“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.
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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.