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We’ve been loading up on equities in our model portfolio during the post-Brexit volatility, but so far, we have yet to buy Clydesdale & Yorkshire Banking Group, one of the most heavily sold stocks given its exposure to the UK.
Banks being one of the most widely held stock by Australian investors, many of you will own Clydesdale following the spinout from National Australia Bank earlier this year. As such, you might be wondering if there’s an opportunity after the recent selldown. To recap, on the last day of May, the stock peaked at $5.86; post ‘vote to leave’, CYB currently stands around $3.69.
So is it an opportunity after the fall?
Well, we’d say yes – it’s cheap and there’s a compelling long-term story on costs – but there’s a good deal of risk short-term.
Clydesdale, like ASX banks, is a leveraged play on the host economy, in this case homeowners and SME businesses in the north of England with a small amount of exposure to the south of England as well. It’s a regional bank much like Bank of Queensland, which has sizeable market shares in Queensland and a lesser presence in other states.
Now there’s a great deal of uncertainty about the near-term direction of the UK economy, which is why this and other UK bank stocks have been sold aggressively, and no one can say whether the UK will have a mild slowdown or a recession due to Brexit.
Figure 1. Uncertainty for the UK economy
Source: ONS, Morgan Stanley
The above charts show business investment had already slowed before the referendum, and household precautionary saving is low now, but spiked from these levels in the 2009 financial crisis, detracting from consumption spending. Something perhaps on a smaller scale could happen again and investment could contract if firms lose confidence in their output markets or EU access. The longer-term risk is of course lower exports to Europe if the UK cannot negotiate the same access to the EU common market it has now. The fork in the road has been likened to either a constructive divorce, in which case the effects on GDP and unemployment are mild, or an acrimonious divorce, where there is a deeper recession. Wider risks include a broader deterioration in the EU economy if sentiment there suffers or there is further political instability. If you ask Clydesdale management what they expect, they have no more than a bias towards a mild slowdown and admit “anything could happen”.
One of the key words for Clydesdale is what I just mentioned: negotiate, or what the new Prime Minister and British representatives can negotiate for the UK’s new relationship with Europe. Much of the Leave campaign was about taking back sovereignty, especially over borders and inflows of migrants and workers, but access to the EU common market comes with the requirement to have open borders and it remains to be seen if Britain can really negotiate the utopia of common market access and border controls promised by the Leave campaign. The Norwegian solution of common market access without EU membership is often promoted but that includes open borders as a tradeoff. At this stage the negotiations shape up as bumpy, tense and unpleasant even though it’s in everyone’s interests to keep trading. There will be an element wanting to punish Britain to discourage other EU members from leaving and how that finds expression remains to be seen. No one really knows what Britain’s eventual trade relationship with Europe will look like and discussions could take years. The UK is an open economy with 25% of GDP from net exports so the prosperity of Clydesdale and every British bank hinges on the level of trade with Europe.
The pound has depreciated sharply against the US dollar and the Euro, and this will stimulate the UK economy especially via tourism, but this might be offset by lower export demand if Britain loses some trade access to Europe or there is a broader downturn in the country’s export markets.
The main risk to Clydesdale would be a sharp, sustained fall in English house prices, which would see credit quality deteriorate seriously and bad debts expense spike. As in Australia, house prices have in many areas been bid to record highs due to the long downtrend in bond yields and mortgage interest rates, so they are vulnerable. At this stage we think monetary support from the Bank of England would mitigate any downturn in the housing market from a recession but there still would be an effect if unemployment jumped.
So those are the general economic risks to Clydesdale this year and in coming years. The best case is consumer and business confidence take a knock but not enough to skittle demand for credit or sink house prices. In this case Clydesdale can continue to grow its mortgage book, as it did by 5% in the first half, and bad debts expense doesn’t outweigh the benefits.
Let’s now turn to the long-term upside. The main attraction – this is a compelling cost-out story.
Figure 2. Simplifying the business. Managing Costs
Source: CYBG plc
We and other investors look to CEO David Duffy to lower the cost-to-income ratio from the 72% of the first half to more like 55%, as he achieved at Allied & Irish Bank. Because Clydesdale was managed mainly for survival and capital strength under NAB during the financial crisis and after, and NAB could never decide if wanted to exit or double up in the UK, the operational side of the business didn’t receive enough attention with the result Clydesdale is very cost-inefficient. Any pressure on revenue from a post-Brexit economic slowdown should spur management to accelerate its cost reduction plans. Things are already heading in the right direction with an improvement in the costs guidance at the half-year result.
Other positives include the 90% deposit funding ratio, which reduces sensitivity to increases in wholesale funding costs, no need for concern about loss of EU passporting rights given Clydesdale is headquartered in the UK and serves only the domestic market, a fortress balance sheet with a common equity tier 1 ratio of over 13%, and a likely reduction in regulatory risk weights against mortgages in 2018 as the Bank of England moves to similar risk weights for regionals as major banks. If there is an economic downturn then the banking sector starts from a good place, with low unemployment now and low non-performing loans. Clydesdale and other banks are not as exposed as in 2008.
We also have met and like the management, which has the right strategy for a regional bank and one we have seen work well for Bank of Queensland, Suncorp Bank and Bendigo & Adelaide Bank: lend conservatively, aim to grow not much faster than system, focus on home lending and SMEs (not large institutional borrowers), prefer mainly stable deposit funding to wholesale money markets, have unquestionable capital strength and reduce cost-to-income towards the majors over time. Clydesdale is already doing all this so the general strategy, approach to risk and choice of management all get a tick from us.
And the stock is cheap. Like other UK bank stocks, Clydesdale trades on just 58% of book value or equity per share of four British pounds or $7.30 Australian, an amazingly low figure compared with ASX major banks, which trade on one to two times equity given their much higher returns on equity in the mid-teens compared with UK banks in the mid-single digits. If you consider this from a StocksInValue valuation perspective it means UK banks are earning less than their required returns, which means they are destroying economic value by reinvesting earnings. So there would be quite a rerating for Clydesdale if it can cut costs enough to get its 6% return on equity up to something more like 10%.
One other important point to remember about Clydesdale is there is no dividend now and nothing forecast until financial year 2017. All bets on a dividend would be off if England did have a recession. In contrast ASX major banks trade on fully franked yields of 6% and better.
So there’s a summary of our views on CYB: cheap, no certainty on dividends, good management and strategy, compelling longer-term upside, hostage to British internal politics and EU exit negotiations. On balance we’re considering taking a small position in the model portfolio.
Read more about our ASX Model Portfolio or CYB
The ASX Model Portfolio balance is $526,916 at the time of writing, representing a 5.4% return since inception. Sign-up to StocksInValue to view our ASX Model Portfolio & more research from our analysts.
Written by David Walker, Senior Analyst.
Disclosure: Clime Asset Management owns shares in CYBG plc on behalf of various mandates for which it acts as investment manager. David Walker owns shares in CYBG plc.