Our new value investor columnist takes issue with the outspoken Fundsmith chief.
Terry Smith doesn’t like banks and his recent opinion piece in the Financial Times explained why. You can read it here on his own website without a paywall.
On occasion, the Fundsmith chief has been referred to as Britain’s Warren Buffett – except the real Buffett really likes banks.
Buffett’s taste for banks is hardly surprising given that his Berkshire Hathaway vehicle has done well out of the sector over the decades.
It reportedly doubled its money on Salomon Brothers in the late nineties, made more than $5.5bn on its Goldman Sachs positions initiated during the 2011 European banking crisis and has a $14bn unrealised gain on Bank of America. He bought BofA during the global financial crisis and it’s currently the fund’s second-largest position after Apple.
Berkshire’s latest 13F filing also revealed holdings in Citigroup, Bank of New York Mellon and US Bancorp and it has owned and sold Wells Fargo and JP Morgan since 2019.
Since part of the Berkshire Hathaway success story is also rooted in insurance, he’s clearly not frightened of leveraged financial companies, knowing all too well that equity is a ‘thin sliver of hope between assets and liabilities’.
Who’s right?
In my previous job at Orbis, I was hired by the late, great Simon Marais, a wonderful man and phenomenal investor with the sharpest of minds and exceptional clarity of thought.
Like Warren Buffett, he could explain things in a simple folksy way, once saying to me, ‘Some investors don’t like banks, yet some of the oldest businesses in the world are banks’ – take note all portfolio managers who like to include data about the average founding year of holdings on their fact sheets.
But Simon’s point is absolutely valid – Barclays was founded in 1690, Lloyds in 1765, JP Morgan in 1799 and Goldman Sachs in 1869.
I could go on, but when you think that all these leveraged institutions have survived a few wars, a couple of pandemics, multiple recessions and a gaggle of black swans, has this business model not stood the test of time? Are they really such bad businesses?
Well, the answer is, of course ‘yes’ – if they are badly managed and fail to control risk, as Credit Suisse, founded in 1856, reminds us.
But – if they are conservatively managed and ruthlessly control risk, they can be very good businesses. Long-term loans offer fantastic annuity income and earnings visibility, customers are sticky (when did you last change banks?), mortgages get first dibs at most peoples’ salaries and technology is lowering costs.
Bad apples everywhere
Let’s also not forget that while failing banks and photos of stressed-out bankers make very good front-page news, badly managed businesses with lots of leverage fail in every part of the investment universe – not just banking.
Here are a few examples:
- Retail: Kmart ‘checked out’ while Walmart grew.
- Real estate: General Growth Properties ‘crumbled’ but Simon Property Group didn’t.
- Airlines: well-known names are constantly ‘crashing’ yet Ryanair keeps ‘soaring’.
- Beauty: Revlon ‘wiped out’ while L’Oréal ‘glowed’.
Birds of a feather
What were the key factors in all those companies failing?
In all these examples, it was bad balance sheets and bad management who failed to make sensible decisions in the long-term interests of the business.
Unfortunately, that’s all too common these days, especially in the US where shareholders want results at quarterly intervals forcing management to make short-term decisions.
Banks have undoubtedly been very tough businesses during the years of QE, but that’s hardly surprising when the selling price of their product (interest rates) was low and went negative in Europe.
Yet, despite this, conservatively managed, retail-focused European banks with the right culture survived and grew book value modestly. Some even paid dividends when the regulators permitted.
More importantly, those low interest margin days are now over, leaving banks in a position to grow earnings faster than many other industries.
Let’s also not convince ourselves that the QE-primed period from 2008–2020 was normal. It was an aberration in time and many companies and funds that excelled during this period have struggled in the more recent (and historically normal) times of higher inflation and interest rates.
Those artificially low yields drove up the share prices of ‘bond proxies’ upon which the track records of many popular funds today have been built.
Of course, some portfolio managers will try to convince you that those share prices rose because, they’re ‘great businesses’, when in truth many were simply attractive because they offered higher dividend yields than bond yields. No longer.
A gamble on greatness?
Is consumer goods giant Procter & Gamble (P&G) (owned by Terry Smith) a wonderful, ‘high-quality’ company because it almost doubled its return on equity (RoE) since 2012 to 32%? No, I don’t think so – it did that by shrinking its equity base by $20bn through stock buybacks. In reality, it only grew pre-tax income at a compound rate of 1.5% over the past 10 years.
Do I fancy P&G today at 25 earnings? No thanks.
That RoE is 32% because it earned $15bn off an equity base of $47bn. But if you took P&G private at today’s market price, it would cost you $346bn.
This would be your equity base (7.5x shareholders’ equity), meaning your RoE would only be 4% (15/346). That’s what happens when you buy ‘great businesses ’ at high prices; you get low returns.
Conversely, French bank BNP Paribas (which I own) has grown pre-tax income by 2.7% a year over that period – hardly exciting but double P&G’s return.
However, higher interest rates are now accelerating that growth rate and most importantly, you’re only paying 6x earnings. The bank earned an RoE of 9% last year. Buying the company at 0.6x book value means my RoE is 15% – 9/0.6.
Unsurprisingly I’d bet on BNP out-performing P&G from here.
Mr Smith also said, ‘The total return on S&P banks sector over the past five years was -15% per year.’ I’m unsure of his data source because Bloomberg tells me the total return for the S&P500 Banks sector is -1.9% a year (to 17 March).
However, choose three years – arguably more relevant in today’s economic environment of higher inflation and interest rates – and the total return is 11.9% a year. I far prefer European banks and their three-year total return is 16.5% a year, even after last week’s tumult!
What’s the answer?
It’s horses for courses – but please don’t think there is only one way of generating returns, especially in a world that has changed so dramatically over the past three years.
Just remember that as with most investment decisions, timing is key – good businesses bought at a great valuation can be fantastic investments. Buffett has repeatedly shown us that.
And conversely, great businesses bought at high valuations can also be very disappointing investments. The underperformance of the highly favoured US ‘Nifty Fifty’ in the early 1970s is an excellent example of that.
What was the catalyst for their underperformance back then? High inflation and a recession…
Price matters.