Exploration and Exploitation in Organizational Learning by James G. March

A mental model that doesn’t get the attention that it deserves, at least in my opinion, is the model of ambidexterity for exploration vs exploitation. “Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” (p.71) Based on these definitions and the fact that there is a trade-off between exploration of new possibilities and the exploitation of old certainties I think you understand why I find this mental model to be so important. The mental model of ambidexterity for exploration vs exploitation is not only important in investing, business and sports but also in everyday life. The article that i present today and that I base my mental model of ambidexterity for exploration vs exploitation on is written by professor emeritus James G. March.  The article was published in 1991 and is called Exploration and Exploitation in Organizational Learning.

Please comment if you have read the article and what you thought of it. Also, if you have found a worldly wisdom in the article that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Four worldly wisdom’s from the article

Both exploration and exploitation are essential for organizations, but they compete for scarce resources. As a result, organizations make explicit and implicit choices between the two. The explicit choices are found in calculated decisions about alternative investments and competitive strategies. The implicit choices are buried in many features of organizational forms and customs, for example, in organizational procedures for accumulating and reducing slack, in search rules and practices, in the ways in which targets are set and changed, and in incentive systems. (p.71)

The certainty, speed, proximity, and clarity of feedback ties exploitation to its consequences more quickly and more precisely than is the case with exploration. The story is told in many forms. Basic research has less certain outcomes, longer time horizons, and more diffuse effects than does product development. The search for new ideas, markets, or relations has less certain outcomes, longer time horizons, and more diffuse effects than does further development of existing ones. (p.73)

Since performance is a joint function of potential return from an activity and present competence of an organization at it, organizations exhibit increasing returns to experience (Arthur 1984). Positive local feedback produces strong path dependence (David 1990) and can lead to suboptimal equilibria. It is quite possible for competence in an inferior activity to become great enough to exclude superior activities with which an organization has little experience (Herriott, Levinthal, and March 1985). Since long-run intelligence depends on sustaining a reasonable level of exploration, these tendencies to increase exploitation and reduce exploration make adaptive processes potentially self-destructive. (p.73)

But it may be instructive to reconfirm some elements of folk wisdom asserting that the returns to fast learning are not all positive, that rapid socialization may hurt the socializers even as it helps the socialized, that the development of knowledge may depend on maintaining an influx of the naive and ignorant, and that competitive victory does not reliably go to the properly educated. (p.85)

James G. March (1991), ‘Exploration and Exploitation in Organizational Learning’, Organization Science

Influence: The Psychology of Persuasion by Robert B. Cialdini

Influence: The Psychology of Persuasion by Robert B. Cialdini is a book structured around 6 key principles of influence: reciprocity, commitment and consistency, social proof, authority, liking and scarcity. It is one of those books that has stood the test of time and one that gives you new wisdom every time you read it. The book has sold well over three million copies since it was published in 1984 and has been endorsed by non other than Charlie Munger. The most evident and in depth endorsement by Munger can be found in famous 1995 speech at Harvard University on The psychology of human misjudgment. In my opinion, reading the book and listening to the speech is one of the most valuable combinations of worldly wisdoms regarding human psychology that exists. I can’t recommend it enough.

Please comment if you have read the book and what you thought of it. Also, if you have found a worldly wisdom in the book that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Five worldly wisdom’s from the book

Weapons of influence

The advantage of such shortcut responding [fixed-action patterns] lies in its efficiency and economy; by reacting automatically to a usually informative trigger feature, an individual preserves crucial time, energy, and mental capacity. The disadvantage of such responding lies in its vulnerability to silly and costly mistakes; by reacting to only a piece of the available information (even a normally predictive piece), an individual increases the chances of error, especially when responding in an automatic, mindless fashion. The chances of error increase even further when other individuals seek to profit by arranging (through manipulation of trigger features) to stimulate a desired behavior at inappropriate times. (p.17)

Commitment and Consistency

Psychologists have long recognized a desire in most people to be and look consistent within their words, beliefs, attitudes, and deeds. This tendency for consistency is fed from three sources. First, good personal consistency is highly valued by society. Second, aside from its effect on public image, generally consistent conduct provides a beneficial approach to daily life. Third, a consistent orientation affords a valuable shortcut through the complexity of modern existence. By being consistent with earlier decisions, one reduces the need to process all the relevant information in future similar situations; instead, one merely needs to recall the earlier decision and to respond consistently with it.” (p.95-96)

Social proof

Social proof is most influential under two conditions. The first is uncertainty. When people are unsure, when the situation is ambiguous, they are more likely to attend to the actions of others and to accept those actions as correct. In ambiguous situations, for instance, the decisions of bystanders to help are much more influenced by the actions of other bystanders than when the situation is a clear-cut emergency. The second condition under which social proof is most influential is similarity: People are more inclined to follow the lead of similar others.” (p.140)

Scarcity 

The scarcity principle holds for two reasons. First, because things that are difficult to attain are typically more valuable, the availability of an item or experience can serve as a shortcut cue to its quality. Second, as things become less accessible, we lose freedoms. According to psychological reactance theory, we respond to the loss of freedoms by wanting to have them (along with the goods and services connected to them) more than before.” (p.231)

Instant influence

Modern day visionaries—like Bill Gates, chairman of Microsoft—agree with Macrae, asserting that we are creating an array of devices capable of delivering a universe of information “to anyone, anywhere, anytime” (Davidson, 1999). But notice something telling: Our modern era, often termed The Information Age, has never been called The Knowledge Age. Information does not translate directly into knowledge. It must first be processed—accessed, absorbed, comprehended, integrated, and retained. (p.237)

 

bebe stores, inc. – Q1 2016

Unfortunately I didn’t have the time to post this analysis earlier in the week when I managed to take a position. The reason I say unfortunately is that the company posted its Q2 earnings release yesterday. The figures below are therefor already dated but also note that the stock price jumped quite a bit on the release today.

NASDAQ:BEBE – 4,90 $

1kr50örebebe stores, inc. designs, develops and produces a range of contemporary women’s apparel and accessories. The Company’s product offering includes a range of separates, tops, dresses, active wear and accessories for a range of occasions. It designs and develops its merchandise in-house, which is manufactured to its specifications and it also sources directly from third-party manufacturers. The Company also offers accessories, which include jewelry, optical, fragrance, shoes and handbags. The Company operates stores in the United States, Puerto Rico and Canada. In addition, it has an online store at http://www.bebe.com that ships to customers in the United States, Canada, Puerto Rico, the United States Protectorates and internationally via its third-party providers, International Checkout and Shoprunner. It has international stores operated by licensees in South East Asia, the United Arab Emirates, Russia, South America, Turkey and other territories. – Google Times.

1. The company is currently a net-net with an adequate margin of safety: 

a)

  • P/NCAV < 1x
    • 0,78x 
    • MoS = 22 %

Assessment of why I think the margin of safety is adequate in relation to NCAV:

Although BEBE is a retail net-net, which many deep value investors stay away from, I believe this company has some favorable and interesting characteristics that makes it a good addition to a diversified net-net portfolio. For the majority of the last ten years the company has been profitable on an operating income level (6/10). Not too surprising, since the company today is selling below NCAV, the four non profitable years has been the most recent ones. Today the company is selling at record low levels since it was listed in 1998 and although the share price has been in a declining phase over the last ten years BEBE has not historically been a net-net (i.e. not a perennial net-net).

bebe1
Source: Google finance

If we believe in some form of mean reversion for BEBE’s business the current ten year average for operating income of 6,4 M$ looks really favorable in relation to both the market capitalization of 39 M$ (6x) and especially in relation to the current negative enterprise value of -8 M$ (-1x). Other positive historical facts is that the company has been a stable dividend payer (2004-2015) and a frequent buyer of own shares. Also, the recent NCAV-brunrate amounts to +43 % QoQ and only -4,1 % YoY.

Last but not least, what I find interesting is that the famous deep value and activist investor Lloyd Miller III has taken quite a big position in the company (Värdebyrån has written a good post about him). In November he initiated a 5,5 % ownership and has since then increased the position to 8 % as of late January 2017. What his intentions are I don’t know. It might have some connection to the fact that the founder and majority shareholder Manny Mashouf of BEBE in June 2016 declared that he intends to gradually sell his then 59 % ownership stake.

shareholders-bebe
Source: 4-traders

2. The risk of permanent loss is low:

2.1 The risk of bankruptcy is low (criterion a) or b) must be met):

a)

  • Debt/Equity < 25 %
    • 0 % 

b)

  • Z-score ≥ 3
    • 2,8 X

2.2 The company’s business model has historically been profitable (criterion a) or b) must be met):

a)

  • Positive retained earnings:
    • -27,5 M$ X

b)

  • Positive aggregate operating income for the last ten years:
    •   64,7 M$ 

3. The company does not have a shareholder unfriendly capital allocation (i.e. not diluting shareholders):

  • Shareholder yield TTM ≥ -2 %
    • Dividend yield TTM = 0 %
    • Net buyback yield TTM = -0,3 %
      • =  -0,3 % 

MoS

Disclosure: The author is long NASDAQ:BEBE when this analysis is published. Also note that NASDAQ:BEBE is a nano-cap stock (39 M$ in market capitalization). The trading is illiquid.

The Worldly Wisdom Project #4

One of the most influential articles for my development of mental models regarding learning and knowledge creation is written by March, J, Sproull, L, & Tamuz, M in 1991. The reason why I find it so influential is that it stresses a very important fact that is often overlooked in organisations, investing and life in general. That is, we learn and create knowledge from very small pool of outcomes. The article does not only make us aware of this fact but also how we can learn from samples of one and fewer with minimised effect from lady Fortuna and here companion Mr Noise.

Please comment if you have read the article and what you thought of it. Also, if you have found a worldly wisdom in the article that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Five worldly wisdom’s from Learning from Samples of One or Fewer by March et al.

Because experiencing an outcome as a success or failure depends on the relation between the outcome and adaptive aspirations for it, what is learned from any particular kind of experience can vary substantially across time and across organizations. (p.4)

In trying to understand unique experiences, organizations make implicit choices between two alternative perspectives on history. In the first perspective, realized events are seen as necessary consequences of antecedent historical conditions. In the second perspective, realized events are seen as draws from a distribution of possible events. If historical events are (possibly unlikely) draws from a wealth of possibilities, an understanding of history requires attention to the whole distribution of possible events, including those that did not occur (Fischhoff 1980, Hogarth 1983). The organizational problem is to infer an underlying distribution of possible events from a series of realized events having varying, but possibly quite low, probabilities. (p.4)

Future admirals learn not only from the battle but also from its near-histories. Standard folkloric observations that great failures often are the consequence of bad luck or timing and great successes the consequence of good luck or timing suggest an implicit distribution of possible outcomes around the observed outliers. They emphasize that the near-histories of genius and foolishness are more similar than their realized histories. (p.5)

The learning process is generally conservative, sustaining existing structures of belief, including existing differences, while coping with surprises in the unfolding of history. Organizations create the same kinds of coherent systems of belief that in science are called knowledge, in religion are called morality, and in other people’s societies are called myths. Experience is used to strengthen and elaborate previously believed theories of life. (p.7)

Every unique historical event is a collection of micro events, each of which can be experienced. In this sense, the learning potential of any historical event is indeterminate. Because both the scope of an event and the depth of its decomposition into elements are arbitrary, so also is the richness of experience. By considering additional aspects of experience and new dimensions of preferences, an organization expands the information gained from a particular case. The pursuit of rich experience, however, requires a method for absorbing detail without molding it. Great organizational histories, like great novels, are written, not by first constructing interpretations of events and then filling in the details, but by first identifying the details and allowing the interpretations to emerge from them. As a result, openness to a variety of (possibly irrelevant) dimensions of experience and preference is often more valuable than a clear prior model and unambiguous objectives (Maier 1963; March 1978, 1987). (p.8)

March, J, Sproull, L, & Tamuz, M 1991, ‘Learning from Samples of One or Fewer’, Organization Science.

Kingboard Copper Foil Holdings Limited

SGX:K14 – 0,275 SGD

1kr50öreKingboard Copper Foil Holdings Limited is an investment holding company. The Company has two operating divisions, which are polyvinyl butyral (PVB) business and license business. PVB business includes manufacturing and trading of PVB and related products, and License business includes earning license fee income from its licensed assets. Its subsidiaries include Blue Atlas Limited, Hong Kong Copper Foil Limited, Fogang Kingboard Industry Ltd, Kingboard Chemical Investment Limited, Kingboard Chemical Investment (Hong Kong) Limited, Chung Shun Copper Foil (MCO) Limited, Kingboard (Fogang) Specialty Resins Limited, Kingboard (Lianzhou) Copper Foil Ltd and Jiangxi Hong Feng. – Google Times.

1. Adequate margin of safety (criterion a) or b) must be met): 

a)

  • P/NCAV < 1x
    • 0,72x 

&

  • EV/Operating earnings(5y&10y) < 3x
    • 5y =  -10,1x 
    • 10y = -3,4x 
      • Negative EV and positive operating earnings 5y and 10y.

b)

  • P/NCAV < 0,75x
    • 0,72x 

2. The risk of permanent loss is low:

2.1 The risk of bankruptcy is low (criterion a) or b) must be met):

a)

  • Debt/Equity < 25 %
    • 0 % 

b)

  • Z-score ≥ 3
    • 6,55

2.2 The company’s business model is not totally unprofitable (criterion a) or b) must be met):

a)

  • Positive retained earnings:
    • 1,468 MHKD 

b)

  • Positive aggregate operating income for the last ten years:
    •   1,182 MHKD 

3. The company does not have a shareholder unfriendly capital allocation:

  • Shareholder yield TTM ≥ -2 %
    • Dividend yield TTM = 0 %
    • Net buyback yield TTM = 0 %
    • Net debt paydown yield TTM = 0 %
      • =  0 % 

Other notes:

MoS

Disclosure: The author is long SGX:K14 when this analysis is published.

The French regional banks – part two (2/2)

I ended the last post (part two 1/2) for the French regional banks analysis with one of my favourite quotes from Charlie Munger:

When you locate a bargain, you must ask, ‘Why me, God? Why am I the only one who could find this barging?

In this final part of the French regional banks analysis I will try to answer the above questions by inverting the last part of it. I will also take a look at the French real-estate and lending market to see if I have missed something in my earlier analysis regarding risk and uncertainty. Finally, I will try to wrap up the value investing story (post two and three) with the risk arbitrage story (post one) into an overall conclusion about the French regional banks as investment candidates. If you stick to the end of this long text you will be rewarded as the final part also includes a new catalyst that I haven’t written about before.

“Invert, always invert”

With the words of Munger borrowed from German mathematician Carl Jacobi: “Invert, always invert”, I will try to answer the last part of the question above. In other words; are there any creditable investor that have a position in the French regional banks?

I started post two with a video where monsieur François Badelon (fund manager at the Amiral Gestion fund Sextant Autour du Monde) laid out his view of the value investing case for the French regional banks. Monsieur Badelon is not alone in his positive attitude towards the French regional banks. Monsieur Louis d’Arvieu, also a fund manager at the Amiral Gestion fund Sextant Grand Large, answered and concluded in an interview in May 2015 (translated with Google)[1]:

The financial services sector was the largest at the end of March (19.8% of invested assets, compared with 11.1% at the end of 2014). How do certain values in this sector have attractive valuations in your eyes?

In this sector, we are present in certain Crédit Agricole regional caisses that we have been loyal to for years. These funds are exposed to the traditional retail banking business, are managed prudently, are inexpensive, poorly tracked, massively over-capitalized and highly discounted compared to their book value. They also pay high dividends and have very strong local market shares.

Although there is a high possibility that the two fund managers from Amiral Gestion are biased by each other’s opinions, I consider the French domestic knowledge of two highly regarded fund managers to be both insightful and trustworthy. There are also three other well-regarded French value focused investment management companies that show up on some of the shareholder lists for the regional banks, HMF finance[2], Moneta Assets Management[3] and Financière Tiepolo[4].

Now that we have established some understanding and conviction regarding the domestic funds view about the French regional banks, what about international funds and investors?

The NYSE listed American investment management company Invesco and their European Small Company fund show up on several of the regional banks shareholder lists[5]. As of November 2016 the regional banks together are the funds second largest holding[6] Also, the Belgian asset management company Value Square NV show up on several of the banks shareholder lists[7]. As of November 2016 the regional banks are Value Squares second largest holding[8]. Last but definitely not least we have Arbiter Partners, a New-York based hedge fund. Behind Arbiter Partners we find Mr Paul Isaac, a famous deep value investor and nephew of the no other than Mr Walter Schloss. If you don’t know who Paul Isaac is I highly recommend reading about him in this fantastic post from Värdebyrån (in Swedish)[9]. In an interview in the Graham & Doddsville newsletter from the spring of 2013 he lays out the value investing case of the French regional banks in detail[10]:

Our second-largest position is more esoteric. It’s in the regional affiliates of Crdit Agricole.”

So there are 13 of these non-voting shares in these various regional banks, which are decent regional banks. They have non- performing assets of 1% to 4% of assets. They usually have loan loss reserves of 70% to 150% of the non- performing assets. The tangible common equity to assets runs 8% to 15% on the outside. The ROE runs in the mid-single digits to about 10%. The efficiency ratios are around 45% to 60%.”

These are not bad regional banks, and as they have assets between $8 and $60 billion apiece, they’re also not tiny, either. You can get information on them if you speak French or can use Google Toolbar. Just go to the website of each of the regional banks. They don’t make it easy for you. You have to go through the site and find the required legal filings, and then they’ll show you the annual and trimestral reports.”

These things are trading at 25%-40% of tangible book, with somewhat depressed earnings this year, partially because of economic conditions in France, partially because of incremental taxes, and partially because of the lack of flow through of any earnings from the holding entity where they take the dividends into their income statement when they pay them.”

These entities are trading at five or six times earnings. They’re paying dividends of five to seven percent. Most of them have buyback programs. There have been buybacks of whole share classes of these entities. When they’ve occurred they’ve been at significant premiums to what these are currently trading for.

We’re getting a nice current income on the position, and there is some accretion to book value. My hope is that these things are not entirely rational for an essentially mutual institution to have outstanding indefinitely, and we may get some buybacks of whole issues. These positions are not terribly easy to buy – they typically trade between twenty thousand and a couple hundred thousand dollars a day each, so accumulating them took a long time.

To summarise and conclude. There seems to exist both a domestic and international conviction that the French regional banks are an interesting value investing case. This is not only evident from the funds mentioned ownership but also from the fact that they all actively engage in the current legal process of stressing the equality between shareholders of the regional banks[11] (i.e. the underlying reason for the risk arbitrage case of the French regional banks presented in post one).

Expanding the area of research

In the Graham & Doddsville interview Mr Isaac answers a question and points to two important areas that should be explored before I wrap this analysis up:

G&D: What is the composition of the assets at the regionals? Is it what we would expect from traditional banks?

PI: Yeah, it’s small commercial, consumer, and municipal loans. The one thing that really concerns me is if interest rates were to go up moderately, it probably would help their profitability. But if interest rates were to go up a lot, there is an inherent duration mismatch because they do some term lending, particularly to municipalities. So I think that is probably the biggest risk if you’re looking for an outlying structural risk.”

The French real-estate and lending market

When I started to get interested in the case of the French regional banks I knew very little of the French banking, real-estate and lending markets. For anyone who feels the same way and wants to acquire some insight into the French banking system I can recommend two papers: The history of banks in France [12] and the ACPR report for 2015[13]. For particular insights into the French regional banking system I can also recommend the following two papers: The French Co-operative Banking Group Model: Too Good to be True? [14] and The challenges of recent changes in French cooperative banking groups[15]. Last, for insights into both the banking and real-estate market in France and Europe I recommend reading the HYPOSTAT 2016 A review of europe’s mortgage and housing markets report.[16] In this part of the report I will use some of the knowledge gained from these reports and try to comment on Mr Isaac point that the regional banks are focused on “small commercial, consumer, and municipal loans” and that there might exist a structural risk related “if interest rates were to go up a lot

Below you will find a picture from loans outstanding for all Caisse Regionale, i.e. the regional banks in the Credit Agricolé Group (39 in total, not only the 13 that are listed on the stock market)[17]:

1

In the order that they are presented above each loan category represent; 59%, 4%, 20%, 9% and 8% of the total loans outstanding as of September 2016. Although the division of loans outstanding vary between the thirteen Caisse Regionale banks the above table provides a good enough picture for the average “loan structures”, i.e. focus is on home and small businesses loans. A similar conclusion can be made regarding the division of loans outstanding for the entire credit activity in France. Housing loans are the main type of loans (46%), followed by equipment loans (26%) and cash loans (15%)[18].

Before diving into the details and some macroeconomic factors related to the biggest chunk of the loans outstanding, home loans, let’s take a look at two important ratios in relation to the total loans outstanding[19]. Again, the two ratios below (impaired loans ratio and coverage ratio) are based on all 38 Caisse Regionale banks but represent a fair view of the average for the 13 regional banks as well:

2

Today, the impaired loans ratio for the regional banks is low. In more concrete terms, the low ratio tells us that the regional banks are not currently having any problems with their lenders ability to pay their interest and mortgage. An impaired loans ratio of 2,5% is low both on an absolute and relative level (see comparison with NPL ratio below from EBA Dashboard of 250 European banks). Also, the regional banks have a solid coverage ratio both incl and excl reserves; 103,4 % and 63,8 % respectively. From this aspect the regional banks are well protected from potential and future losses. Again, this is true both on an absolute and relative level (see coverage ratio of NPL below from EBA Dashboard of 250 European banks).

3

Although the above ratios are solid for the regional banks I would nonetheless like to investigate what the underlying situation for one major part of these ratios. Because 59% of the total loans outstanding is house loans I thought it be a good idea to look at some macroeconomic factors for France in relation to this figure. As I am by no means an “macro expert” I would like you take my analysis in this part with an extra grain of salt.

The French real estate-market

To start of I would go back to a statement made by Mr Paul Isaacs in the Graham & Doddsville newsletter from the spring of 2013:

These are conservatively run regional banks. France didn’t have a gigantic real- estate boom. If you don’t think the French banking system is completely imploding, these are really cheap certificates, and you are paid a fair amount while you wait.”[20]

So let us first examine how the situation has developed since 2013 when the above statement was made. In the HYPOSTAT report of the European mortgage and housing market there are graphs showcasing house price development since 2006. In the graph with countries where house prices were, in 2015, around 2006 levels, we find France[21].

4

A similar graph but with a longer time frame (from a different source) shows a more volatile price development than the picture above[22].

5

Regardless of what graph we look at I think it is fair to say that although there has been an increase in house prices since Mr Isaacs statement in 2013 there is still no signs of a “gigantic real- estate boom” in France. Nonetheless, the HYPOSTAT report does the following statement about the current trend: ”Finally, in countries where house prices have been falling in recent years such as Cyprus, France, Greece and Italy, there were signs of deceleration and of an upcoming reversal in trend.[23]

The above quote should also be put in context to another statement made in the HYPOSTAT report regarding the price development of capital cities, Paris in this case: ”In other countries such as France, the Netherlands and also the US, the country-wide HPI has not dramatically changed with respect to 2006, while their capital cities’ prices increased by between 25% and 40%, pointing to very segmented domestic markets in some instances.”[24]

So what about the outlook for the French real estate market then? I came across an article last week that mainly focused on Sweden’s real estate market but also included some information about France. The outlook for the Swedish real estate market was not positive to say the least. However, for France the European Systemic risk board (ESRB) has not issued a similar warning for the vulnerability in its real estate market[25]:

6

So to summarise and conclude so far. There seems be no sign of a current real estate boom in France in general, although prices are currently in an upwards trend in relation to recent years. The same statement cannot be made for the Paris real estate market where prices have increased far more than the French average. However, putting it all together there seems to be no need to worry about the outlook and stability of the French real-estate market as the ESRB declares no waring for the vulnerability. This final conclusion leads us into the quest of trying to look at other factors that supports this notion.

Real-estate lending and some other important macroeconomic factors

Price development in the real estate market is only one side of the coin that could lead to a vulnerable real estate market. The other and more interesting side, I think, is to look at how residential lending has developed over the years.

So let’s start with one important graph that in my opinion verifies the conclusion drawn by ERSB[26]:

7

From the above graph there doesn’t seem to be a current residential lending boom in France. More importantly I think the graph should also be viewed in relation to the earlier graph of house price increase in France since 2006 and the conclusion that there are currently no signs of a real estate boom. In other words, France doesn’t seem to have a real estate bubble financed with borrowed money. This is very good news.

Moving on to the next graph. Let’s take a look at the percentage of home owners with mortgage loan in relation to mortgage to disposable income for France and some other European countries[27]:

8

Again, the above graph doesn’t ring any alarming bells to my novice macroeconomic ears. France in relation to other European countries don’t have a particular high degree of home owners with a mortgage loan (an untapped revenue stream for the regional banks?). Also, the relationship between outstanding mortgage to disposable income for France is not particularly high. In other words, the underlying stability in the real-estate lending market seems to be pretty good. Both in relation to absolute and relative levels.

As I said before, I don’t consider myself a person with in-depth knowledge or analytical skills regarding macroeconomic situations and factors. However, with the presentation above I think it is fair to say that the statement about France having no gigantic real-estate boom made by Paul Isaac is still true. Considering that the regional banks total loans outstanding is made up of about 59 % home loans this is good news. In other words, investing in the banks now mean that you are not buying into a loan portfolio that is structured around historically high-priced real estate properties (i.e. low risk of overvaluation). In regards the future vulnerability of the home loans for the regional banks I think the last graph and the conclusion therefrom put in relation to the figures earlier presented for impaired loans ratio and coverage ratio for total loans outstanding provides a good margin of safety for potential negative macroeconomic developments.

What about the rest of the loan portfolio (41%) to SME businesses, farming and local authorities (municipalities etc.) then? From a macroeconomic standpoint there are both positive and negative notions that can be made. France is battling with high unemployment rate and a low GDP growth in comparison to other European countries.[28] At the same time French corporation tax is likely to be lowered in coming years from 35% to about 28% (especially if the right-wing wins the election) and the country is still the third largest economy in Europe[29]. Also, as in every other European country today the rates on French loans are at record low levels. Overall, my conclusion is that if we don’t see an explosive increase in rates I see no particular reason that the 41% of the loans outstanding should be seen as riskier than the 59% of home loans. Again, this statement in should be put in relation to the figures earlier presented for impaired loans ratio and coverage ratio for total loans outstanding and the margin of safety that appears to exist in therein.

9

Wrapping up the value investing and special situations story

In the good old days banking was simple, the bank would lend money to local people and businesses at a higher rate than it was deposited for, i.e. retail banking. Today the situation is a whole lot different since most banks as they have expanded wide in their field of business and geographical presence. However, as has been presented in this analysis there are still a few of these traditional local banks left. In France we find thirteen of these that are publicly traded.

As of 31 December 2015, total bank assets on a consolidated basis held by French banks, in France and abroad, amounted to EUR 7,674 billion. 83% of these assets were concentrated in the six largest French banking groups (BNP Paribas, BPCE, Crédit Agricole group, Crédit Mutuel, La Banque Postale and Société Générale)[30]. France is in other words not different than many other countries from the fact that the banking industry has an oligopoly structure. As an investor I don’t mind this at all, quite the opposite. However, you want the structure to be in “your” favour as the market share is often quite sticky in oligopoly industries, especially in the banking. If we take a look at some market share figures for mortgage issuance the picture is quite pleasant for the regional banks as it amounts to a 54,5% (i.e. mutual and cooperative banks)[31]. However, it should be noted that the Caisse Regionale banks are not the exclusive “owner” of the 54,5% whole market share cake as other branches also have regional/mutual/cooperative banks. I haven’t found any exact figures but according to a large investor in the Caisse Regionale banks that I have had the opportunity to email with (more on this later) the market share in most regions is above 50%. Considering that the Crédit Agricole group is the largest bank network in France I view this figure as plausible.

10

When I first started to dig into the bits and pieces of the Caisse Regionale banks it was the combination of simple retail banks with a large market share in an oligopoly structured industry selling at deep value multiples (P/B 0,3x and P/E 6x) that got me really excited. After a bit of research, I also found out that the regional banks could be viewed as a special situation case. This as a result of a buyout of Credit Agricole SA (ACA) at 1,05x P/B-multiple while excluding minority shareholders from the same deal. In the first part of my analysis of the French regional banks I presented this case and came to the conclusion that there existed a strong underlying catalyst. However, the story was highly unlikely to include a happy ending in the short to medium time horizon. Since the publication of the first part this I still my conclusion and things haven’t changed. However, this might change over the next couple of weeks since the legal process is about to start. If and when something happen I will write a follow-up post about it.

In my second and third post of the thirteen regional banks I moved on to present the value investing case of the Caisse Regionale banks. What I concluded in my second post was that the banks had continuously been profitable at the bottom line level for the last ten years. That the regional banks profitability was quite good, both in absolute and relative terms, and both from a bank efficiency ratio (53,2% average for the thirteen banks) and an ROE-ratio (5,9% average for the thirteen banks) perspective. That the regional banks financial stability was strong both in terms of absolute levels and in comparison to Basel III requirements. Finally, that the regional banks paid a dividend yield of 4,8% (average for the thirteen banks) at a non-distressed dividend pay-out ratio and a net-buyback yield of 0,8% (average for the thirteen banks). In other words, a shareholder yield of 5,7% (average for the thirteen banks). In this third and final post I concluded I was not alone in my interest of the French regional banks. I presented some well-known domestic and international value investors that have a large stake in the banks and are actively engaged in the current legal process. Finally, I found no signs that the regional banks loan portfolio was exposed to current high risk or overvaluation and that there was enough margin of safety to protect against future vulnerability in relation to worsening macroeconomic conditions.

In all of my three posts for the Caisse Regionale banks I have tried to punch a whole to the investment idea and continuously, in my opinion, failed to do so. That doesn’t mean that there exist negative factors and explanations for why these banks are selling at such low valuation multiples. Some possible explanations for the low valuation multiples (I don’t necessarily consider them negative) are the following:

  • The regional banks are quite small and illiquid. That makes them un-investable for many fund, institutions and big private investors.
  • The ownership structure is very complex and hard to get a grip of but was even more complex until just recently (see more about this in post one). This might result in that investors put the regional banks in the “too hard pile”.
  • All of regional banks financial information is in French. This makes them quite hard to analyse for a non-French speaking investor. Again this might result in that investors put the regional banks in the “too hard pile”.

In my opinion there also exist two factors that have some real weight to them for at least part of the explanation of the low valuation multiples:

  • One explanation for the low valuation multiples I think has to do with the banks limited growth opportunities. They conduct their business only at a regional level and more complex banking business is outside of their purpose and reach.
  • The second explanation for the low valuation multiples has to do with the fact that the shares publicly traded for the thirteen regional banks, CCI-certificates, are not entitled to the right of a vote (read more about this in post one). This will eliminate many institutions, funds and large investors as that don’t want or aren’t allowed to invest in these types of securities.

With the negative factors in mind I still consider the regional banks to be one of the best investment opportunities I ever laid my eyes on. In other words, the above negative factors can in my opinion not even close explain the price vs. value discrepancy (low valuation multiples) that the banks are selling for today if we take into account the positive factors earlier stated.

One last thing – a new catalyst in the horizon

In the last couple of weeks, I have had the delightful opportunity to pick the brains of monsieur Etienne Vernier over an e-mail conversation[32]. You might remember his name and articles that I linked to in the first part of the French regional banks analysis. He is a large and long-time shareholder alongside the funds earlier mentioned and is also actively engaged in the current legal process against the banks. He holds deep knowledge about the banks and I consider his insights truly valuable. Our conversation has helped me tremendously in finalizing this post. One thing really stood out from our conversation and has to be placed on top of my earlier positive facts about this investment opportunity. This has to do with his thoughts about the SACAM company, the 39 regional banks holding company, that now is the owner of ACA former ownership in the regional banks (read more about the this and the SACAM company in post one). Some of Etienne Vernier thoughts were:

CR = Caisse Regionale

 The loan to CASA are directly in the balance sheets of each 39 CR and the interests paid will be passed in expenses and diminish in their tax corporation liabilities. But the CR dividends received by SACAM will most likely be non-taxable. That makes net of taxes that dividends will be twice the interest paid or so.

Also i believe (I am not sure) that it would be absurd that SACAM repays to the CRs the dividends received by the same CRs (300 M€ in total). That would be strange. More likely, SACAM will amass that money and use it to buy CCIs on the market where they are at 0.3 of Net Assets versus 1.05 paid by SACAM. 300 M€ yearly would push the market prices up on CCIs.

After acquiring the Memorandum of Association of SACAM MUTUALISATION and 26 of the annual reports for the Caisse Regionale banks that are not listed Etienne Vernier concluded:

I consulted the 2015 annual reports of the 26 unquoted CRs in order to obtain a finer estimate of the dividends that would have received SACAM MUTUALIZATION if the deal had been in place last year. 

This resulted in a global dividend of € 297 million for SACAM and € 88 million to the CCI float of the 13 listed CRs.

PS: if they had bought the free float for 5.2 billion euros, it would have cost + – 40 M € of interest to CR to compare with +88 M € of additional dividends ….

[Etienne Vernier referring to the Memorandum of Association of SACAM MUTUALISATION]

You can see that the goal of SACAM is solely to hold, AND acquire eventually more CCA/CCis. Nothing else is specified so just one thing to do with their dividends. Buying more CCIs or at the worst sending this back to the CRs. The later alternative will improve the CR’s results but this loop would be very weird.

If you consider that SACAM yearly will receive close to 300 M€ of dividends and that the free CCI Float is around 1.800 M€, it will simply take 6 years for them to buy them all. Obviously since only 10% of the free float is dealt yearly on the stock exchange, such moves will probably push CCIs prices closer to 1.05 x their net asset values ! At the minimum, they can start doing it and this will sustain the prices and lower the cost of their holdings compared with the 1.05 they paid.

So to summarise and conclude both the value investing and the special situation case. Taking a basket approach (buying all thirteen regional banks) you are able to buy a stable +12% return (~6% ROE in an oligopoly structured industry and a growing shareholder yield of another ~6%) for a P/B multiple of 0,3x. On top of that you get the potential legal catalyst valued at 1,05x P/B for free and another free high possibility buyback catalyst in the form of the SACAM company putting its dividend money to use on the thinly traded CCI free float. In my opinion this is an investment I would make every single day with a smile on my face and one that I consider to be the closest to the Dahando investment philosophy that I have ever seen – heads I win tails I don’t lose much.

Disclosure: The author is long all thirteen regional banks (Caisse Regionale) mentioned when this analysis is published.

[1] https://translate.google.com/translate?sl=fr&tl=en&js=y&prev=_t&hl=sv&ie=UTF-8&u=http%3A%2F%2Fwww.clubpatrimoine.com%2Fpartenaire%2FAmiral_Gestion%2Farticle%2FQuels_sont_les_secrets_de_Sextant_Grand_Large_L_interview_gerant_de_P_Maupas-a20089.aspx&edit-text=&act=url

[2] http://www.hmgfinance.com/en/company/who-are-we/index.php

[3] http://www.moneta.fr/en/process/stock-picking/index.php

[4] https://translate.google.com/translate?sl=fr&tl=en&js=y&prev=_t&hl=sv&ie=UTF-8&u=http%3A%2F%2Fwww.tiepolo.fr%2Fphilosophie-engagement%2Fpolitique-dinvestissement%2F&edit-text=&act=url

[5] https://www.invesco.com/portal/site/us/investors/mutual-funds/product-detail?productId=241&ticker=ESMAX&title=invesco-european-small-company-fund

[6] https://www.invesco.com/portal/site/us/investors/quarterly-holdings/?javax.portlet.endCacheTok=com.vignette.cachetoken&javax.portlet.pst=765b2a95280e4cce456cc731524e2ca0_&javax.portlet.prp_765b2a95280e4cce456cc731524e2ca0_fundId=241&javax.portlet.begCacheTok=com.vignette.cachetoken&javax.portlet.action=true

[7] https://www.invesco.com/portal/site/us/investors/mutual-funds/product-detail?productId=241&ticker=ESMAX&title=invesco-european-small-company-fund

[8] https://www.value-square.be/media/1486-e2016-11-factsheet.pdf

[9] https://vardebyran.wordpress.com/2014/12/02/vem-ar-paul-isaac/

[10]https://www8.gsb.columbia.edu/valueinvesting/sites/valueinvesting/files/files/Graham%20%26%20Doddsville%20-%20Issue%2018%20-%20Spring%202013_0.pdf

[11] https://translate.google.com/translate?sl=fr&tl=en&js=y&prev=_t&hl=sv&ie=UTF-8&u=http%3A%2F%2Finvestir.lesechos.fr%2Factions%2Factualites%2Ffronde-des-actionnaires-minoritaires-des-caisses-regionales-1527197.php&edit-text=&act=url

[12] http://www.fbf.fr/en/files/888HK2/History_banks_france_EN.pdf

[13] https://acpr.banque-france.fr/fileadmin/user_upload/acp/publications/rapports-annuels/20163011_ACPR_figures_report_2015.pdf

[14] http://www.strategie-aims.com/events/conferences/2-xixeme-conference-de-l-aims/communications/2-the-french-co-operative-banking-group-model-too-good-to-be-true/download

[15]http://recma.org/sites/default/files/THE_CHALLENGES_OF_RECENT_CHANGES_IN_FRENCH_COOPERATIVE_BANKING_GROUPS.pdf

[16] http://www.hypo.org/content/default.asp?PageID=524

[17]www.credit-agricole.com/en/content/download/…/Actualisation+A04+2016+VA.pdf

[18] https://acpr.banque-france.fr/fileadmin/user_upload/acp/publications/rapports-annuels/20163011_ACPR_figures_report_2015.pdf

[19] www.credit-agricole.com/en/content/download/…/Actualisation+A04+2016+VA.pdf

[20]https://www8.gsb.columbia.edu/valueinvesting/sites/valueinvesting/files/files/Graham%20%26%20Doddsville%20-%20Issue%2018%20-%20Spring%202013_0.pdf

[21] http://www.hypo.org/content/default.asp?PageID=524

[22] http://www.globalpropertyguide.com/real-estate-house-prices/F#france

[23] http://www.hypo.org/content/default.asp?PageID=524

[24] http://www.hypo.org/content/default.asp?PageID=524

[25] http://nordic.businessinsider.com/this-barclays-chart-shows-the-most-fragile-property-markets-in-europe-2017-1

[26]  http://www.hypo.org/content/default.asp?PageID=524

[27] http://www.hypo.org/content/default.asp?PageID=524

[28]  http://www.hypo.org/content/default.asp?PageID=524

[29] https://en.wikipedia.org/wiki/List_of_sovereign_states_in_Europe_by_GDP_(nominal)

[30] https://acpr.banque-france.fr/fileadmin/user_upload/acp/publications/rapports-annuels/20163011_ACPR_figures_report_2015.pdf

[31] http://www.hypo.org/content/default.asp?PageID=524

[32] https://www.linkedin.com/in/etienne-vernier-43922b7

The Worldly Wisdom Project #3

A few weeks back I came across an interesting article about rewards named On the folly of rewarding A while hoping for B written by Steven Kerr. As I’m a strong sceptic of stock options program and alike I always find stuff like this interesting to read. Although it was written in 1995 the lessons given by Kerr in the article have no expiration date. Instead, the article has over the years become an classic in its field of study. In the article Kerr gives numerous examples that showcase how we humans as every other organism on this planet “seek information concerning what activities are rewarded, and then seek to do (or at least pretend to do) those things, often to the virtual exclusion of activities not rewarded“. (p.7) Other than stating examples, Kerr dives into the discussion about causes and what might be done to improve the situation of rewards. In this worldly wisdom post I will focus on some of the examples as they were the ones that really caught my attention while reading. However, I do recommend reading the whole article as it is only 9 pages long and can easily be find with a Google search.

Please comment if you have read the article and what you thought of it. Also, if you have found a worldly wisdom in the article that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.

Four worldly wisdom’s from On the folly of rewarding A while hoping for B by Steven Kerr

In War

If some oversimplification may be permitted, let it be assumed that the primary goal of the organization (Pentagon, Luftwaffe, or whatever) is to win. Let it be assumed further that the primary goal of most individuals on the front lines is to get home alive. Then there appears to be an important conflict in goals—personally rational behavior by those at the bottom will endanger goal attainment by those at the top.

Consider, however, some critical differences in the reward system in use during the two conflicts. What did the GI in World War II want? To go home. And when did he get to go home? When the war was won!

Consider the reward system in use in Vietnam. What did the soldier at the bottom want? To go home. And when did he get to go home? When his tour of duty was over! This was the case whether or not the war was won.” (p.8)

In Medicine

Theoretically, physicians can make either of two types of error, and intuitively one seems as bad as the other. Doctors can pronouncepatients sick when they are actually well (a type 1 error), thus causing them needless anxiety and expense, curtailment of enjoyable foods and activities, and even physical danger by subjecting them to needless medication and surgery. Alternately, a doctor can label a sick person well (a type 2 error), and thus avoid treating what may be a serious, even fatal ailment. It might be natural to conclude that physicians seek to minimize both types of error.

Such a conclusion would be wrong. It has been estimated that numerous Americans have been afflicted with iatrogenic (physician caused) illnesses.* This occurs when the doctor is approached by someone complaining of a few stray symptoms. The doctor classifies and organizes these symptoms, gives them a name, and obligingly tells the patient what further symptoms may be expected. This information often acts as a self-fulfilling prophecy, with the result that from that day on the patient for all practical purposes is sick. Why does this happen? Why are physicians so reluctant to sustain a type 2 error (pronouncing a sick person well) that they will tolerate many type 1 errors? Again, a look at the reward system is needed. The punishments for a type 2 error are real: guilt, embarrassment, and the threat of a malpractice suit. On the other hand, a type 1 error (labeling a well person sick) is a much safer and conservative approach to medicine in today’s litigious society.” (p. 8-9)

In Universities

Society hopes that professors will not neglect their teaching responsibilities but rewards them almost entirely for research and publications. This is most true at the large and prestigious universities. Cliches such as “good research and good teaching go together” notwithstanding, professors often find that they must choose between teaching and research-oriented activities when allocating their time. Rewards for good teaching are usually limited to outstanding teacher awards, which are given to only a small percentage of good teachers and usually bestow little money and fleeting prestige. Punishments for poor teaching are also rare.” (p. 9)

In Sports

Most coaches disdain to discuss individual accomplishments, preferring to speak of teamwork, proper attitude, and one-for-all spirit. Usually, however, rewards are distributed according to individual performance. The college basketball player who passes the ball to teammates instead of shooting will not compile impressive scoring statistics and is less likely to be drafted by the pros. The ballplayer who hits to right field to advance the runners will win neither the batting nor home run titles, and will be offered smaller raises. It therefore is rational for players to think of themselves first, and the team second.” (p.10)

Kerr S. (1995) On the folly of rewarding A while hoping for B. Academy of Management Executive; 9(1): 7-14.