Friday Morning Coffee Nr. 139 : "Riskless Returns"

190221 Friday Morning Coffee

Friday Morning Coffee Nr. 139 : "Riskless Returns"

This was the week of 13F filings. The 13F are the quarterly reports filed with the SEC by the US based institutional investors. Just like quarterly earnings release by companies, the 13F filings are also closely watched and followed amongst the investor community. Amid the barrage of newsfeed, we came across the news of Berkshire Hathaway, investment vehicle of Mr. Warren Buffett, building 33% stake in Davita Inc. Now, it seems that it is certainly not the trading position he has been routinely taking lately. We are highlighting this news, because it ties together back to the morning coffee, we wrote two weeks back on Fresenius SE. In that we mentioned that the biggest business division of Fresenius SE is Fresenius Medical Care and it is a biggest player that operates in dialysis care market in the US, which happens to be a duopoly. The second and much smaller player is Davita Inc. In fact, Davita purchases the equipment and supplies used in some dialysis procedures, especially home dialysis, from Fresenius Medical Care. We suppose the corporate structure of the Fresenius may have prevented Mr. Buffett to build such a large stake in the company, nonetheless, we are happy that we are not the only one betting on this industry.

Moving on to the riskless returns. We would like to talk about our investment into ING Group. At the depth of Covid-crisis, European banking sector had taken a big time beating with SX7E index trading at decades low. There were tons of opportunities to choose from, but being a quality value investor, we were looking for riskless returns. And, when it comes to banking sector, we like to keep it simple; asset quality, sensitivity to rates curve for the given market outlook, cost base, core markets, asset gathering potential and capital sufficiency as well as efficiency. One such name that ticked all the boxes for us was ING Bank.

ING bank is purely into the business that banks are meant to do, borrow at the lower rates and lend at the higher rates, have an efficient cost base that enables profitable growth and maintain duration match with least possible leakage. ING has two third of the loan book comprised of retail banking division and remaining third from wholesale banking division. In the retail banking loan book, 62 percent is towards residential mortgage. Consumer loans forms tiny 5% of the retail loan book. Wholesale Banking loan book is well diversified across geographies, with core markets having highest weight. ING bank has almost 50% of exposure to core Benelux markets. Despite it’s limited potential the reason we like this market is because of high concentration. A high level of market consolidation is a key competitive advantage for banks, particularly in a context of negative rates. If domestic banks benefit from scale and pricing power, both can be better exploited in highly concentrated banking markets. As it is evident empirically, the mortgage and SME loans pricing in this geographic region has been consistently well above the average pricing across EU region.

Another important aspect of this market being that it belongs to the group of fixed-rate mortgage markets wherein a mortgage is priced on the long end of the curve and remains fixed throughout the whole duration of the mortgage. Which brings back that earlier point we made; borrow at the lower rates (short end of the curve) and lend at higher rates (the long end of the curve). The risk that we see here is central banks could engage, in much talked about, rates curve control measures. In that eventuality we see three scenarios unfolding; (1) Glue the shorter leg at the lower levels and let the longer leg float to the market’s imagination, (2) Bring the curve up parallelly across the tenure and (3) Flatten the curve. We think the central banks can not afford option three at this stage because, the shorter end of the curve is where the grease of the economy lies, that’s the playground of market participant to create profitable growth for themselves and thereby for the wider economy (remember the, now forgotten, crisis in the repo markets in Q3 of 2019, where fed had to start “Not-QE”?). Unless they want the Japanification of never-ending QE generating dismal growth. Not to mention, the FX markets being most sensitive to shorter end, any misadventure there would also hurt debt raising and fiscal spending ability of the sovereigns. The other two scenarios would be conducive for ING to grow and create value for its shareholders.

Only drawback that its highly lucrative core market has is that it has limited potential for growth. ING is aiming to rectify it by gathering assets in high growth fringe geographies that too with emphasis on going digital. The benefit of having digital infrastructure, though not suited for all the markets, is that it enables superior profitability once it reaches critical mass, higher growth and cross selling opportunities due to feedback loop and lastly the costs involved to winding down the operations, in case it choses to exit the market, are relatively lower.   

At that time, we found ING trading at 25-30% discount to closest peers on price to tangible book basis even after having returns on tangible equity expectation in line with the sector at slightly higher than 7% in crisis scenario. In the mid-term, the management targets 10-12% ROTE. ING has a track record of maintaining capital surplus well above the peers. But, imagine a situation where it is unable to grow at targeted growth rates and with complexity around M&A in the banking sector, it would eventually have to return the cash the shareholders. It reported CET1 ratio of 15% on fully loaded Basel IV basis (and 15.5% on Basel3 basis), which is 250 bps above management targets. Based on last RWA of EUR 306.3 billion, excess reserves amount to EUR 7.7 bn. Add to that EUR 3.3 billion reserved for dividend distribution, the total amount is almost 33% of current market cap and it was almost 40% of the market cap when we entered the position. For the upcoming year, even if we base our estimate of ROTE of 7.2%, that would be sufficient to for ING to generate enough income to grow at 3-5% at the same time keep 50% pay-out ratio and still end up building excess reserves. All we are waiting for is a green light from ECB without any clause on these distributions.

In conclusion, we had this bank with superior asset quality, above average profitability, solid capital structure and optionality for growth which was trading at distressed levels. For us that makes riskless returns.