Northern Rock: business booming for the wrong reasons
I have few skills, but possibly my best has been to act as an early warning radar for bank implosions. This ability to sniff out disaster arose, I think, for two reasons. The first was from witnessing so many collapses at first hand: Hong Kong's entire banking system in the 1980s; America's Savings and Loans companies; the Asian bank crash of 1997 (before which I personally called any client placing large bank buy orders and urged them to reconsider); then the crash of 2008. By June 2007, no client of mine held a bank share and nor have I since.
Secondly, I attribute this ability to asking tangential questions rather than focusing on ratios. For example: is the chief executive a proto-Napoleon bent on world dominion, such as Fred Goodwin at RBS? Is the board dominated by family or a cabal? With few exceptions, such as the tiny C. Hoare & Co, family control over generations leads to ignorance, a clash of interest, or secrecy. Is growth too high? Northern Rock's net profits rose 47% in the year before its bankruptcy. Is management in denial, or does it understand its business and funding needs?
Standard Chartered has long been in this camp, as its recent two for seven rights issue at £4.65 demonstrated (too little, too late). Is there government involvement, be it direct ownership or appointing allies? This is a major red flag. Exemplars include all China's banks, France's Societe Generale and Singapore's DBS Group. In the last decade, Soc Gen's share price is down over 60%. DBS is flat, although in some ways this is worse, given the underlying economy's growth.
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We're currently in a global bank mini crash with falls of a "mere" 20% or so, and in several countries the falls will worsen before any recovery. But unlike previous cycles, many of the standard problems excessive leverage, over-lending to property and huge bets being made with the banks' own capital are absent. And there are some real positives too. Capital buffers are not as strong as professed, but better than for 20 years. And several banks once seen as "Masters of the Universe" have shrunk high-risk operations, reduced leverage, slashed their betting books (AKA proprietary trading) and sold non-core businesses.
These changes are so revolutionary that, for the first time since 2007, I want to invest in banks. I think we are approaching what in 1997 was dubbed the "Jakarta moment" in the emerging-markets crash when both the currency and stockmarket had collapsed by 90%. Awesome profits were made in the next 12 months from the rapid turnaround. Using both standard ratios and the tangential approach, I plan to buy the five banks listed below in three tranches from early April (the current bounce reeks of the dead-cat variety). At the core of every economy there must be sound, dull and profitable banks these five are a glimpse of the future.
My third choice is Bank of Ireland (Dublin: BIR), one-time cheerleader for Ireland's paper tiger economy. Bankruptcy and regulators have enforced real changes so efficiently that Bank of Ireland is now repaying its last tranche of government bail-out money. The valuations of all three of these stocks are low by most measures, and on single-digit multiples for 2017. Each should return to paying dividends and enjoy modest growth this is not currently in their share prices.
Elsewhere in Europe most banks in Mediterranean countries will survive, but in many cases equity investors will be diluted or destroyed as necessary restructuring is finally enforced (as James's diagnosis suggests). France's state-directed banks fail every tangential test and nor am I keen on Deutsche Bank.
Yet German number two, Commerzbank (Frankfurt: CBK), an RBS-like case study in hubris and overreach, has worked its way out of the government's €18bn bail-out and is now refreshingly dull and domestic. It has even just re-absorbed its "bad bank", which is becoming profitable, and the 2.7% dividend should rise.
My final bet is another dull bank with a reputation for actually serving customers' needs, especially in the UK. This is Sweden's Svenska Handelsbanken (Stockholm: SHBA). All Sweden's banks went bust in 1992 on sub-prime mortgages. Ever since, folk memory and tight domestic regulations have ensured deep conservatism. The 4.1% yield is a useful bonus.
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