A Short History of Financial Euphoria - lessons for a value investor

Those who learn the lessons of history are saved the doom of repeating its mistakes; for history repeats itself. And as John Kenneth Galbraith lays out in entertaining detail in his magnificent book, financial history is no different. The one constant which can be taken for granted in the free-enterprise economy is that speculative insanity and its associated financial devastation will reliably recur. From the Dutch Tulipomania and John Law’s infamous Banque Royale scheme of the 15^th century, to the Great Crash of 1929 and the dot com bubble of late the 19^th century, to the more recent devastation heaped by the subprime mortgage crisis and the resulting credit crunch, and the numerous episodes of financial insanity in between, financial history has repeated itself time and again in reliable fashion. But the value of John Kenneth Galbraith’s book comes not from its fascinating description of all the major episodes of insanity, from the Tulipomania to the October 1980 stock market crash, and the entertaining stories from each episode. The value of his work comes from his analysis of the features common to these episodes and the things that signal their certain return. Knowing this has great practical value for an investor – firstly, in terms of being able to preserve ones wealth, and secondly, in terms of being able to profit from the insanity of the markets. I must note here that this is by no means easy and almost everyone is prone to disillusion and insanity.

The common features of financial euphoria (and the ones which ensure their recurrence in the future)

1.      Some artefact or development, new and desirable, captures the financial mind. For examples: Tulips in Holland (Tulipomania of the 1630s), Gold in Louisiana (John Law and Banque Royale in 1700s), the untold riches of Americas which The South Sea Company was all set to exploit in the 1700s, the stock market which was always set to raise in the late 1920s, the enormous economic lift to be provided by the Regan administration in the 1980s, the great dotcom companies which signalled the arrival of the new digital economy of the late 1990s, and the amazing power of securitisation to make risk disappear in the mid-2000s. By the way, Trumponomics could be the new and desirable development in today’s market.

2.       The price of the object of speculation goes up; this increase in price and prospect attracts new buyers and ensures a further increase in price; more are attracted and the increase continues. This process is only clearly evident after the fact – i.e., after the doom.

3.       The basic attributes of the participants in such episodes of financial insanity take two forms:

a.       Those who wholeheartedly believe in the new artefact or development and its price-enhancing characteristics; and,

b.       Those who believe that they have the ability to perceive the speculative mood of the times and profit from it by riding the momentum and somehow magically get out just before the crash.

4.       Both the price and the participants are sustained by their vested interests. They are experiencing an increase in wealth and no one wishes to believe that this is undeserved; they all wish to think that it is the result of their own superior insight or intuition. To directly quote John K Galbraith – “Speculation buys up, in a very practical way, the intelligence of those involved.” This is particularly true of the first group of participants discussed above.

5.       The other common feature is the condemnation heaped on doubters and dissenters. There is a general tendency in such times to ignore the sceptics and suspend disbelief.

6.       The financial world also suffers from brevity of memory, a feature which ensures that it cannot learn the lessons of history. Again, I must quote John K Galbraith on this – “Let it be emphasized once more, and specially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius.”

7.      The public and the market believes that intelligence and wisdom are closely associated with possession of wealth and/or control of money. In consequence, possession or control of wealth creates a lack of self-scrutiny and the general belief in one’s superiority. Again to quote John K Galbraith’s rule – “Financial genius is before the fall.”

8.     Almost all episodes of financial insanity have involved debt in some fashion; debt that became dangerously out of scale in relation to the underlying means of payment. Again, there is a tendency by participants to view each episode as being unique, a new normal, where debt take a form which is considered perfectly reasonable if not innovative and genius. As John K Galbraith notes – “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets”. And in episodes of financial insanity, the scale of this debt goes awry.

9.      Built into each episode of financial euphoria is its eventual fall. It doesn’t matter what triggers this fall – however much the cause of the fall gets debated – what matters is that it always comes and comes with a bang. At some point in the cycle, the participants who had been riding the upward wave decide to sell; and those who had up until then believed that the increase was forever get their confidence shaken and also decide to sell. When everyone decides to sell, a collapse ensues. As John K Galbraith notes – “The rule, supported by experience of centuries: the speculative episode always ends not with a whimper but with a bang.”

10.   After every collapse, anger and recrimination ensues. This always focuses on individuals who were previously admired for their financial ingenuity. Some end up in jail and others in financial obscurity. New regulations are brought in to tackle the financial excesses of the times. But what is always forgotten is the speculation itself or the insane optimism behind it. To quote John K Galbraith – “Those who are involved never wish to attribute stupidity to themselves”.

To avoid being caught up in an episode of financial insanity is no easy task. The crowd’s force is a strong pull and it is by no means easy to sit on the side watching the masses get rich. At the height of financial euphoria it is easy to buy into the euphoric belief, especially when it seems to be supported by superior financial opinion at all fronts. The only remedy, as John K Galbraith states, is an enhanced skepticism that would resolutely associate too evident optimism with probable foolishness and that would not associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money.

Strong adherence to the philosophy of value investing comes to the rescue. A true value investor must never be caught up in episodes of financial euphoria. At its core, value investing requires a contrarian mindset and a long term investment horizon; the first quality inspires skepticism and the second quality inspires respect for the lessons of history. By always being disciplined; carefully measuring intrinsic value; constantly challenging and updating ones measure; and only buying at a discount to ones measure of intrinsic value, a value investor can not only preserve his wealth but also look to profit from episodes of financial euphoria.

UK's student loan book sale

Earlier this month (6 Feb 2017) the UK Government announced it will commence the process to sell a part of the pre-2012 English student loan book through securitisation. The plan is to sell the loan book which entered repayment between 2002 and 2006, with the reminder of pre-2012 loan book to be sold over the next 4 years. A bunch of investment banks are working towards bringing the initial tranche to market and the sale is expected to close in the second quarter of 2017.

There has been a lot of press over the last few days – mostly negative for the Government and its plans. But what caught my eye were the numbers.

The total pre-2012 English loan book stands at ~£45.4bln as at April 2016; and the Government expects to raise £12bln through the sale of this loan book over the next 4 year. This equates to a ~74% discount to the outstanding loan book. Given these numbers, this opportunity is worth a look. 

Valuing the student loan book is not easy. This is not your typical fixed income instrument where you have a defined cash flow and you apply a discount rate based on your cost of capital after taking account of credit and interest rate risk. These student loans are income contingent where repayment is triggered based on the income of the borrower. Broadly, each student pays 9% of the difference between his/her income over a set threshold. Currently, for the pre-2012 loans, this threshold is £17,495; therefore, a borrower earning £25,000 would pay £675.45 per annum. On top of the income contingent nature of these loans, default rates tend to be very high – current average default rate on the loans granted between 2002 and 2006 is ~50%. The high default rate reflects the fact that there is no credit or other checks needed to be eligible for these loans which means that almost any student enrolled in any university course is eligible. Before getting to my estimate of value for the 2002 – 2006 loans, here is a brief table showing the key terms for these loans:

Key terms of the English student loans granted between 2002 and 2006

Type of loan	Income Contingent -current annual repayment threshold - £17,495
Payment terms	9% of income above annual threshold
Annual Interest rate set on 1 Sep each year	Retail Price Index (RPI) in the previous March, or 1% above the base rate, whichever is lower. It is worth noting that as the graduates only pay 9% of the income above threshold, interest rates only change the duration of the loan and not the amounts repaid.
Cancellation	Any outstanding balance on the loans taken between 2002 and 2006 is cancelled when the borrower reaches the age of 65; the loans are also cancelled upon death or disability of the borrower
Collection process	For most borrowers, payments are collected by the HMRC through the UK tax system by employers taking amounts from their salary through the Pay as You Earn (PAYE) system. Borrowers who are self employed pay through the tax self-assessment process by filing returns with the HMRC. Borrowers living abroad pay direct to Student Loan Company

Valuation

There is some data available from the Student Loan Company (SLC) which I have used to estimate future cash flows and to value the loans which entered repayment between 2002 and 2006. It is by no means easy to do and requires some big assumptions. I see this exercise as a bit of homework before I can get my hands on the pitch book from the banks when they bring these loans to market. By doing some homework and knowing the difficulties / assumptions required in valuation, I should be better prepared to review the sales pitch from the Government and its advising banks when it becomes available.

Data available from the SLC

The SLC has some good data from which can get the following information for each repayment cohort:

a)       number of students paying their loans each year;

b)       number of students who were liable to repay each year (borrowers become liable to repay the April after graduating or otherwise leaving their course and are required to make payments if their income is above the threshold);

c)        implied default rate (number of students repaying divided by number of students liable to repay);

d)       total amount outstanding (liable to repay) at the end of each year;

e)       total amount paid each year;

f)        average amount paid by each paying student (total amount paid divided by number of students paying);

g)       income threshold for each year;

h)       interest rate for each year; and,

i)         implied average income per paying student (on the basis that each paying student pays 9% of his/her income above the income threshold, this can be calculated as – [(f) average amount paid per paying student divided by 9% plus (g) income threshold per year]

The below tables show the trend in above variables, from the first year when they entered repayment, for each of the repayment cohort currently earmarked for sale. 

Projecting future cash flows                 

Projecting cash flows for these student loans is more art than science. I have used the following variables to arrive at my projected future cash flows for each repayment cohort:

1.       I have assumed that the number of students repaying will fall by ~10% each year for the reminder of the payment period. The trend over the last 5 years for each repayment cohort indicates that the number of students repaying has fallen by ~10% each year.

2.       I have assumed that the implied annual income per paying student increases by 1% each year. Again, the trend over the last 5 years is consistent with this assumption.  

On the basis that the repayment cohorts above are fairly mature – these repayment cohorts include students who would have finished their education between 2001 and 2004 – I believe that the last 5 year trend in number of students repaying and implied annual income should be a reasonable estimate to use in projecting future cash flows. For example, if the average implied income over the past 10 years has been ~£28k and growing at ~1% over the past 5 years, it is unlikely to change materially in future given the amount of time it has been since the student graduated and any uncertainty should be to the upside.

3.       I have assumed that each repayment cohort will pay for 30 years from the year it entered repayment. I believe this is a conservative estimate – e.g. these loans pay till the borrower turns 65 and assuming an average age of 25 when the borrower becomes liable to pay, these loans should pay for 40 years from the year they entered repayment.

4.       The other key assumption required to forecast cash flow is the income threshold for each year. This variable has a significant impact on the cash flows as the payments are set at 9% of borrowers’ income above the income threshold. This is a difficult one to predict and I am sure will be a key focus for investors when they see more detail on the sale. This will be a political hot potato for the Government – for example, freezing the annual income threshold could maximise the proceeds from sale as there is less uncertainty for the investors but will likely invite severe rebuke for the Government; similarly, any uncertainty on this variable (e.g. if a future socialist Government is able to increase this threshold materially to the detriment of the private investors but playing well to its constituents) will mean reduced proceeds. Based on last six year trend, average increase has been ~2.5% and I have used this as the basis for my cash flow forecast.

5.       Interest rate is another key variable which is difficult to forecast. As discussed earlier, this is the lower of RPI or base rate plus 1% each year. Given the low base rate in the UK over the last several years, this rate has hovered around the 1.5% mark over the last several years and is at 1.25% at present. I have assumed a rate of 1.25% for my forecast cash flow. As discussed above, the interest rate does not impact the amount of cash a student has to repay but only impacts the duration of the repayment – e.g. the amount repaid each year is fixed at 9% of the income earned above the income threshold with the interest being added each year to the outstanding balance. On the basis that I am assuming cash flows coming in for the next 30 years only, interest rate should not impact my valuations and any uncertainty should be for the upside.

Using the above variables to project cash flow for each repayment cohort and discounting cash flow at a rate of 10% gives a present value of ~£1bln for 2002 – 2006 repayment cohort, implying a discount of 75% to estimated £4bln outstanding amount on these cohorts. 

The assumptions I have made in arriving at the above valuation are fairly conservative and provide a decent chance for an upside. If the Government does decide to sell these loans at a ~74% discount, it definitely merits a detailed look. The other point of interest will be how the securitisation is structured – e.g. will it be by repayment cohort where earlier years merit a higher discount than later years, or will it be by quality of borrowers.

From the UK Government’s perspective one could ask why sell at such a heavy discount?; clearly these loans should be worth more than 25p in a pound to the Government given its low cost of capital. Apparently, for the Government, immediate cash is worth more than cash coming in over a number of years in future; this is because it can then use this cash to fund near term needs (like making more student loans) instead of borrowing which impacts on its commitment to reduce public sector net debt in the near term. 

It appears that we have a situation where the seller is selling for reasons other than pure economic value which should present an opportunity for the buyer. 

Bank of Cyprus (LSE:BOCH)

Investing in the shares of distressed European banks requires tremendous courage – success requires a decent dose of luck and good timing, in addition to picking the right horse. The big discounts to tangible book value reflect the very high risk of future dilutive equity issuance owing to the massive challenges faced by these banks on their NPLs. Investing in the NPL book or entering into a 3^rd party servicing agreement to run down the NPL book offers significantly better odds of success. However this is more for the Hedge Funds and PE houses given their deep pockets and resources. For an individual investor, I still believe that a basket of carefully picked distressed stocks offers a decent chance of success (of my 3 picks so far – Eurobank and Deutsche have returned 2x and Millennium BCP has tanked; for an overall return of ~35% in under a year). And now, I want to add Bank of Cyprus to my basket.

Bank of Cyprus is the largest bank in Cyprus with ~41% share of the loans and ~30% share of the deposits. It currently trades at just under 50% tangible book value.

Investment thesis

FY16 could be the year that turns a corner for BoC –
- it is set to make its first net profit after six years of losses;
- it has now fully repaid its €11.4bln loans to the troika and is able to pay dividends in future;
- deposits are returning;
- the trend in NPLs and 90DPD formation is reversing;
- it has an enviable net interest margin of 3.5% and cost to income ratio of 42% both of which should support pre-provision income; and
- the Cypriot economy has shown better than expected recovery supported by a growing tourism sector and a resilient business services sector and this is reflected in the falling unemployment rates, improved credit ratings and the fall in government bond yields.

The ~25% deleveraging in total assets since bail-in in FY13 - including the sale of all/most of its non-core assets - has made the bank a leaner more focused outfit.
Here are some graphs from the bank’s most recent investor presentation to illustrate the above points

Source: Bank of Cyprus investor presentation 11 Jan 2017

Potential upside

I don’t believe BoC’s shares offer value in the short-term; but over the long-term (1.5-3 years), they could do well. There are still significant challenges around NPLs (discussed in more detail below) and the market seems to be pricing in additional dilutions or hit to income owing to additional provisions or both. For the gap between price and tangible book value to narrow, the positive trend achieved over the last year/year and a half will need to continue for another year at least – in particular, the market will want to see positive net income and continuing reductions in 90DPD formation and NPEs. The recent trend in key metrics makes an entry at current price an attractive proposition.

Based on my projections for FY16, I expect the bank to make a Return on Asset of ~0.6% and Return on Tangible Equity of ~4.6% (ignoring the one of costs incurred in connection with the London listing and re-org). This assumes the bank taking provisions of ~70% against pre-provision income (consistent with provisions taken during 9M to Sep16). If the positive trend in 90+DPD formation and NPL’s continue provisions as a percentage of pre-provision income should come down. There is no doubt that provisions will stay high given the level of NPEs, but the bank should be able to generate a 1% ROA even where provisions stay as high as 50% of pre-provision income.

If the bank hits ROA of 1%, I calculate value per share of €0.052 (~169% upside to current price). Even in a scenario where provisions stay as high as 60% of the pre-provision, per-share value could rise to €0.041 for a 135% upside. The above assumes no growth in pre-provision income.

Downside risk

The biggest challenge is the risk of dilution owing to the bank having to rise additional equity to cover further write-off’s in the loan book. NPE’s currently stand at an alarming ~55% of gross loans with accumulated provisions covering ~42% of the NPE’s.

But the trend in NPE’s and 90+DPD formation has been positive, with both falling consistently over the past 12 months consistently every quarter.

Source: Bank of Cyprus investor presentation 11 Jan 2017

Based on my calculation, the bank will most likely need to rise additional equity if TBV falls by 
~€750mn; such a fall will take its capital ratio from the current ~14.5% to 10.75% which is the minimum required by the ECB for the bank. For TBV to fall by €750mn, the default rates would need to increase from the current ~55% of loan book to ~69% at constant coverage of 42%. To put this into context, At its peak in Dec14, NPE stood at 63% of gross loan with coverage at 34%; currently NPE is at ~55% of gross loan and coverage is at 42%. 

In the table below, I have calculated downside under 3 scenarios - if default rates rise to 63%, 69% and 80%. Per my estimates, even if default rates rise to 63% (last peak), the bank won't loose €750mn in TBV if allowing for 3 years' of pre-provision income and won't need equity issuance. Default rates need to rise to 69% for the bank's TBV to fall by €750mn; assuming the bank issues new equity at 35% discount to TBV, downside to current equity holders will be ~35% in this scenario. Default rates need to rise to 80% with loss given default going up to 50% for current equity to be wiped out.  
 

I think the current downward trend in NPE and 90+DPD formation, including the fact that the bank has achieved healthy recovery rates on restructured loans make the downside scenarios discussed above less likely.

Finally, there are a couple of elements that offer considerable upside with virtually no downside for a long-term investor. The first is the potential of Cyprus’s offshore natural gas fields. The recent auction of another block of concessions attracted the participation of some major international companies and recent drilling activity suggests that there could be decent level of natural gas offshore Cyprus. The second game changer is the possible reunification of north and south of Cyprus after more than 50 years of divide – both sides have recently held positive talks. The bank has significant property assets in the north which is currently valued at zero in the books and any reunification will mean the bank getting the assets back or being owed compensation for expropriation. None of the two elements above form part of my thesis but provide a decent upside if they come to fruition.