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):
”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, Moneta Assets Management and Financière Tiepolo.
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. As of November 2016 the regional banks together are the funds second largest holding Also, the Belgian asset management company Value Square NV show up on several of the banks shareholder lists. As of November 2016 the regional banks are Value Squares second largest holding. 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). 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:
“Our second-largest position is more esoteric. It’s in the regional affiliates of Crédit 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 (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  and the ACPR report for 2015. 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?  and The challenges of recent changes in French cooperative banking groups. 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. 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):
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%).
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. 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:
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).
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.”
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.
A similar graph but with a longer time frame (from a different source) shows a more volatile price development than the picture above.
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.”
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.”
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:
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:
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:
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. 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. 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.
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). 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). 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.
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. 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.