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Bank withdrawal

“When my information changes, I alter my conclusions. What do you do, sir?”
John Maynard Keynes

Until last year, I hadn’t owned a bank in my portfolios since 2002 but I have always kept a close eye on the sector. I have had several meetings with the management of the UK-listed banks during this time but have remained concerned about the quality of loan books, capital adequacy and high leverage ratios. I continue to believe that the process of post-crisis balance sheet repair still has a long way to go, particularly for the UK-focused high street banks.

HSBC is a very different beast, however. It is a conservatively-managed, well-capitalised business with a good spread of international assets. As Chief Executive, Stuart Gulliver has done a great job over the last four years, making a very complicated organisation much simpler to understand. It is still a huge and complex business, however – its 2013 Annual Report & Accounts document runs to around 600 pages, many of which are dedicated to the risks that it faces.

It is a challenged business in a troubled sector, but it has navigated through the headwinds that have blighted the banking industry in recent years robustly. I have questioned its valuation at times both pre and post financial crisis. But over the past couple of years it has returned to a more attractive valuation level, regularly trading at around or even below its book value and its yield is also appealing.

I started to build a position in HSBC for some portfolios in May last year and I included it in the portfolio of the CF Woodford Equity Income Fund at launch. In recent weeks, however, I have started to become more concerned about one particular risk: that of “fine inflation” in the banking industry. Clearly, banks have attracted many fines in the post-financial crisis world as regulators and policy-makers have cracked down on past and ongoing wrongdoings in the industry. The size of the fines, however, appears to be increasing.

For example, in 2012, HSBC was fined $1.9bn for failing to prevent Mexican drug cartels laundering money through its bank accounts. Last month, Bank of America agreed to pay $16.7bn to end investigations into its role in the run up to the financial crisis, selling toxic mortgages. This would represent the largest single federal settlement in the history of corporate America.

Clearly, in both instances, these are wrongdoings which would be expected to incur a substantial fine. I am concerned, however, that these fines are increasingly being sized on a bank’s ability to pay, rather than on the extent of the transgression. In particular, I am worried that the ongoing investigation into the historic manipulation of Libor and foreign exchange markets could expose HSBC to significant financial penalties. Not only are these potentially serious offences in the eyes of the regulator, but HSBC is very able to pay a substantial fine.

The size of any potential fine is unquantifiable, so this represents an unquantifiable risk. Nevertheless, a substantial fine could hamper HSBC’s ability to grow its dividend, in my view. I have therefore sold the fund’s position in HSBC, reinvesting the proceeds into parts of the portfolio in which I have greater conviction.

Sometimes, the evolution of an investment case can be subtle but significant enough to represent a change in investment view. I’m not suggesting that HSBC is a bad investment but in the light of this growing risk, I now view the shares as broadly fair value. By contrast, there are plenty of stocks I can invest in which look significantly below fair value – AstraZeneca, BAe Systems, Drax, Legal & General to name a few of the positions that have been recently increased – and I believe the long-term interests of my investors will be better served by focusing the portfolio towards them.


The views expressed in this article are those of the author at the date of publication and not necessarily those of Woodford Investment Management LLP. The contents of this article are not intended as investment advice and will not be updated after publication unless otherwise stated.

Conversations

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Got a view?

  1. QAff says:

    Really appreciate these blogs, keep up the good work. i know many read them, even if only a few leave comments.

    1. Mitchell Fraser-Jones says:

      Thanks for the feedback. Interestingly, there was an article by Gillian Tett in the FT on the issue of fine inflation just last week: Regulatory revenge risks scaring investors away

    2. Clive Collins says:

      Begs the question why Neil bought them in the first place, or two months ago, I think it was? I think he would have been aware about the regulatory risks, though, so full disposal is unclear.

      1. Mitchell Fraser-Jones says:

        Thanks Clive, we are long-term investors but we are also disciplined investors. An investment case is always fluid and the opportunity set we are monitoring is always evolving – it is therefore critical that we can respond to this gradual evolution by changing the portfolio when we believe to be appropriate. Hence the quote from John Maynard Keynes at the start of the article.

        All investment decisions are made with the long-term in mind but that doesn’t necessarily mean that all investments will be held for the long-term.

        1. Clive Collins says:

          I see the danger with large turnover is transaction costs acting as a drag on investment return. With the advent of high speed trading systems, there seems to be more of a reliance on shorter term style trading/investment. In the end, the decision to stay invested will be based on the longer term returns generated by the fund, which should in theory justify the on-going fund charge.

  2. Elizabeth davis says:

    As one of your most ignorant investors it may not help you to know that I agree with this move.

    1. D Michael M Jones says:

      Well, that makes two of us! Wise move.

  3. Jonathan says:

    Yes, I agree it’s really helpful to have regular updates on portfolio changes, along with some insight into the rationale behind decisions to buy or sell. I recently sold my own position in HSBC for similar reasons (but also had in mind, oh well Neil Woodford holds it in the fund so I’ll still have some exposure to any upside!) It’s possibly the best of a bad bunch, but the regulatory / fine risk just seems to be increasing rather than diminishing.

  4. paul melville says:

    Good to see an active manager like Neil always putting his investors interests to the fore.

  5. Colin says:

    Thanks so much for this advice which makes perfect sense now that you have brought it to your readers attention. Also thanks for the advice on where the funds are being placed.

    1. Mitchell Fraser-Jones says:

      Thanks Colin, but just to be clear, this is not advice. We just want to keep investors informed on our thinking.

  6. Robbie says:

    Excellent and appropriate quote to start the blog. As an investor I appreciate the information, but more appreciate the flexibility and proactive outlook by the fund manager.

  7. Nordy Tawndish says:

    There is still a political will to punish Banks because politicians see it as a vote winner. Fines are going to be high to create media impact and to appease voters. There needs to be a major shift in the banking system before the public will forget 2007 onward and so for an investor the Banks remain too risky. Good decision Neil in correcting the mistake of buying it.

  8. gordon lynes says:

    Thank you, Neil. The explanation is welcome and helpful.

    For what it’s worth, I viewed HSBC as being different and, in a small way, owned the stock until the 2012 money laundering fine, then selling on the principle of “three strikes and you’re out.”

  9. Matthew Bird says:

    I remember Neil selling his Tesco stakes a while ago, but I’d love to know what he thinks of them at their current price level and how he sees things panning out for them, and for that sector as a whole?

  10. tom says:

    I sold my entire share stock with HSBC due to them laundering drug money in Mexico.

    1. Simon says:

      It’s perhaps wise to point out that HSBC are not believed to have laundered any money.

  11. Steve watson says:

    These updates are great and give peace of mind he portfolio is in good hands!

  12. Andrew says:

    Where does all the fine money go?

    1. Mitchell Fraser-Jones says:

      Hi Andrew, that depends on which regulatory body is imposing the fine. Much of the proceeds from fines levied by UK regulators are distributed to charities. It’s less clear where the money goes in some other jurisdictions, however, as highlighted here.

  13. George Milleare says:

    Good move Neil, I have been worried about this for some time.

  14. Anthony Dunsdon says:

    I moved my personal accounts to HSBC after the banking disasters. Always thought they were the best of the bunch. Interesting to read your comments and thanks for your views re their possible future dividends and therefore my future income.

  15. Robert Barnett says:

    The article makes good sense and I follow the reasoning. However, I don’t understand what Neil says when he writes he will continue to invest in stocks which are “below fair value”. If HSBC is broadly “fair value” how does this follow?. Please excuse my ignorance if I am missing something.

    1. Mitchell Fraser-Jones says:

      Hi Robert, Neil is explaining that he has reinvested the proceeds of the HSBC disposal into stocks that he believes are below fair value – i.e. where he sees more attractive valuations. Does this help?

      1. Robert Barnett says:

        Yes. Thank you. The penny has dropped

  16. Oliver Sherman says:

    Really like the blog, but for the life of me I can’t see the value you see in Legal & General – would love to know what you see that I don’t!

  17. Derek says:

    Really appreciate this informative update and understand “reasons why”
    But as previously asked, where do the fine monies go?

    1. Mitchell Fraser-Jones says:

      Thanks Derek. There’s not much more we can say about where the fine monies go. At least we know that the UK policy is to distribute some proceeds to charity but elsewhere, as the article I linked to previously states, “The simple truth is that no one really knows where most of the money goes.”
      Link here again.

  18. Edwarg173@btinternet.com says:

    I notice that BT is not mentioned a share that Neil will be reinvesting more funds in. Has BT’s recent announcement of line rental / broadband increases changed his view on this share?

  19. Lifeboat No. 7 says:

    It has been said the most sure fire way to make some one a Vegetarian is to show them how sausage is made. Likewise the most sure fire way to sour someone on HSBC is to show them the inner workings of the bank. It is good to see that. Woodford has as opted to get off the Titanic at Cherbourg. The issue of fines being out of proportion with the offense is a valid one, yet the truth is fines, even record ones, are still failing to deter banks (especially HSBC) from making bone-headedly operational decisions. Douglas Flint’s recent tone-deaf op-ed on how all the pesky regulations are making it harder to gamble with his customer’s money is just the latest symptom of HSBC’s overall illness. They just don’t get it. The recent raid on HSBC offices in Buenos Aries by Argentine Federal Police, over yet ANOTHER allegation of money laundering is starting to make Matt Taibi’s Rolling Stone article look less like a hit piece and more like prophesy.

    The Monitors stationed inside the bank are losing patience, and with good reason. Rather than take. AML Sanctions and Risk seriously, the bank opted to outsource all the training on this critical area to a US firm that couldn’t find their own arse with both hands and a flashlight.

    As key investors like Woodford finally begin to see the writing on the wall, the common folk have been heading for the door of the Retail Bank for some time. I’m just surprised it took Woodford this long to notice.

  20. Oliver Kumaran says:

    HI, your fund is heavy on tobacco and big pharma, both of which are heavily exposed to regulatory fines of the magnitude that could destroy some of those companies. How do banking fines compare to those levied on tobacco and big pharma? Surprised that no one else has brought this up yet.

    1. Mitchell Fraser-Jones says:

      Hi Oliver,

      All businesses in all industries face the risk of regulatory fines and litigation. Some more than others, but a major part of a fund manager’s job is to assess these risks and make a judgement on their potential long-term impact on a business financially in the context of the prevailing valuation.

      Clearly, our judgement for the tobacco and pharmaceuticals sectors currently, is very different to that for the banks. Interestingly, the total fines accumulated by the tobacco industry is still significantly larger than that of the banks, as outlined in this article (thanks @conkers3).

      The subject of a future blog post in the making, perhaps…

  21. Suzanne says:

    Well done Neill and Co for honest information …keep up the good work!

  22. sachome@btinternet.com says:

    Interesting article in tonight’s London Evening Standard calling out an opposing view of the HSBC dump. It was potentially fair comment but only if the market generally was anywhere near ‘normal’, and by that I mean market forces and not central bankers dictating the highs and lows. The key premise revolved around ‘when interest rates rise’ and the potential gains all banks stand to make. My own view is that first the government really cannot afford an interest rate rise in the short term (2 years or so) as the country could not afford to service the National Debt (it is struggling to do that now with current rates). Second, any gains on interst rate rises (on debt to the bank) will be more than offset against the huge increase in bad debts the bank would have to suck up combined with the bank [potentially] having to find even more credit to pay the savers. I for one am pleased with the call. Thank you Mr Woodford.

  23. chris@bvassociates.co.uk says:

    Really interesting views in this blog with regards to Banks. I have a large proportion of my pension pot here based on the long term view and professionals running this diverse portfolio. I am pleased that the fund has the foresight to stand by its own research and risk management decisions and was actually surprised to see HSBC in the original portfolio.

    Kind regards

  24. Pritam says:

    With the interest rates rise in the horizon and banks having to deal with bad debts and regulatory regime would keep banking sector in the doldrum.I think it was a very shrewed move by Neil Woodford to dispose of the HSBC.

  25. ClandonMan says:

    Today’s HSBC news headlines suggest you made the right decision to ‘back track’ on the HSBC investment back in September and explained your reasons for doing so. Go to the roof of your building. Raise a flag. Shout it loud.

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Important Information: We do not give investment advice so you need to decide if an investment is suitable for you. Before investing in a fund, please read the Key Investor Information Document and Prospectus, and our Terms and Conditions. If you are unsure whether to invest, you should contact a financial adviser.