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Great year in the markets-so far

October 3rd, 2012

Appearing on BNN’s Market Call earlier this week meant I needed to check up on how various indices have been performing year-to-date to put the performance of the stocks being discussed into context. Would you believe that as of the end of the third quarter, 2012, the S&P 500 was up 15.4% year-to-date, the MSCI Emerging Markets Index up 10%, the MSCI EAFE Index up 8.2% and the TSX 60 Index up 4.2%? In other words, all the major stock  indices are up between 4% and 15%, against the DEX Bond Index, up a mere 1.2%, yet it is the latter and its US, German, Japanese and UK counterparts that have been receiving steady inflows of investor money, most of it coming out of equity funds.

Over the last year, the contrast is less extreme, with the DEX providing a return of 6.05% againt 6.7% for the TSX 60, 12.1% for the MSCI EAFE Index, 18.9% for MSCI Emerging Markets Index and a remarkable 27.8% for the S&P 500. Yet the relative attractiveness of the two asset classes is clearly tilted in favour of equities, either on the basis of income, where the S&P  500 yields 1.9% and the TSX60 2.7% against approximately 1.7% for the 10 year bond in both countries , or on the earnings yield. This is the inverse of the P/E ratio, and is used to determine the relative attractiveness of equities against bonds, ignoring how much of the earnings are paid out as dividends. The ratio of the 10 year bond yield minus the earnings yield of the S&P 500 is nearly one standard deviation above its 90 year average, making stocks as cheap relative to Treasury bonds as they have been in 35 years.

At a time when the average retail investor has been forced by government and central bank actions to accept yields on supposedly risk free government bonds that are the lowest in 60 years, it seems counter-intuitive that they are unwilling to purchase companies with sound balance sheets that pay dividend yields that are higher than bonds yields in absolute terms. When one adds in the tax benefits of dividends as opposed to interest, and the ability of companies to keep their payouts stable or rising in real terms as they are able to increase dividends, the unwillingness to buy shares becomes all the more remarkable.

More Canadian Bank Dividend Increases

September 18th, 2012

After a summer spent in the UK, it seems only appropriate that my first post after returning to Canada should echo my last one, namely to note further dividend increases by the Canadian banks. Furthermore, amongst those raising their payouts was Bank of Montreal (BMO-T;BMO-N) which had been the only one of the Big Six banks (RBC, TD, Scotiabank, BMO, CIBC and National Bank) not to have raised its payout since the Financial Crisis of 2008-09. In fact, BMO had not raised its dividend in 5 years, the longest period since the early 1980s, although its U$4  billion acquisition last year of US bank Marshall & Ilsley, the largest bank in Wisconsin, which effectively doubled the size of its US operations, had meant that it had considered issuing a large number of shares, giving it an excuse not to follow the example of its rivals.

TD led the way, raising its dividend 7%, followed by RBC with a 5.3% increase, CIBC with 4.4%, Scotia with 3.6% and BMO, whose 2 cent increase to $0.72 a quarter represented a 3% increase. The only one of the Big Six not to increase its dividend this quarter was National Bank, but that was because it had increased its dividend 5% the previous quarter. Between them, the Big Six banks made net profit of $8.3 billion in the quarter ending on 31st July, although that did include a large one-off profit of $614 million for Scotia, which had sold its Scotia Plaza headquarters building in Toronto. Canadian banks continue to be amongst the most profitable and soundest financial sector companies in the world, helped by the effective oligopoly they enjoy in Canada, reinforced this quarter by Scotia’s purchase of ING Canada, the eighth largest bank in Canada with 1.8 million customers and $30 billion in retail deposits for $3.1 billion ( a net $1.9 billion). Its Dutch parent was required to sell-off the 15 year old business, which had used its direct business model with no physical branches and higher deposit rates to attract almost 6% of the Canadian population who were dissatisfied with the conventional banks, as a condition of the financial aid it had received from the Dutch government during the financial crisis.

Having completed the acquisition of $24 billion of assets between 2009 and 2011, Scotia’s purchase may mark the start of another buying spree by the cash rich Canadian banks. Last year CIBC bought 41% of the American Century asset management business with U$112 billion in assets under management for $848 million, and other banks are looking at expanding their asset management arms, which do not require much, if anything, in the way of scarce bank capital, and provide steady fee based income, with RBC having bought PH&N in Canada in 2009 and Blue Bay in the UK for $1.6 billion in 2010 and Scotia having bought Dundee Wealth Management for $2.3 billion last year.

RBC is by far the best performer amongst the banks over the last year, up 21% on its disposal of its loss-making US retail operations, while TD is up 11%. The other banks are up less than 10%, led by National up 6.8%, Scotia (+3%) and CIBC (+1.8%), with BMO, probably due to its failure to raise its dividend actually down -0.4%. Based on the principle that I mentioned in my last post, that given the similarity of their businesses one should sell the best performer and buy the worst performer amongst the banks over the last year, it seems probable that BMO could be an out performer over the next few months, especially now it’s finally raised its dividend.

While

Canadian Banks Keep Raising Dividends

March 13th, 2012

After a further gap in postings due to the family medical issues I had mentioned, which now happily seem to be resolving themselves, it’s appropriate the first post in a couple of months should be about Canadian banks raising their dividends. It’s a theme that I touched on last year, when five of the Big Six banks raised their payouts, the one exception being my former employer, Bank of Montreal (BMO-T, BMO-N). In 2011, Bank of Nova Scotia (BNS-T, BNS-N) raised its dividend by 6.1%, CIBC (CM-T, CM-N) by 3.4%, National Bank (NA-T) twice by 7.5% and 5.6%, RBC (RY-T, RY-N) by 8% and TD (TD-T,TD-N) by 3%. The principal reason for BMO not raising its dividend was the U$5.7 billion acquisition of Marshall & Ilsley bank in mid 2011, which doubled the size of its US operation but also saw it issuing $4 billion worth of equity. Its dividend was also has one of the highest amongst its peers as a percentage of its earnings (the payout ratio) at 52.2% against payout ratios in the low 40% range for its rivals.

When Canadian banks reported their first quarter earnings for the period ending January 31st, 2012, several of them raised their dividends again. Both RBC and TD increased their payouts by 6%, and Scotiabank by 5.8%. Neither CIBC, which has the highest payout ratio after BMO at 49.5% nor the two smaller banks, Canadian Western (CWB-T) and Laurentian Bank (LB-T)  increased their dividends this quarter. The latter pair had however, already raised  their dividends twice each over the last year, by 15% and 25% respectively.

This leaves Canada’s Big Six banks, recently ranked amongst the top twenty five most creditworthy in the world by Global Finance magazine, all yielding more than 3.5%. TD has the lowest yield at 3.5%, followed by National at 3.8%, RBC at 4% and Scotiabank at 4.1%. It is noteworthy that the two highest yielding banks, BMO and CIBC,both of which yield 4.8%, are the two which have either not raised their dividend or raised it only once and by the smallest amount.The willingness of bank managements to raise their dividends reflects their confidence in their capital ratios and the outlook for the Canadian housing market, which remains their largest exposure.

The Canadian banks remain the most attractive in the OECD, in terms of outlook and the ability to continue raising their distrbutions to shareholders, which were not reduced during the financial crisis. Their only rivals in this respect are the Australian banks, which are over exposed to an inflated housing market and a slowing commodity sector. Within the  Canadian banks, a good rule of thumb has been to purchase the banks which have underperformed over the previous twelve months, as despite different exposures to the various sectors, all of them are primarily influenced by the domestic Canadian market. Therefore, investors selling those which have out-performed and buying those which have lagged have tended to add between 1-2% p.a. to the performance of the sector. This would suggest adding to CIBC and Scotiabank, off 9% and 6.6% over the last year, and reducing TD, down only 1.3% and National, up 6%. Another approach would be to buy the BMO Equal Weight Bank ETF (ZEB-T), which holds the Big Six banks in equal weights, and re-balances its positions periodically to maintain them at equal weights, thus mechanically carrying out the approach suggested above.

The Year The Music Stopped

December 23rd, 2011

As is customary at this time of year, it seems appropriate to look back at how markets have performed and to make some predictions about the outlook for next year, 2012. However, before launching into any detailed analysis, I believe the most important development in the last year was a change in investors’ attitudes towards some of the basic assumptions that have underpinned investing over the last half century or more.

By this I mean the loss of faith in developed countries’ government bonds as the “risk free” asset class against which other investments should be measured, as well as the crumbling of belief in fiat (paper) currencies. Since the end of the Second World War, no developed country has defaulted on its bonds, or reduced the interest rate it paid. this contrasts sharply with the inter-war period, when defaults and cuts in coupons were commonplace, and with emerging markets. Yet after the last eighteen months, there are few observers who do not now expect other countries to follow in the footsteps of Greece, which imposed a “voluntary” 50% haircut on its private sector bondholders as part of the second bailout package announced in November. Furthermore, because the haircut was supposedly voluntary, the insurance against such an event which bondholders had purchased in the form of Credit Default swaps (CDS), was not triggered!

The inevitable result of such an attempt to circumvent the market was a flight by bondholders out of the sovereign debt of other countries in the PIIGS (Portugal, Ireland, Italy, Greece and Spain) group whom investors suspected of following Greece’s example. Portugal and Ireland had required bailouts in 2010-11 when their 10 year bond yields rose above 7% as Greece’s had done in May 2010, and by early December, Italy and Spain had both seen their 10 years yields also exceed the vital 7% level. While heavy bond buying by the European Central Bank has brought yields back below 7%, and the recent announcement by the ECB of a 3 year Long Term Repurchase arrangement which lets Euro-zone banks borrow unlimited amounts at 1% provides support to the banking system, the underlying systemic problem remains.

When the US Federal Reserve and the bank of England (BoE) undertook similar arrangements in 2008-09, it allowed their banks to borrow at very low rates (at or below 1%) and invest the borrowings in longer-dated government bonds paying 2%, 3% or even 5%. Riding the yield curve like this, while using 10-15 times leverage is a licence to print money and recapitalized the US and UK banking systems. unfortunately, the ECB rapidly began to reduce the amount of cheap funding it was supplying, which in turn led directly to the original Greek debt crisis in may last year. Ironically, now that the ECB under its new President Mario Draghi has shown itself willing to follow in the footsteps of the Fed and BoE, Euro-zone banks are too afraid to do so, as they are not certain that the government bonds they invest in will repay them in full. Domestic investors in Italian or Spanish bonds, for the first time in over half a century,  face the prospect of suffering capital losses on government debt, as domestic Greek investors already have experienced.

Along with the realization that developed government bonds can default has come an awareness that currency unions can break up if they are not backed by a fiscal union with the power to raise taxes or issue bonds backed by all countries in the currency bloc. The belief held by investors over the last decade that Greek, Portugese, Spanish and Italian bonds were only marginally more risky than German bunds has disappeared, and brought the realization that a currecny union does not remove currency risk. Why this should have come as a surprise is an interesting question. less than 20 years ago, Italy and the UK were forced out of the predecessor to the Euro, the ERM, leaving investors with 30%+ losses in DM or U$ terms.

As a result, investors in 2011 have experienced losses of more than 15% in European markets such as the German DAX and the French CAC-40, before taking the weakness of the Euro against other currencies into account. Even European countries not in the Euro-zone such as the UK have lost 5% and Japan is down almost 20%, while resource dependent Canada is off more than 10% too. Emerging markets didn’t fare any better, with the BRIC (Brazil Russia India & China) countries all down more than 20% except for Russia and commodity indexes were affected by slower growth, falling around 5%. The best performing major market is the US, which is effectively flat on the year, helped by the resilience of the global multi-nationals, with the Dow Jones Industrials up 8%.

Yet bond indexes were all up sharply, with the exception of the economically sensitive high yield and emerging markets sectors. Despite starting the year with 10 year government bond yields at 3-4%, most bond indexes produced a total return of 10% or more, with investment grade corporates lagging at 7-8% and governments outside of the Euro-zone returning investors 12-14%. German bunds were the only Euro-zone bond market to achieve a similar return as they were viewed as a safe haven, along with UK gilts, and US Treasurys, both selling at yields that had not been seen for over 60 years by the end of 2011.

It seems reasonable to expect that this pattern will not be repeated in 2012. Bond yields are now so low in developed countries regarded as not at riak of default that any increase in grwoth or inflation should lead to falls in price that will more than offset the very low absolute yields now available. Meanwhile, after the second bad year in four for equities, valuations for non financials are reasonable and the dividend yield on the indexes, let alone on stable businesses with good balance sheets, are higher than bond yields, for only the second time in the last 50 years. Assuming that governments are successful at offsetting deflation by their money printing efforts, then it would reasonable to assume that economically sensitive assets such as equities and commodities will once again be the beneficiaries, as they were in 2009 and in late 2010-early 2011. Investors should never underestimate the ability of a central bank with a printing press to raise the price of assets initially. Of course, it may not be the asset whose price they’re intending to raise, but some assets will go up in price. in fact, unless the European authorities are intent on reliving the 1930s, then inflation is the answer to the credit problems that their banks face.

It’s All Greek

November 2nd, 2011

After an extended absence owing to family medical issues, it’s surely appropriate that my first blog for a couple of months once again is on the subject of the continuing European debt crisis, just as the last one in early August was. The decision by Greek Prime Minister George Papandreou on November 1st, 2011 to hold a parliamentary confidence vote and then a national referendum on the bailout package for his country agreed with so much difficulty by European countries last week has led to a major sell-off in markets globally.

 The crisis meetings last week in Brussels between European leaders (essentially those of France and Germany) and the European banks which hold most of the debt of the peripheral Euro-zone countries, alias the PIIGS (Portugal, Ireland, Italy, Greece and Spain),  resulted in an so-called “voluntary” agreement by the banks to accept a 50% haircut in the value of their Greek debt. They would also have to raise E106 billion in new capital by June 2012, while the E440 billion European Financial Stability Fund (EFSF) would be leveraged to expand to E1 trillion in size, allowing it to continue purchasing Italian and Spanish government bonds, whose 10 year yields were nearing an unsustainable 6%. The proposed Greek referendum has thrown this tentative agreement into jeopardy. With Greece’s total debt totalling E330 billion, a bigger write-off than 50% would cause problems, but the real worry is the contagion in Spanish and Italian bond markets. Spain’s debt is almost double that of Greece at E640 billion and Italy’s almost six times as large at E1.85 trillion. With French banks and institutions owning E110 billion Spanish debt and E300 billion Italian debt, any markdown in these countries’ sovereign debt would wipe out French bank’s equity, and make a serious dent in German Banks own capital, as their combined Spanish and Italian exposure is E250 billion. The willingness of European governments to bail out their banks for a second time in 4 years is the issue, and has already occurred with Belgian bank Dexia, which has essentially been nationalized by the Belgian and French governments after its borrowing costs spiralled in October.

The obvious and only possible solution is to allow peripheral countries such as Greece, Portugal and Ireland, all of which have already received bailouts that have not worked, Greece for E219 billion, Ireland E85 billion and Portugal E79 billion,  to leave the Euro-zone and devalue their way to competitiveness. This is what the UK and Italy did in 1992 when they were forced out of the Euro`s predecessor currency union, the European Exchange Rate Mechanism (ERM), and both countries boomed subsequently, as imports fell, exports expanded and they became more attractive and cheaper destinations to visit. because of the indecision and political posturing of the European elites, the likelihood now is that Spain and Italy will be forced to leave the Euro-Zone as well, leaving a core group surrounding Germany, including the Netherlands, Austria, Belgium, Luxembourg and France, effectively resurrecting the Deutschmark bloc which made the EEC successful from when it was established in the 1950s up to the 1980s. the attempt to introduce political union via a monetary union was always doomed to failure as long as there was no fiscal union. Different countries with different economies and cultures cannot all have one currency and interest rate unless they are willing to surrender their political autonomy. By calling a referendum, Mr Papandreou has given that decision back to the voters. The sharp fall in markets indicates that investors guess what the answer will be in January, and probably will not have to wait until then to see some radical changes in the structure and membership of the Euro-zone.

Keep Calm and Carry On

August 9th, 2011

During our family vacation in Europe last month, my wife bought a few postcards with the motto “Keep Calm and Carry On” underneath the British royal crest against a burgundy background from a quirky shop in Arundel, a delightful little market town in West Sussex in southern England. They were produced during World War II to be distributed amongst the British population in the event that Hitler managed to invade the UK. As the Luftwaffe failed to win the aerial Battle of Britain in the summer of 1940, the campaign was not actually rolled out, but the postcards have become a tongue in cheek acknowledgement of the British “stiff upper lip”. Meanwhile Winston Churchill wanted to use the slogan “You Can Take One With You” to encourage people to kill the Nazi invaders, but from an investor’s perspective, the official slogan is the more appropriate course of action.

As North American markets approach the close on Tuesday afternoon, August 9th, it seems that the actions of the European Central Bank and the EFSF bailout fund in buying Spanish and Italian government bonds, combined with Ben Bernanke’s promise today that the US Federal Reserve will keep short term interest rates effectively at zero until mid 2013, have stemmed the panic that saw stock markets down 3-8% yesterday. Earlier today, the UK’sFTSE100 Index joined the German DAX and the S&P/TSX Index in “official” bear market territory, i.e. down more than 20%, while the S&P500 in the US was off almost 15% from its 2011 highs. However, the actions by the authorities saw a sharp rebound in markets. Furthermore, the slide has happened with disturbing suddenness, with many indices hitting or approaching highs for the year as recently as the end of June, or early July. While many observers are reluctant to classify the recent sell-off as a true bear market, owing to its speed, several more observant commentators are grouping it with the Crash of 1987, which saw the index down -33.5% in less than 3 months (101 days), the 1990 sell-off caused by the invasion of Kuwait (-19.9% in 87 days), or the Long Term Capital/Asian Crisis of 1998 (-19.3% in only 45 days.

Nonetheless, the damage that has been caused to investor confidence, the credibility of the European authorities and the perceived creditworthiness of the US by the dissension between and within European governments and the downgrade of the USA from AAA to AA+ cannot be undone. Those commentators claiming the fall in US government bond yields in the last few days proves that the downgrade does not matter are failing to recognize that at present, investors are flocking to perceived “safe havens”, which include not merely US Treasuries but also the Swiss Franc, Japanese Yen and gold. The weakness in the US dollar against assets that , rightly or wrongly, are believed to be safe by panicky investors does not bode well for Treasury yields and prices once the dust has settled. Already, US 10 Year Bonds have seen their yields rise from 2.31% to 2.39% today, while the Swiss Franc has risen 5% against the U$. The inevitable arrival of the QE3, the next round of intervention by the Federal Reserve, will reinforce foreign central banks in their determination to diversify their reserves away from US government debt.

In the meantime, investors should continue to rely on blue chip companies with solid balance sheets, some exposure to faster growing emerging economies and good dividends as their major asset. For fixed income, cash is a sensible choice for Canadian investors, and makes sense for U$ and sterling investors as well. Investors requiring higher yields from fixed income should keep exposure to government debt limited to short to medium term bonds or funds and investment grade corporate and floating rate debt, with a small exposure to emerging market debt via a diversified fund, which is higher yielding and better quality than most developed country debt. However, after stock markets falling as far and as fast as they have done in the last few weeks, the instructions on the postcard are a useful reminder that life goes on. While the volatility makes it difficult to stay calm, as long as your investments keep paying you a reasonable return, the reason you are invested in the first place is still relevant.

Leaving your money in the bank will not provide the average investor with a sufficient return and will be eroded by the inflation that the government support of markets will produce. Government bond yields have been driven down to 40 year lows by frightened investors, and there will be many more bonds coming to fund all of the stimulus that economies need to avoid falling back into recession. Only profitable companies that share their wealth with investors through increasing dividends offer the possibility of maintaining the real value of  investors’ incomes in the next decade.

Those Magnificent Men in their Flying Machines

August 4th, 2011

Getting to Europe involves the joys (and agonies) of trans-Atlantic flight. Over the last few years, I used Air Canada’s (AC/A-T) business class, when my former employer was paying, and found the lie-flat beds and professional service an enjoyable experience. Paying for the flights on one’s own dollar makes business class out of reach, as the cost each way with taxes can easily reach $4,000.

This year, on the recommendation of a friend who frequently flies to the US and is a British Airways Gold card holder, I tried BA Premium Economy, which has a separate cabin, with free drinks and dedicated staff, although the seats and meals are the same as ordinary Economy. The cabin was full going over and almost empty returning, although that was during low season in February. BA uses the new Terminal 5 at London Heathrow, although it was so busy when we landed that we had to park off terminal and be bussed over. For $1,800 return per person, it was a reasonably priced compromise between basic economy and business, although I’m not sure how often I’d want to do overnight flights and the price for high season is another $300-400 estra.

However, the airline that we as a family have used most often over the last half dozen years has been Transat (TRZ/B-T), the largest Canadian holiday specialist airline and travel company. While its economy class was notorious for lack of legroom, until it took out a couple of rows 2 years ago to increase its seat pitch to 32 inches, all of its A310 and A330 aircraft have 20 or 21 business class seats, called Club Class, which cost around $1500-2000 (inc. taxes) return for the Toronto-London Gatwick route. While an old fashioned business class seat, essentially a recliner with a leg-rest, it does provide ample legroom, free and edible meals and drinks, and the luxury of separate check-in and extra baggage allowance. Furthermore, Transat provides direct flights once or twice a week to regional destinations from Toronto such as Exeter, Newcastle and Manchester in England and Toulouse, Marseilles and Bordeaux in France (the latter usually through its Montreal headquarters).

As an investment, Transat has been disappointing for the last few years, down -60% against -40% for ACE Aviation(ACE.B-T), Air Canada’s  holding company and a 40% gain for budget operator Westjet (WJA-T), as despite its rock solid balance sheet with over $275 m in cash and almost no debt (although there is$630 m odd in aircraft leases), increased competition on its winter routes to the Caribbean and Mexico and rising jet fuel prices have reduced its profits. Also, some of its cash was invested in Canadian Asset Backed Commercial Paper (ABCP), the market for which froze in 2007 and on which it had to take a write-down of one third. Nonetheless, it has consistently remained profitable through the 2008-09 recession, is upgrading its fleet with new A330s, and has survived for 40 years without going bankrupt in one of the most competitive industries. It also is one of the more reasonably priced and comfortable ways to cross the Atlantic from Canada.

Euro-zone Banks Problems

July 26th, 2011

In my previuos blog, I mentioned that many Continental European banks in the Euro-zone had balance sheet issues, owing to their large holdings of peripheral countries’ sovereign debt. With Greece effectively defaulting last week and having its ratings reduced to their lowest ratings by Fitch and Moody’s, E20 bn of the E109 bn bailout package had to be used to recapitalize Greek banks. Europe’s biggest banks outside Greece own E98 bn in Greek debt, on which they are estimated to lose E20.6 bn (21%)  if everything works out as the authorities hope. Most observers are more pessimistic, pencilling in losses of between 50% and 75%, or E-50-75 bn, enough to put a sizable dent in banks’ capital. And that’s before taking losses on positions in Ireland and Portugal into account.

While the Stoxx banks Index jumped 5.7% last week on news of the rescue package for Greece, Portugal and Ireland, it is still selling at only 0.8 times published book value, and has been the worst performing of the 18 Stoxx industry sectors in Europe over the last 18  months according to Bloomberg, down 18% since the beginning of January 2010. An article on Bloomberg today (July 26th) about the second largest French bank Societe Generale (GLE-FP) notes it has E2.5 bn in Greek exposure, approximately 5% of the E56 bn of the total Greek exposure of the French banking system, which includes E15 bn of sovereign debt. This makes France the largest holder of Greek debt in Europe, according to the Bank of International Settlements (BIS)., which is why Societe Generale and two other French banks were put under review by the ratings agencies in mid July in anticipation of a Greek rescheduling.

Societe Generale, which lost E4.9 bn in 2008 when rogue trader Jerome Kerviel made E50 bn in unauthorized trades, also owns 88% of Athens based Geniki Bank (TGEN-GA), which lost E441 m last year, and another E99 m in the first quarter of 2011. Geniki has never made any money for Societe General since its acquisition in 2004. It has lost another E450 m in its 700 branch Russian subsidiary between 2008-2010, and wrote off E2.1 bn in 2008 on US debt securities, a small part of its E11 bn in writedowns since 2007. It still has E29.5 bn in legacy assets, risky securities which were badly affected by the global financial crisis and which are in run-off mode.

Yet Societe Generale is a world leader in equity derivatives, and anchored by its profitable Frennch retail bank, which has made at least E1 bn a year every year since 2005, it was profitable through the crisis, making E2 bn in 2008 and E679 m in 2009. Being paid out in full on its E11 bn of Credit Default Swaps (CDS) it had bought from AIG when the US government bailed out the giant insurer helped a lot; Societe Generale was the largest AIG creditor made whole by the US. Despite its losses in Greece and the Middle East this year, it still made E916 m in the first quarter of 2011, down 14%. In other words, Societe Generale has been one of the better European banks.

A realistic write-down on its Greek positions would be a major problem for Societe Generale, and when added to exposure to Spain, Portugal and Italy, it becomes apparent why investors have been cautious about buying seemingly cheap European banks. Dexia (DEXB-BB), the Belgian bank which was the largest user of the Federal Reserve’s emergency liquidity facility in late 2008, is selling for only 0.4 times book value, but who can trust a historic book value where debt from the PIIGS is valued at par? Societe Generale will lose E500m if the 21% write-down in Greek debt turns out to be accurate, wiping out 15% of this year’s earnings. There’s a reason that it sells for one third of its 2007 price, and the same caution applies to other Euro-zone banks.

Greek Tragedy Part II

July 25th, 2011

My family and I returned to Canada last week from a 3 week vacation in Italy, France and England, staying with friends and seeing family, as well checking out possible schools in England for the children. We were in Europe at the height of the Euro-zone debt crisis, yet it was remarkable how little effect the impending implosion of the peripheral economies such as Greece, Portugal and Ireland seemed to have on French and Italian citizens and visitors. It was hard to discern any concern about the collapse of the Euro on the French Riviera amongst the well dressed and prosperous-looking holidaymakers strolling through the streets of Antibes or Nice. Likewise the elegant and stylish inhabitants of Milan and the tourists flocking around the Duomo and La Scala didn’t appear gripped by angst over the potential return of the lira.

Over the next couple of weeks, I will be examining some of the issues that have emerged as the Euro debt crisis has developed, including the outlook for the Euro and European banks,  few comparisons between the cost of living in Europe and North America and some individual company ideas that emerged from our travels. Of course, in Europe, July and August are holiday time, when half of Paris leaves for the month of July and the other half for August, causing horrendous traffic jams (“Bouchant”(kissing), as the Auto-route signs phrase it) on the roads down to the Mediterranean.  Germans and Scandinavian tourists descend en masse on beaches in Spain, Italy and Greece, although the latter has not been too popular this year with all of the strikes affecting it, while hard drinking British youths infest Majorca and Minorca and just about anywhere else that is cheap to fly to and has cheap beer and wine. A lack of interest in arcane financial dealings is understandable, and the crisis in Greece and the other peripheral Euro-zone economies such as Portugal and Ireland has been rumbling on for over a year.

However, the realization that holders of Euro-zone debt were becoming increasingly worried about Spain and Italy, as it became apparent that the E110 bn ($150 bn) bailout of Greece last May, let alone the E78 bn for Portugal and the E65 bn for Ireland, had not worked, finally struck home in Brussels. As yields on Spanish 10 year debt rose above 6% and above 5.25% for Italy, the Eurocrats were staring over the edge of a debt precipice. Neither Spain nor Italy could afford to fund their budget deficits at these rates and maintain their existing social and industrial policies, while it finally sank in that Greece Ireland and Portugal were trapped in a a classic 1930s style “paradox of thrift” debt deflation. As Keynes pointed out, what is logical behaviour for individuals and companies, cutting expenditures and practicing austerity, was doomed to failure, as one person’s expense was another person’s revenues. Thus attempting to cut your way to solvency merely saw revenues falling even faster than expenses and the deficit widening, not shrinking, as Greece and Ireland have been demonstrating over the last eighteen months.

With the E109 bn package announced last Thursday, July 21st, 2011, Germany, the heart of the Euro-zone and the banker of the whole Euro project, has accepted the logic of the Euro experiment for the first time. Within a currency union such as the Euro-zone, unless there is a willingness on the part of member states to contribute resources to other member states when they run into financial difficulty, then the only solution for the countries in difficulty is to leave the currency zone and devalue to regain competitiveness. This, in effect, is what the UK did in September 1992, when George Soros and other “speculators” helped drive the pound sterling out of the predecessor to the Euro, the ERM. Sterling was devalued by 30%, making Mr Soros several billion dollars as he became “the man who broke the Bank of England”.

Within a few years, however, the British economy was booming as reduced imports and rising exports contributed to an export led manufacturing boom, reinforced by rising tourism revenues and capital inflows as the UK became a very cheap place to visit and live. In the end, last week’s rescue of Greece and the other PIIGS may yet end up with the weaker countries leaving the Euro, which reverts to being what it originally was; the Deutschmark by another name. Germany’s immediate neighbours in the Benelux countries and France will form part of a currency bloc which is driven by the performance and needs of the German economy, and not weighted down by Mediterranean economies which cannot remain competitive with Germany.

Of course, the rescue package also effectively created a European Monetary Fund in the European Financial Stability Facility (EFSF), whose E440 bn of capital can now be used to buy sovereign bonds in the secondary market and issue “precautionary” loans to countries that face liquidity pressures. It will also offer borrowers longer maturities and lower interest rates than those with which their bonds originally were offered.

This is a default by Greece, soon to be followed by Portugal and Ireland. The private sector, in this case largely French, Spanish and Italian banks, will be forced to accept longer dated bonds with lower interest payments than those they had on their balance sheets. Of the E109 bn, E35 bn will need to be kept in a contingency fund to ensure that the new bonds will be repaid and that lenders will be willing to accept the new bonds, while another E20 bn will be needed to recapitalize Greek banks which hold the old bonds as capital. It is estimated this will be equivalent to a 21% “haircut” or loss, but more realistic estimates indicate that losses will run between 50% and 75%.

in my next posting,  I will look at some of the consequences of this decision and what it means for investors in European markets.

Canadian Banks Keep Raising Dividends

June 27th, 2011

The release of second quarter results for the quarter ending April 30th, 2011 by the Canadian banks saw both National Bank (NA-T) and Royal Bank of Canada (RY-T, RY-N) raise their dividends by 8% on the back of stronger results. When combined with further increases by the two smallest banks, Canadian Western Bank (CWB-T) and Laurentian Bank (LB-T), this means that four out of the Big Six banks and six out the eight Canadian banks have increased their dividends over the last six months, three of them (National, Canadian Western and Laurentian) twice. This leaves Bank of Montreal (BMO-T, BMO-N) and CIBC (CM-T, CM-N) as the only Canadian banks not to have raised their dividends in the past year.

Gerry McCaughey, the CEO of CIBC, did indicate during his conference call that bank’s directors were seriously considering he possibility, even though CIBC’s Q2 earnings were felt to have been the most disappointing of any of the banks that have reported. But he explained that, as any review of the big Canadian banks would have shown, its distribution rate (dividends as a percentage of net earnings) needed to be lower before any increase could occur. Both CIBC and BMO, whose U$4.1 billion takeover of Marshall and Ilsley Bank has been approved by regulators and Marshall’s shareholders, have distribution rates above the 45-55% range that they have indicated is the highest level they feel comfortable with.

While it was initially a little surprising to see Royal Bank raising its dividend with its distribution rate still above 50%, its subsequent announcement of the sale of its sub-scale and loss-making US retail operations to PNC Bank (PNC-N) for U$3.65 billion last week made it clear why the directors were comfortable doing so. The capital freed up can be reassigned to more profitable operations such as asset management and capital markets, and brings an end to an unsuccessful attempt to build up a US retail presence in the fast growing south-eastern US markets of the Carolinas, Georgia and Alabama. Having lost $3 billion in operating losses over the last decade, and taken an additional  U$1 billion writedown on its investment, most onservers felt that getting PNC to pay it the reduced book value of the former RBC Centura busienss was a good outcome. The problem for Royal was that it was not even amongst the Top 5 banks in any of the states it operated in, with the exception of North Carolina, where it was No. 5. As TD’s US expansion has indicated, in the US retail market, you need to Go Big or Go Home, and TD’s US operations now have more branches than its Canadian business, although they are less profitable at present. Similarly BMO’s takeover of Marshall & Ilsley doubles the size of its US business, which is No. 3 in Chicago and the surrounding areas, and makes it the leading bank in the adjacent state of Wisconsin, giving it both size and geographical concentration. Canadian banks have the advantage of size and an oligopoly in their domestic market, which has enabled them to surmount the finacial crisis (a healthy housing market helped as well) and become as profitable as they are. When they are outside their home country, the same benefits do not apply, and management has to have a clear vision of their strategy and competitive advantages to succeed.

(A slightly different version of this article appeared in the June edition of The Income Investor).