate investor confidence, multiple business opportunities in Argentina and very low portfolio returns internationally (let’s recall that $8 trillion worth of bonds are operating at negative rates).
The challenge we are facing is to get these portfolios to a level of diversification and return that brings peace of mind to our clients and bankers.
Foto cedidaRichard Halle, courtesy photo. M&G: "The Valuation Gap Currently Between Value and Growth Stocks is Almost as Wide as it Has Ever Been"
Richard Halle, portfolio manager of the M&G European Strategic Value Fund believes that the context is favorable for value investing in equities. In his interview with Funds Society, he explains that the economic recovery environment in Europe, together with the reduction of political and macroeconomic uncertainty and the increase in interest rates, should turn the situation and prove beneficial to this style of investment.
What are the main arguments in favour of investing in European equities?
European equities look attractively valued, in our view, both in absolute and relative terms, particularly compared to US stocks. In addition, European companies should benefit from the region’s economic recovery which should support earnings growth. Economic growth has picked up, unemployment rates have fallen across the eurozone and inflation has started to rise. The European Central Bank has arguably provided the necessary support to revive the eurozone and investors are now focusing on how the stimulus measures will be withdrawn.
You apply a value investing approach…how easy (or hard) is it to find undervalued companies in Europe?
While the overall market has risen this year, we think there are still plenty of opportunities for selective value investors. In our view, value stocks are attractively valued on both a relative and absolute basis.
Value as a style has been out of favour for several years as investors have favoured growth stocks with reliable earnings and ‘bond proxies’ offering steady income payments. The value recovery in 2016 proved to be short-lived and investors have preferred growth stocks this year. As a result of this prolonged underperformance, the valuation gap currently between value and growth stocks is almost as wide as it has ever been. If this gap were to narrow we think the potential rewards could be significant.
More recently, we have been finding value opportunities right across the market, rather than concentrated in particular sectors.
Is it necessary to hold cash in case better opportunities arise?
As value investors who are looking for mispriced opportunities to arise we tend to have a slightly elevated level of cash in the portfolio. This is so we are able to take advantage of short-term volatility and mispriced stocks.
What is the potential upside of your current portfolio? With the recent stock market rally…has this figure decreased?
We think there are plenty of stocks in the portfolio whose prospects are being significantly undervalued. While a number of our cyclical holdings have performed well recently as investors have become more optimistic about the outlook for the European economy, we continue to believe that the portfolio still has several cheap stocks that are being mispriced. In terms of valuation, the fund is trading at a significant discount to the MSCI Europe Index (on both price to book and price to earnings metrics).
Are you expecting a market correction in the medium or long term that could benefit your strategy?
In recent years, value has underperformed as investors have sought defensive ‘bond proxies’ amid uncertainty, volatility and ultra-low rates. Looking ahead, we believe the continued recovery in Europe, a reduction in uncertainty (both political and macro) and rising interest rates should be beneficial for a value approach.
How do you harness volatility episodes in your management strategy, such as the recent French elections of the future elections in Germany?
As long-term investors, we see uncertainty and the volatility it can generate as a source of opportunity rather than something to be feared. When sentiment rather than fundamentals drives markets, stocks can often become mispriced. As long-term bottom-up stockpickers we would try to take advantage of any valuation opportunities that present themselves in these situations.
Sectors and names: how are you positioning your fund now? Which sectors are you overweighting and why?
The fund’s sector allocation is an outcome of our bottom-up stock selection process rather than top-down views. Nor do we take high-conviction positions in individual stocks. The fund is limited to a 3% weight in stocks relative to the MSCI Europe Index. As a value fund, the value style is expected to be the main driver of fund performance rather than bets on particular stocks or sectors.
Having said that, we have been focusing lately on finding attractively valued opportunities that could benefit from the European recovery. We have been adding to a number of our more cyclical holdings, including Bilfinger, a German engineering and construction company, and Randstad, a Dutch recruitment firm. We have also invested in Wereldhave, a Dutch real estate company that invests in shopping centres.
At the sector level we have overweights in consumer discretionary, industrials and energy. In contrast, we have underweights in consumer staples (an area that we believe is expensive as investors have sought the perceived safety of defensives in recent years), financials and materials.
Even though we have a below-index position in materials, we have been adding to our holdings in stainless steel makers Aperam and Outokumpu, which we believe have attractive prospects given potential demand for steel.
Banking sector: many fund managers are staying on the sidelines. Are you following the same strategy or not? Why?
We have an underweight in financials which is due to an underweight in insurers – we think the current environment is difficult for them to grow their earnings.
However, we have been investing in individual banking stocks lately. For instance we have a holding in Bank of Ireland, which we believe is well positioned to benefit from the improving economic situation in Ireland. Another recent purchase holding is Erste Bank, Austria’s largest bank by market value. In our view, Erste Bank has strengthened its balance sheet recently and is arguably now well placed to benefit from stronger economic growth in Europe.
