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Deutsche Bank, Deutsche Bank, what shall I do with thee? I am not sure why I shifted to the renaissance period, but that’s the question to which I seek an answer today. Welcome to this 16th post of investing, not rocket science! Investing Doesn't Have to Be Rocket Science: this is our Non-Expert Guide to Portfolio Management.
A quick recap this series so far:
In the 1st post: I defined a basic portfolio framework. The objective of this million dollar portfolio is beat inflation and an equity index. Active portfolio management, without the use of leverage and a time horizon greater than 5 years. The benchmark index is the MSCI ACWI IMI.
From posts 2 to 15: I have evaluated 57 stocks and 4 potential bond additions. The portfolio is long 11 stocks, 1 Bond and short 1 stock. Let’s take a look at it.
Portfolio update:
· Since Inception (14FEB2023) to yesterday (29MAR2023), the portfolio is up +2.3% while the benchmark index is down -2.43%
· Asset Class: Equities, Bonds and Cash have contributed to positive performance in the portfolio, only the Real Estate stock is slightly lower.
· Risk Measures: Sharpe ratio: 2.62 Sortino Ratio: 3.66 Standard Deviation 0.35%
· In my understanding, some of the key reasons for this outperformance: Diversification (Asset Classes and Stock Sectors), Research before decisions, current cash exposure at 25%.
· There is however, market risk that cannot be avoided in a portfolio, unless I were to redeem completely and move into cash. Which unfortunately may not be a good option in the current inflationary scenario.
Portfolio details:
· The largest detractors: Deutsche Bank has fallen -21% and Citigroup (-9%).
· The biggest gainers: Google (+15%), Glencore (+13%), JD.com (+8%)
· The hedge (short position) continues to remain in the green, so far. That may change this week.
Let’s dive into todays evaluation:
The objective is to assess the losing stocks in the portfolio (Deutsche Bank and Citigroup), compare them with other stocks in the Financial Sector and decide on one of the following: Hold, Add, Reduce or Replace. The stocks on the list for todays evaluation are JPMorgan, Bank of America, BNP Paribas, Banco Santander and Lloyds.
To assist with the evaluation will be the semi-quant method that I introduced in post 14. This should help avoid biases while assessing financial data.
Why the Financial Sector?
· Exposure to the broader economy: growth is correlated to economic activity, we will see more of this while assessing financial trends.
· Diversification: helps spread portfolio risk by investing in different sectors.
· Exposure to interest rates: after a long period of low interest rates, inflation and interest rates are likely to remain sticky going forward, which in turn boosts bank earnings.
· Dividend Income: financial stocks tend to provide a regular dividend income (not mandatory though).
Company Financials:
· In terms of Annual Revenues, JPM is the largest bank followed closely by Bank of America and Citigroup. The smallest bank is Lloyds and Deutsche Bank which is one notch above.
· Revenue multiple: Deutsche Bank is relatively undervalued at 0.7x, followed by Citi and Banco Santander at 1.3x, while JPM and BAC are at higher multiples of 3.1x and 2.5x respectively.
· Earnings yield: Deutsche Bank leads with 28.9% followed by Lloyds and Banco Santander.
· BAC, JPM, BNP and LLOY have negative free cash flows, while SAN has the highest.
· A table with the semi-quant data is on the illustration.
Efficiency, Valuation and Volatility:
· Operating income margin close to 40% for LLOY, SAN and JPM. Lowest for DB and C. (The two stocks in this portfolio.. well done guys!)
· Price to tangible book value: DB, Citi, BNP and SAN are relatively undervalued compared BAC and JPM.
· Net income to stockholders in the range of 21% to 31% for all stocks.
· Realized volatility highest for DB (tell me about it!) at 42% (funny that it did most of the downside after I picked up the stock.. does that ever happen to you?), lowest for JPM at 28% (its not really that low, just on a comparison basis).
Trends in Company Financials:
· Revenues for financials look cyclical, likely a strong correlation to economic growth, which goes back to the first reason for investing in the financial sector. The US financials show negative revenue growth rates, however Citi and JPM have shown signs of bottoming out, while the trend on BAC continues to remain negative. Among the European financials, SAN has a negative trend currently.
· While Lloyds sees the highest operating income margin in its most recent reading, its 5 year average is similar to JPM, BAC, SAN and Citi. BNP has a stable operating income margin in the last 5 years. JPM and Citi have declining trends in operating income margin.
· BNP and JPM sees stable trends in earnings yield, DB sees rising trend post pandemic.
· DB and SAN see stable trends in Free Cash Flow margins, while JPM, BAC and LLOY see sharp falls.
· The quarterly earnings report for this quarter (Q1 2023) are likely to begin in 2 to 3 weeks and the latest data will certainly add to the trend analysis. This is a continuous process, although I must also say that fundamental analysis is based on past data and performance, there is no guarantee that the trend will continue. Research can reduce risk, cannot eliminate it.
Fair Value, Upside Potential and data points from SEC Filings:
· I assess fair value and upside potential using two methods: Fair Value (InvestingPro) and the Analysts Fair Value estimate. While the InvestingPro method is objective and based on their valuation models, the analyst fair value is subjective to the view of the analyst. Both are important and an average of the two tends to provide a good indication of the potential upside.
· In addition to fair value and upside potential, I also looked into the SEC filing documents for each of these banks for two data points: Their Liquidity Coverage Ratio and Total Capital Ratio (Excess to the requirement in bps)
· The LCR is calculated by dividing HQLA (High Quality Liquid Assets) by estimated net outflows assuming a stressed 30-day period. A minimum requirement of 100% is necessary.
· Total Capital requirement depends on the assets held by banks, a calculation based on Risk Weighted Assets is used to determine TCR.
Reason for this additional information from SEC filings? First, I realize that capital adequacy ratios are important to determine the health of a bank. Second, I compared these numbers to FRB.. You remember First Republic Bank, which almost went out of business because of a bank run (sudden increase in withdrawals)? Well, their capital ratio requirements are 10% + a buffer of 2.5% and according to the form 10K that they filed with the SEC, the TCR was 12.6% (which is a +10bps excess to the requirement?). Third, I compared this to the now defunct SVB and according to their Form 8K filed on March 8th 2023, their total capital was at 14% after a sale of $21 billion of securities. (As the saying goes; the details are in the details!).
Summary of the evaluation:
Back to the objective in this evaluation, from the evaluation and then semi-quant data: I am pleased to say that DB and Citi are good investments, which are going through a rough patch currently. Data from the semi-quant is in the illustration. Among the US financials, Citi has the highest decision points. Among the European Financials, Banco Santander and Lloyds could be alternative choices. However, I am not considering them currently due to sharp fall in free cash flow for LLOY and the downward trend in revenue growth for SAN.
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I am going to increase the exposure into both DB and CITI by 1% each. LLOY and SAN are the two new equities that I evaluated today, which will go into the watchlist to review at a later point.
In the next few posts, I evaluate more stocks that can be added to this portfolio from across sectors, including travel and tourism.
Thanks for your time! See you in the next post!
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