Portfolio Update: Greece is the Word!!

With OM’s position in Greece having been sized up to 20% of the portfolio (start of Q2), it deserves a post of its own!    While OM  has provided updates on his Greek thesis before, which can be found here and here, the entirety of the thesis is not available in a single place.  This post, will rectify that. 

Our Man’s Greek exposure is primarily held through the Greece ETF (GREK) as well as smaller positions in two Greek Banks – Alpha Bank (ALBKY) and Eurobank Ergasias (EFGEY).

OM believes that the public markets reward contrarianism, especially when it’s tied to common sense, and his playbook for a dislocation is:

1. An investment that has had abysmal performance.  Ideally, investors will have been burned badly and/or are fatigued by the situation, which means it is likely overlooked.
2. Valuations are cheap and the fundamentals are turning, yet very few people care, and the stocks should at least suggest that they have found a bottom.
3. A change in narrative that provides an excuse or all-clear sign for investors to consider the area investable once more.

From OM’s research, the most attractive part of the investment is the ~24 months after the narrative has changed.  While the situation may continue to be attractive, potentially for many years, once it gets beyond a couple of years it will fall into OM’s Thematic portion of the portfolio and be evaluated and sized on that basis.

1) It All Goes Wrong for Greece

For Greece, the Global Financial Crisis was followed by a starring role in the European sovereign debt crisis.  While most people are largely aware of the Greek debt problems and the associated economic problems, the severity isn’t fully appreciated.  The crisis saw a 45% decline in GDP and unemployment top 27% in Greece – similar to what the US saw during Great Depression!

Greek GDP

Unsurprisingly, this saw Greek equity markets get decimated; down over 90% from their 2007 peak, over 80% from their post-08 highs, and over 70% from their 2014-highs.  The fall from 2014 is particularly important as ‘sophisticated’ investors helped recapitalize the Greek banks in 2013 and 2015, with the expectation that the crisis was largely over.  It was not!!

(click to enlarge)

Well for Greece, the opportunity is pretty clear; economic disaster and collapsing equity prices, over a prolonged period means that even ‘sophisticated’ money has been scared off.  

2). Valuations Become Attractive, and Things Turn Around

However, take another look at that chart of economic growth – things have turned around, and stabilized over the last couple of years.  Those aren’t the only signs though; the country passed over 450 reforms under the conditions of its IMF/European Central Bank/European Commission (the “Troika”) bailout deals and under those deals it is financed through 2033, when its debt amortizations start.  In exchange for this financing to help build a cash buffer, Greece had to agree to remain in a post-program surveillance program.  This helps guarantee the Greek government continues to deliver on its already enacted reforms.  Finally, for a country where people don’t pay their taxes and has historically spent recklessly, times are changing!  Greece has had one of the largest turnaround in public finances in history; it posted a budget surplus for the last couple of years and is committed to running one for years to come! 

Greek Government Budget Deficit

The same is true in equity markets, which bottomed back in 2016.  As a sense of the broad value in stocks, the CAPE ratio – an inflation adjusted 10-year price-earnings ratio – is negative!   With regards to the banks; Alpha Bank and Eurobank Ergasias ended 2018 trading at ~0.25x their estimated 2019 book value compared to European peers that traded at just under 1.0x.  Now, OM gets it…investors are rightly skeptical – after all there have been three bank recapitalizations this decade (2010, 2013 and 2015) that have seen investors lose almost all of their money.  However, OM would note that at this point regulators have been insiders on Greek banks for a decade (so book value really should be book value), vetted capital levels in continent-wide stress tests last year, and that Alpha and Eurobank both have 15%+ Tier 1 capital and are profitable!

Fundamentally, the banks continue to improve their non-performing exposures (NPEs) which have fallen 20% from the 2016 peak, with the ECB monitoring and acting as ‘big brother’ to help ensure this.  Last November, saw reasonable new NPE targets set by the ECB, working in conjunction with the Greek banks.  The ECB, the Bank and the Greek government all know that the banks must continue to reduce NPEs in order to be able to lend again, and help the economy grow.  This is why you’re seeing NPE sales by individual banks and various government plans being floated by the Central Bank  and Ministry of Finance to help speed up the process.  These combined with the recent Katseli law that makes it harder for people to strategically default, and the banks’ self-help (cost-cutting, etc.) are all  positive signs, and give the banks substantial operating leverage to improved conditions.

3) What will draw others back in

Which brings us to the change in narrative! Last year saw some steps in this direction, with Greece exiting its official bail-out program and raising money from the bond markets. Those bond markets, seem pretty sanguine on Greek risk.

The Greek government further took advantage of these low yields, to raise money and prepay $4bn+ of higher-interest IMF loans.  Further steps like this, and the banks continuing to fix themselves, will help but they won’t draw most investors back in.  That will require political change, and Greece is having elections in 2019! 

SYRIZA and their leader Alex Tsipras, who came to power in 2015, are broadly viewed as crazy leftists.   Yes, it’s in their name…SYRIZA being the syllabic abbreviation for The Coalition of the Radical Left.  Despite this, SYRIZA agreed to the Troika’s demands, passed bankruptcy laws, generated budget surpluses and helped the economy start to climb out of the abyss.  Irrespective, they are not a government that investors (especially US-ones) feel comfortable investing alongside.  However, 2019 is an election year in Greece and what if the country elected a leader that comes out of Western investors’ central casting?   You know, the kind that went to Stanford and Harvard, had spent time working for well-known US banks and consultancy firms before becoming a PE/VC investor, was pro-markets and business and came across as more efficient technocrat than ideologue.   Well, that’s the resume of Kyriakos Mitsotakis, the leader of the New Democracy party that’s currently comfortably ahead in the polls.   Should they seem likely to win as the election approaches, and eventually do so, I think it will remove a key obstacle for investors – Greece will no longer be scary, nobody will be fired for looking at it again, and it might even become the latest ‘unique idea’ for hedge funds.   This isn't to underplay all the good that Mr. Mitzotakis and a new government could do, just a reflection on what investors respond to.

Some Risks

While the above all suggest how Greece is setting up to be very attractive, under no circumstances should anyone think that it is even close to a risk-free investment.  As such, here are some of the key risks for OM.

• An important risk to the thesis is if global, and especially European, growth materially slowed down or became recessionary.  The most immediate impacts to the thesis would be to weaken the economic fundamentals in Greece and to increase the stress on the banks.  Additionally, stock markets and risk appetite would likely be weak in such a recessionary environment.  That wouldn’t spur anyone to invest in Greece.  In such a situation Our Man’s position should be vastly smaller.

• An obvious risk is that SYRIZA returns to power, hamstringing the change in narrative and remaining an impediment to investor interest rekindling.  A SYRIZA victory would also remove the optionality that a more business-friendly government could increase economic growth.  As such, Our Man’s position would be smaller, though it should be noted with the Troika continuing to monitor Greece’s compliance to its economic agreements, the fundamentals likely wouldn’t change substantially. 

• A final important risk is that the position, especially in the Banks, is dependent on regulatory forbearance.  The ECB has worked with the banks as a ‘big brother’ to set NPE reduction targets, and those most recently agreed for the period 2018 to 2021 were firm but fair.  Should the ECB change its approach it would likely mean further write downs and recapitalization for the banks that would negatively impact both investor and economic confidence.  While the ECB’s current plan is working well and the ECB is an independent central bank, the President is appointed by the leaders of the countries that have adopted the euro.  ECB President Draghi’s term ends in late 2019, and a new President (and team) may choose to take a different approach to Greek banks for their own political reasons.  This is something to continue to monitor, and much like investors the ECB decisions may be tied to the election result.

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above that way.  For added clarity, while Our Man is invested in all of the securities mentioned – Alpha Bank (ALBKY), Eurobank Egrasias (EFGEY) and the Greece ETF (GREK) - that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a many 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.