The Standard Chartered saga revisited

Two years ago, Standard Chartered plc made headlines when it was fined $667 million by the US federal and New York state authorities for laundering, including through its New York unit, some $250 billion on behalf of Iran, Sudan, Libya and other countries in violation of American sanctions.

Going a long way to explain how the bank got into its regulatory travails was the memorable line attributed to its then Chief Financial Officer: “who these f*** Americans think they are to tell us what to do”.  Not only did the bank hide its illegal dealings, it obfuscated (before being forced to cooperate) and even threatened to countersue the NY Department of Financial Services for causing damage to its reputation!

Back in August of 2012, I wrote that Standard’s difficulties stemmed from either a culture harking back to the Indian colonial days or the need to preserve a business overly dependent on risky emerging markets (EMs).  Either way, although its stock price had then fallen in the mid 1300s[1], I felt that the conditions were not met to justify investing in the stock.

Today the stock is at 1,218p, yet I don’t feel tempted to buy. First semester 2014 net income is expected to be down 20% year-on-year[2], full year 2013 net income was down 15% from the year before, and 2012 net income was essentially flat with 2011; return on common equity has been trending down steadily since 2004[3]; loan impairments have been rising (+35% in 2013)[4].  Finally, the business risk profile of the bank remains, in my opinion, high, with close to ¾ of its loan book in emerging markets as well as almost all of its profits[5].

Culturally, and despite some senior management reshuffling since the 2012 fiasco, not much has changed according to a Financial Times article of 7/24/14 which noted “widespread criticism that the bank is run like a colonial empire” and that “arrogance at the bank has got so high”.

Criticism from large shareholders has mounted, so much so that the bank’s board felt obliged yesterday to issue a press release reiterating its support for the current CEO; and last May, 41% of voting shareholders rejected the new management pay policy.  It may well be that the bank owners will force a change in management; but that does not guarantee a change in culture.  Culture in an institution that spans vast regions and whose Country Heads are generally all powerful (because they possesses far more local knowledge than Head Office does), is hard to reshape.

More crucially, I believe that Standard Chartered is following a high risk strategy by being so dependent on emerging markets, particularly Asia.  I have some experience in this, having spent my banking career with a bank (American Express Bank Ltd) which had a similar emerging markets focus, although with greater regional diversification[6].

China and Hong Kong are the single largest business focus of Standard Chartered.  While I am sure that its country officers have good knowledge of their local customers and counterparts, I don’t think that they have a comparable knowledge of the macroeconomics or politics, because nobody really does. That is a big risk that the bank is assuming.

While emerging markets have had faster economic growth than the developed ones over the span of several decades, they also have had more crises and these have been more severe[7].  These crises have also tended to spread from one emerging market to another as individuals and institutions rush out to cut risk.

Because of their inherent leverage, banks are most exposed to financial and economic crises.  When such crises hit emerging markets, the big international money center banks can usually count on their large home businesses to absorb EMs losses; this was evidenced by the Latin American crisis of the 1980s, the Mexican crisis of 1994 and the Asian crisis of 1997-1998.  But a bank such as Standard Chartered has no large home market to fall back on, and should such an EM crisis come about, it will find that EM central banks have neither the resources nor the inclination to save foreign banking institutions operating on their soil.

So while Standard Chartered looks cheap, it remains, in my view, beset by two big problems: (1) “tainted” management team and culture, and (2) overexposure to emerging markets.  The first problem may soon see the beginning of a solution, but changing a culture takes time.  The business strategy is much more complicated (and costly) to fix, and some of the biggest macro risk factors affecting the bank are very difficult to assess.

JP Morgan has better management, a lower risk profile and better profitability, and it sells for 1.06x book value and 1.45x tangible book value.  Standard Chartered sells for 1.11x and 1.31x[8] respectively.  Is that logical?  I don’t think so.  In my opinion, STAN should probably sell at a 25% valuation discount to JPM.  This would put STAN stock price at 878p to 912p.

I remain on the sidelines, neither owning not shorting the stock.

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[1]  After recovering from a precipitous drop to 1,228p on 8/7/12.

[2]   As per management preannouncement.

[3]   Source: Bloomberg.

[4]   Source: JP Morgan.

[5]  It is estimated that close to 70% of the profits come from Asia and the subcontinent and another 25% from Africa and the Middle East.

[6]   Coincidentally, American Express Bank Ltd was sold to Standard Chartered in 2007.

[7]   Obviously, the US and Europe have just had a very severe crisis, but I would argue that it has forced them to take remedial measures.

[8]   Based on end of year 2013 tangible and overall book value.

Quick recommendation update

As summer is approaching, it is timely to revisit some previous recommendations.

I just sold my Telecom Argentina shares for a 79% profit.  I continue to like the company’s management and its business, but the political and macroeconomic environment in which it operates (Argentina) is getting increasingly difficult.  Maybe it is the darkness before dawn, but given the gain which was to be realized and the uncertainty ahead, booking a good profit seemed appropriate.

Standard and Chartered plc, the UK international bank, has essentially been flat since our post of last August.  I maintain my negative stance: the business model, in my view, continues to be riskier than generally assessed and I am not comfortable with the bank’s corporate governance.  I am not short, I am just on the sidelines.

Finally, Apple made some important announcements, although more evolutionary than revolutionary, at its annual developers conference.  We are still awaiting the unveiling of truly eye popping devices or services.  My previous price target of $600 pending the release of new products looks a bit too high; $500-$550 is probably more appropriate.  Nevertheless, I continue to hold the stock as it looks reasonably priced at current levels and increased dividends and share buybacks are positive.

2102 revisited: stock commentaries

We reviewed a few stocks this year.  So far, our take has been mostly right.  Our current scorecard is provided at the top of each section.

YPF (+33%) and Telecom Argentina (+16%)

Last April we noted that the nationalization of YPF and the expropriation of its then controlling shareholder, the Spanish multinational Repsol, was part of a long standing pattern of misbehaving by the Kirchner governments. 

Last month, with surprise developments affecting its unrestructured sovereign debt (impounding of the frigate Libertad in Ghana, adverse New York court judgment), with massive street demonstrations against the Kirchner government and the evident difficulties that YPF had in closing joint-venture deals with the likes of Chevron and others, we surmised that change may soon become inevitable and we started to invest in Argentina, just a little.  We thought that YPF would be a good start, with Telecom Argentina as a less speculative second choice.  At the time, their ADR prices were $10.46 and $9.82 respectively.

Today, they are $13.90 and $11.41.  While Repsol’s legal pressure is continuing, the Spanish government has made it known that it was in regular contact with its Argentine homologue and that a resolution of the dispute was likely.  After initial difficulties, YPF was able to raise substantial sums by issuing bonds on the local market; ironically, the repressive financial controls made YPF bonds the best deal in town.  It also helped that the government could force its Social Security system to buy half of the company’s debt offerings.

Negotiations seem to be continuing with Chevron and now Bridas, and they are very difficult: how could it be otherwise given the Repsol expropriation precedent and the unrealistic energy pricing system?  In the end, I think that Argentina has no choice but to pay Repsol for its stake in YPF and to adopt economically sensible oil and gas prices.  After all, its shale deposits are among the richest in the world, it will control and benefit their exploitation and it doesn’t want to be too dependent on Bolivia and Brazil for its energy needs.

Even though it gears to become the energy national champion (by taking control of Metrogas and with its expected bid for Petrobras Argentina),YPF continues to be priced for disaster (see peer comparisons in our September post). I do believe that the current strategy consisting in copying the Brazilian energy model is wrong and terribly costly; but even then, if the Repsol dispute is settled, as I expect it will, the YPF stock should rise very appreciably.

Telecom Argentina is well managed, profitable and carries a large net cash position.  Price controls and high inflation have squeezed its profit margin, but it too is priced for disaster.  Its stock may not pop up as much as YPF’s, but it is offers lower risks.

The other big risk factor for US investors is the continued listing of these companies’ ADRs in New York, as this provides liquidity and attractive economics given the overvaluation of the Argentine peso.  One would think that, unable to tap international bond markets, Argentina would be anxious to maintain access to international equity markets. 

JP Morgan Chase (+19%)

In May, I commented on the London Whale travails of JP Morgan which had pushed its stock price down to $36.96 on the day of my post.  I advised prudence, cautioned that the loss on its derivatives could well exceed the initial estimate of $2 billion (it did) but took the view that buying below $36 would result in a profitable trade.  The stock price spent two months below that level, bottoming at $30.70.  Today it is $42.81.

The bank management was extensively reshuffled.  Yet markets have responded without enthusiasm.  Although the stock price should appreciate further next year, my view of the company has evolved.  I have come to the conclusion, partly through personal experience and partly through industry review, that the bank has grown too big and diversified to provide superior customer products and services and to be effectively controlled. 

Warren Buffett once said that he wanted to invest in businesses that even fools couldn’t sink, because sooner or later fools would be in charge.  JP Morgan’s top management is very smart, even if it may suffer from some hubris; but I wouldn’t want to own the stock if fools were at the helm.  Admittedly, this is a remote possibility in the case of JPM.

Standard Chartered plc (-6%)

Last August, I wrote about Standard Chartered plc.  I expressed disbelief with their decision to continue doing business with Iran through their US facilities despite clear prohibition imposed by their host country.  I questioned the bank’s decision-making and the oversight exercised by its Board of Directors.  I also felt that its market value failed to reflect the inherent risks of its business model.  I elected to pass and wait for another day to invest.  The stock price then was 1,418.5p; today it is 1,497p.

Since then, little has changed. Of its twenty-one Directors, only two new have joined the Board following disclosure of the Iran saga.  No top or senior manager has paid the price for this fiasco.  The bank settled the outstanding charges with the US federal authorities for $327 million.   However, its latest quarterly results were satisfactory and, had I bought the stock back then, I would have made a 6% gain to-date.  I remain a skeptic but I admit that I may have been wrong.

 

Apple (+26%) and Research in Motion (+87%)

Last September, I argued that Apple was not a cheap stock despite its modest p/e multiple, the reason being that such multiple resulted from a very high gross margin.  I noted that reverting to 2006 gross margin levels would push the p/e above 23, even after deducting Apple’s large cash balances from its market value.  I also expressed some doubt that Apple could maintain its growth rate and gross margins by targeting emerging markets such as China.  Interestingly, Apple’s latest quarterly results showed a small drop in margins which the company put on the concurrent launches of new products.  The stock price, which was $691 on the day of our initial writing, has now fallen to $510. 

Irrespective of its fundamentals, Apple, once buoyed by client adoration and investor exuberance, seems to have lost some of its magic:  Steve Jobs passed away; it stumbled with its handling of Google Maps and Youtube; it continues to rankle with its refusal to support Adobe Flash; Apple TV remains an undefined possibility.  That said, relative to its peers, it remains a unique company; it is just very difficult to keep beating extraordinary expectations and to have to add $50 to $70 billion a year to justify current market valuation.   

On September 28^th, I argued that Research in Motion, the maker of the Blackberry, was a buy as it was priced for extinction, which didn’t seem likely. Today, a consensus has emerged that its new Blackberry 10 will come to market early next year.  Carriers and large corporate clients are testing it.  Besides its reported merits, the BB10I is benefitting from telephone carriers wanting to break the Apple/Android duopoly.  On the other hand, RIMM is faced with patent litigation from Nokia and has a very steep hill to climb in Europe and North America to regain market share. 

How will RIMM look like in two years, will it have succeeded in regaining critical mass, I don’t know.  But it has a sporting chance thanks to a meaningful client base (80 million), strong technology and good finances.  Back on 9/28/12 the stock price was $7.50.  Today, even at $14.05, its stock price continues to discount a somber future.

We should remind ourselves that extrapolating in a straight line is always dangerous; that was true when I wrote about these stocks back then and that is true now.  Market valuations are right most of the time, but when consensus reaches 90% or more, it is usually worth our while to investigate.

 

The Standard Chartered Bank plc saga, part I

I will not be alone in saying that the Standard Chartered Bank’s compliance problems with the New York State banking regulator (Department of Financial Services - DFS) caught me by surprise. 

I have been following this bank for several years, as it seemed to provide straight forward banking services internationally and made a good return in so doing.  Management seemed quite competent.  Finally, the fact that it had acquired what remained of American Express Bank Ltd. where I spent the first 16 years of my professional career added to my interest.  Actually, I was looking for a good entry point to invest in its stock.

However, the misdeeds that it allegedly committed and apparently did not contest as well as what has transpired so far about its senior management’s conduct have led me to suspend any investment attempt.

Essentially, the bank was accused of willingly defying US regulations forbidding banks to channel money of sanctioned countries such as Iran through the US.  The DFS accused it of laundering more than $250 billion over several years through its US banking operations, of falsifying internal records to prevent regulators from tracing the identity of its Iranian clients and of filing untrue reports.  That a major bank decide, in a very big way, to defy the laws of its host country is simply baffling.

The reaction of senior and top management in this whole affair further raised alarm bells in my mind.  There was of course the now infamous email exchange between the Head of US operations and his superior in which the former clearly outlined the dangers of the bank’s course of action and the latter replied “who these f*** Americans think they are to tell us what to do”.  There was also the truculent initial response to the DFS action stating that only $14 million of transfers had been mishandled and that the bank was contemplating countersuing for damage to its reputation!  This from a bank that had been under Federal oversight from 2004 to 2007 for money laundering.  Then, in short order, the bank agreed to settle with the DFS, paying $340 million and accepting renewed oversight.  As Butch Cassidy asked the Sundance Kid in the eponymous movie, “Who are these guys”? 

What is worrying in this case is that this is not an instance where a low level trader decides to go rogue.  It is likely that the decision to continue doing business with Iran was vetted by the very top management; the Board of Directors was probably at least aware of the decision/policy, and if it was not, then more serious questions must be asked.  What management decides to choose Iran over the US?  What kind of senior manager blurts out the f*** word when referring to the Congress of a host country?  So far, I find no reassuring answers.  Either we are dealing with a culture or a strategic problem. 

The cultural hypothesis is that the top echelons of the bank include throwbacks to the Indian days of the British Empire, except that New York is not a remote outpost in the bush.  When a senior manager not only refuses to listen to his country manager’s cogent alert and advice but also responds with unrestrained fury, when the corporation lets it be known of its intent to counter sue its regulator for damage to its reputation, under the circumstances, I, for one, wonder about the culture of the place.

The strategic hypothesis is that the bank’s main focus is emerging markets, many of which, by definition, are less closely regulated than developed ones, often condone business practices which would be frown upon elsewhere, and in some cases are governed by regimes which are not models of good behavior.  New York is important to the bank for providing access to the US dollar system, but the Americas-Europe-UK segment accounted for only 10% of Standard’s operating income in 2011.  In that sense, and in my view, the bank probably has a higher risk profile than generally acknowledged.

Bottom line, the US regulatory and judicial process is not over by a long shot as the Federal Reserve, Treasury and the Justice Department are still to conclude their own enforcement actions.  I am among those who applaud the DFS decision to go public and break the apparently stalled multi-party negotiations.  I found the allegations against the bank shocking (called me an old-fashioned banker). 

Finally, having myself spent most of my banking and investing careers in emerging markets, I have come to the conclusion that the Standard Chartered business model is riskier than previously thought, and more importantly, that such higher risk profile is unlikely to be easily reduced. 

At some point under the right circumstances and at the right price, the bank may become an interesting investment or trading idea.