During the middle of the fourth quarter of 2023, Our Man built a dislocation position in European (and specifically UK) Banks. The crux of the thesis can be summed up as European banks spent the last 15 years using profits to rebuild their capital base and are now ready to start returning those profits to investors, and it comes right at the moment when profits are likely to rise due to higher interest rates. The market doesn’t believe this as everyone knows European Banks are terrible no good investments, and that a UK recession is coming and thus rates will go back down.
Yes, I know you’re disgusted that OM bought European/UK banks – perhaps almost as disgusted as Mrs. OM was - but that’s a necessary condition for a dislocation investment! As a reminder, dislocation investments should be unloved by investors (hated is even better!) and thus absolutely and relatively cheap, but with something upcoming that will help change the narrative and price.
Everyone knows that European banks have been an awful investment for over a decade. Here’s Barclays over the last 10-years; a whole of ugly!
And it’s not just Barclays, the entire European Bank index has a measly 2% annualized total return over the last decade, and negative returns over 20 years! And yes, OM did notice the 2023 demise of Credit Suisse!
However, the terribleness of European/UK banks is a known known and it leaves Barclays – a premium UK bank (stop laughing in the back!) – trading at ~0.5x book and a P/E of 5x. Furthermore, expectations are low with market analysts expecting little to no growth in earnings in the upcoming years.
Yet, the dirty secret is that after spending over a decade of using profits to repair balance sheets and capital ratios, the European banks are finally ready to return some of that lucre to a moribund shareholder base. Whisper it quietly, but European banks are much better capitalized than their US counterparts (and with far less of the not marked-to-market financial chicanery)!
While OM could walk you through all the financials, Barclays were kind enough to provide a slide that goes directly to the heart of the matter.
What’s going on here? Well, Barclays invested in a massive long-term interest rate swap portfolio to smooth its P&L. Their timing was suboptimal, locking in exceptionally low rates – as seen by the average hedge yield of <1% through 2022. However, the good news is that about 20% of the portfolio (50-60B GBP) rolls off each year and in 2022 and 2023 it began being reinvested at much healthier rates (4.57% at Q3-23). This is why the light blue bars for 2024 and 2025 are a cloudy white at the top; if the entire portfolio generated 4% (vs 1.54% as of Q3-23) then the hedge income would be ~10B GBP, off the charts compared to the dark blue bars of 2019 to 2022.
So why doesn’t the market see this or care? Well, the uncertainty is of course over the 5-year swap rates in 2024 through 2026, given it will take till 2026 for the low rates to be rolled out of the portfolio. For simplicity think of the portion of the hedge at 2019s rates being rolled into 2024s rates, and 2020s in 2025s, etc. The market’s belief is that the UK economy is weak, a recession is coming and that rates will fall. While this is certainly possible, it helps create the kind of dislocation trade that OM loves; hated, cheap and with the market already assuming bad things and pricing that in. If nothing happens, and the UK just muddles along with rates remaining broadly similar then Barclays will profitably roll that massive hedge portfolio and the stock is seriously mispriced.
The same analysis broadly holds true for other European banks, but OM has focused his positions on the UK since (i) inflation is likely a little more structural there (in part due to Brexit) and (ii) ‘everyone knows’ that the UK economy is weak and rates are coming down.
Disclaimer: Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take it that way. For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so. Our Man also holds some cash and a few other securities (of negligible value). You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc.
