Banking on overlooked and undervalued stocks

A family friend recently told me that they invested in Commonwealth Bank of Australia shares because it seemed popular and was the market leader among Australian banks. Also, as a customer, my friend found CBA’s customer service very good.

While there is nothing wrong with investing in banks per se (the Equity Fund currently owns three of the big four Australian banks), that decision should be based on fundamental analysis, not because everyone else is investing or because you like the company’s product or service. You are likely to pay a premium for popular shares and, as contrarian investors, we instead search for buying opportunities in places others overlook or undervalue, where the price may be more attractive.

An example of a contrarian bank share

Let’s consider Virgin Money UK (VMUK), a regional bank based in the United Kingdom but listed on the ASX under the ticker code VUK. VMUK might be a smaller bank that not many people notice, or want to invest in, based on its depressed share price. We feel that this is a contrarian investment worth discussing.

VMUK offers both retail and commercial banking services. It was formerly known as Clydesdale and Yorkshire Banking Group (CYBG). CYBG was a subsidiary of National Australia Bank (NAB) and was spun off in 2016 due to several years of significant credit impairment charges caused by the Global Financial Crisis (GFC) and the provision charge of payment protection insurance (PPI) mis-selling (when customers were sold credit card and loan repayment insurance that in many cases was unsuitable). In 2018, CYBG acquired Virgin Money (VM – a bank that consisted of the best-performing mortgages of another bank, Northern Rock, and VM-branded credit cards) and rebranded the combined group and service as Virgin Money UK.

Currently, VMUK’s loan book is £73bn, split between about 80% mortgages, 12% business loans, 6% credit cards and 1% other personal loans. Funding is sourced from balances of current accounts, savings accounts, term deposits and wholesale funding.

Why was VMUK unloved?

VMUK and other UK banks have had a tough time since 2018. There have been several reasons for this, including:

1. The fear of a no-deal Brexit and the unknown implications
2. Strong competition in the mortgage market
   
3. More than £38bn of PPI redress paid by UK banks between 2011 and 2020 (VMUK had a £350m provision blowout in FY18)
   
4. The economic impact of COVID-19.
   

VMUK’s share price plummeted by 44% between September 2018 and February 2019 and its price to tangible book value dropped from 1.2 times to 0.7 times. During the same period, the share price of Lloyds bank, the market leading bank in the UK, declined by 10% and its price to tangible book value decreased from 1.2 times to 1 times. 

Whilst many investors turned away from VMUK, we believed the disproportional price and valuation change might imply a potential misprice for the company, which ignited our interest.

To test our theory of a mispricing, we undertook a stress test using the GFC as a benchmark. We studied the excess credit loss rate (the difference between the loss rate and their long-term median) of each loan class after the GFC. Applying the total of these one-off impairment charges to VMUK’s book components, we estimated that we are paying around 1 times for the remaining equity if VMUK had an excess credit impairment as it had during GFC. Even at a depressing long-term return on tangible equity of 5% after a credit event, we are buying VMUK at 20 times earnings at £2 per share. Comparing with the 0.9 times tangible book value of Lloyds bank or the PE multiple of ASX 300 today, the outcome of the stress test showed a large margin of safety for the price of VMUK at the time.

There are other differences in levels between now and the GFC that needed to be considered. For example, the household debt to disposable income ratio is lower today than the pre-GFC levels. Also, in 2014 a cap was introduced that no more than 15% of a lender’s mortgage book could be high loan-to-income. In other words, there seems to be less loan default risk today than there was in 2008.

VMUK’s underlying half-year 2021 profit before tax (PBT) was £205m, which puts VMUK at 7 times underlying PBT, compared to 7-9 times underlying PBT for Westpac (WBC), NAB and ANZ bank.

Aside from the large margin of safety and attractive multiple, there are other factors that drew our attention towards VMUK compared to the major Australian banks:

1. In the first half of this year, WBC, NAB and ANZ benefitted from releasing some of the impairment provision they had put aside when COVID-19 hit. This was a one-off positive contribution to profit for these major banks, instead of a cost in a normal year. Once this normalises, we believe that the earnings of the major banks will decrease compared to VMUK, if all else is equal.
2. VMUK’s non-interest income in early-2021 decreased by around 25% from the previous year, as did the value of transactions of UK credit spending. Whilst this is attributable to the COVID-19 lockdown and low spending activities in the UK, the experience has been different domestically, in that the value of transactions has recovered and is merely 4-5% lower than the level of pre-COVID period.
   
3. Because VM did not have a proper digital platform to attract clients to use its current account, VM’s current account balance was nearly zero. The combined group’s current account balance as a percentage of retail funding balance was 22%, which is much lower than its peers and also much lower than the balance ratio of 44% of CYBG pre-merger. After the merger, VMUK can cross-sell its current account products to old VM clients and therefore reduce its funding costs in the long term. Furthermore, with higher use of current accounts for daily transactions, VMUK might also receive some non-interest income.
   
4. The Bank of England Base Rate has been below 0.75% since March 2009, which is a period long enough to see that the low-rate impact has flowed through the whole book of UK banks. VMUK FY19 results indicated that the difference between yields of front book (new customers) and back book (existing customers) mortgages would be small and its net interest margin in 1H20 before the COVID-19 lockdown seems to have bottomed out. According to Financial Conduct Authority in the UK, the rate of outstanding fixed rate mortgages is 0.03% lower than the new fixed rate mortgages. The largest spread between fixed rate front book mortgages and back book mortgages in the UK during 2020 was 0.26%. In contrast, Australian banks have around 0.3-0.5% difference between the rates of front book and back book according to RBA data, so Australian banks face greater earnings’ headwinds as existing loans mature and are replaced by the newer, lower-earning loan book.
   
5. VMUK’s underlying operating expenses were £460m in the first half of FY21. Following the merger with VM and the resulting synergy, management expects operating expenses to be £430m in 2H21 and is targeting annual operating expenses of £780m in the mid-term.
   

Looking at the bigger economic picture, the UK has a lower household debt to gross disposable income ratio (shown in the graph below) and lower housing price to income ratio compared to Australia. Less debt means less chance of mortgage defaults and this might make the tail risk probability of the mortgage market lower in the UK than in Australia.

Graph: Household total financial liabilities as % of gross disposable income

Source: Australian National Accounts by Australian Bureau of Statistics and United Kingdom National Accounts by Office for National Statistics as at March 2021.

What challenges does VMUK face?

As with any investment there are no guarantees and VMUK faces some challenges:

1. The UK banking market is competitive, especially considering the growing number of challenger banks and neobanks. The rate of new loan and non-interest income might be lower in future if VMUK cannot differentiate its service from its competitors.
2. If VMUK’s service quality and rates cannot attract good quality customers, there is a possibility of lower credit quality than the market average.
   
3. The potential scale of a financial crisis in the UK due to Brexit and COVID-19 might be greater than the level of the GFC.
   
4. Negative interest rates. Although the UK official base rate is near zero, it is still possible that the Bank of England might reduce it into negative territory if the economy does not recover as much as expected. If so, the net interest margin and profitability of VMUK could decline further from the current level.
   

The big four banks remain some of the most popular shares for Australian investors. Historically they’ve been viewed as ‘safe’ and reliable dividend payers, but as we saw during the market turbulence of 2020, this is not guaranteed as some banks cut their dividends. The Allan Gray Australia Equity Fund has some exposure here, as in our view the major banks, excluding CBA, offer some value compared to the S&P/ASX 300 Index. The Fund is overweight both ANZ and NAB, with a smaller position in WBC. VMUK, however, does seem to present a more long-term attractive opportunity for the Fund.

When choosing investments, blindly following the crowd and only looking at the most popular opportunities may not be the best strategy. Better value could be found if you’re willing to stray from the pack. 

Want to learn more?

Contrarian investing is not for everyone, however there can be rewards for the patient investor who embraces Allan Gray’s approach. Visit the Allan Gray Australia Equity Fund profile to find out more.

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