Late last year, I wrote a blog post on the Greek banks, with a particular focus on Eurobank. I discussed how the popular narrative at the time had completely crushed Greek bank share prices, despite clear evidence existing that the economic and banking-industry fundamentals were actually markedly improving, not deteriorating. I took a meaningful position in Eurobank (2.0%), and eventually also about a 50bp position in Piraeus, mostly in the 0.60-1.15 range.
True to form in markets, where stories routinely change faster than facts, the narrative has now flipped, which has sent Eurobank up as much as 90%, and Piraeus by 5x its early-2019 lows. The magnitude of the former's recovery vs. the latter has been inhibited by its (probably unnecessary) highly-dilutive merger with Grivalia late last year, which I discussed here. The merger reduced downside tail risk along with upside, however.
Markets have not just belatedly recognised that the Greek economy is actually starting to do quite well (which has also seen Greek bond yields fall), but have also responded very positively to the recent outcome of European elections, which for Greece's representatives, handed a resounding victory to Greece's more right-wing New Democracy party. Accompanied by Syriza's call for upcoming snap elections, it has given rise to optimism that a more market- and reform-oriented government is set to take power.
A new narrative has emerging that is easy to sell: "The economy has bottomed and a new market-friendly government will replace its socialist predecessors, and usher in an era of reform and rapid recovery." As is usual, the narrative is overly simplistic, and ignores (1) the significant - if imperfect - reform that has already occurred under the existing government, and the resulting recovery that is now already well underway; and (2) the practical challenges to implementing reform by any government - present or future; reform is seldom easy or swift. But no bother - Greece is now a good news story and the stocks are going up, so let's buy first and ask questions later!
With an improving narrative, investors are now rushing to try to get any exposure to Greece at all, often simply buying the Greek ETF blind. Arguments are made that "the Greek ETF is down 90% from its highs", while the fact that the index-heavy Greek banks have been recapitalised multiple times, diluting former valuations down to essentially a permanent zero, is ignored. And to top things off, after the stocks' recent rallies, MSCI has also announced that it will be re-admitting Greek banks to various indices, resulting in the index funds who dumped the stocks near the lows only six months ago now having to buy them back at multiples of their prior prices. The result has been a surge in Greek stocks - and particularly banking stocks - at a time when broader global markets fell 6.5% in May on trade war/economic fears, and European banks in general were sold off meaningfully. This makes the magnitude of the Greek bank's recent gains all the more significant.
Templeton once said that there are two types of investors - 'outlook and trend' investors, and 'price and value' investors, and believed about 90% of investors were the former. Outlook and trend investors are now starting to jump into Greece, and are doing so despite the fact that prices have already significantly risen, rendering the risk-reward ratios today far inferior to what they were six months ago, despite how it feels.
Granted, the outlook has potentially improved somewhat, but it has not improved all that much given the evidently-robust recovery trajectory Greece was already on by late 2018 (discussed in my blog post). True, the New Democracy party might succeed with more reforms, but generally speaking, it is far easier to talk a good game to investors than it is to execute. Furthermore, some fundamental factors have actually deteriorated at the margin in recent months. The EU economy has continued to rapidly slow, for instance, and the EU (and UK) are important trading partners for Greece/sources of tourism. The current account has also ticked down from 0% toward a 2-3% deficit; and Greek domestic PMI readings & other leading indicators have also moderated from very strong levels late last year.
I am a value investor, and I focus on price and value, not the (putative) outlook, which is almost never a simple and clear-cut as investors believe, and I have sold my Piraeus position entirely - most in the past two days - and also reduced my Eurobank position to about 1.2% (and am considering trimming further). The stocks might well continue to do very well in coming months if the herd continues its inward stampede, but the truth is that the fundamental risk-reward characteristics of these stocks has actually meaningfully deteriorated. Value investing is all about focusing on prices and valuations, and letting others prognosticate about what the future might hold.
Let's have a closer look at Piraeus, which has rallied a remarkable 5x from its lows, which true to form, has started to trigger pro-cyclical upgrades/buy calls from various quarters. An easy thing for investors rushing to buy Pireaus to overlook is the 2bn or so outstanding CoCos (contingent convertibles) that exist, that convert at 5.71 (current price 2.76), which are meaningful relative to the company's 1.2bn market cap. On a fully diluted basis Pireaus' market cap is 2.2bn, and in the meantime they are paying 160m in interest which is not deducted from the company's headline PPoV (but is paid for by ordinary shareholders). If the CoCos don't convert, they will have to keep paying 160m a year into perpetuity.
The company's 'core Pireaus' division, which excludes legacy bad debts, is earning about 175m a quarter in PPoV (pre-provision operating profits), or 700m a year. However, if you net CoCo payments, it's 540m to the common. If we use a normalised cost of risk of 50bp on performing exposures of about 24bn, this subtracts another 120m, getting one to pre-tax earnings of 420m. After tax of 29%, this gets you to 300m NPAT. They have a lot of DTAs, so won't pay cash taxes for a long time, but they need use the cash benefit of their monetisation over time to replace this fake capital with real capital (DTAs are included in their capital ratios), so shareholders cannot benefit from those tax deductions (because Piraeus has no excess official capital above regulatory requirements). There is upside to this 300m in core profits over time as the company's cost-to-income (CIR) ratio continues to improve and Greek's economy heals, but for the timebeing, the stock is on a 4x core PE (vs. 1.2bn market cap); or about 5x on a fully-diluted basis (NPAT of 415m excluding CoCos interest, and 2.2bn diluted market cap) - up from closer to 1x earlier this year.
If that was all there was to it, the stock would be clearly cheap and should be bought. However, the stock is not as cheap as it looks because the company still has a lot of unrecognised bad debt on its books, which in economic terms (for shareholders) is analogous to a large non-interest-bearing liability held against those core earnings that needs to be repaid before shareholders will have any access to those core earnings. Winding down & writing off legacy assets will probably consume virtually all of their core profits out until 2023, or another 4 years, and will then likely consume a meaningful minority of earnings (perhaps 20-50%) for perhaps another 3-5 years thereafter. When you include this liability alongside the 4x core PE - even acknowledging the latter is struck on depressed economic activity - the high earnings yield appears less compelling than it might otherwise.
Furthermore, while market fears of such have abated for the timebeing, it is still possible they will need to raise more capital (something fickle investors thought was inevitable as recently as four months ago). Successful investing has a lot to do with identifying risks and opportunities investors are ignoring/unaware of today but which they could well concern themselves with in the future, rather than merely reacting to the zeitgeist of the day - being ahead of the curve, so to speak. It was only six months ago that people were focused only on the risks, and none of the opportunities, and sentiment is now swinging back the the other direction.
But the reality is, both the risks and the opportunities that exist today exist in a form that is largely unchanged from what they were only six months ago. It's sentiment rather than the fundamentals that have meaningfully changed. Piraeus is only barely compliant with current minimum capital requirements (including DTAs), and the reality is that they have not yet succeeded with a targeted Tier 2 issuance, even if markets are now happy to assume they will now most assuredly be able to pull it off. They still have a lot of bad debt to work through; they are still under-reserved for legacy loans; and the economic-political outlook is - as always - still uncertain!
To be sure, if everything goes according to plan, this stock could easily be trading at 8-10x core earnings by 2023 as legacy bad debt write-offs start to ease up - 100-150%+ upside from current levels (about 20-25% a year compounded over 4 years), and probably more if European banks in general re-rate upwards. That is actually my base case expectation. However, there is quite a lot of risk involved - they have to succeed in winding down NPEs from current elevated levels of 52%; not need (or choose) to raise more equity capital; and have the economy continue to recover steadily in a no-surprises environment. I tend to think they will probably pull it off, but it's definitely not assured.
In addition, from a market sentiment flux point of view, if investors at any point start to worry again about the need for another capital call, the stock will get crushed like it did late last year/early next year, as it also will if optimism about the political-economic outlook for Greece wanes (e.g. if New Democracy doesn't win the election); or (to a lesser extent) if New Democracy wins but fail to effectuate any meaningful reform, and the economy slows.
At current prices, Eurobank appears to be a superior risk-reward alternative to Piraeus in my view - albeit with less upside in a bull scenario. The company has already raised about 1bn in extra capital (merger with Grivalia complete), and assuming they get their securitization plan executed (which is on track, with binding offers received for the better tranches, and non-binding offers in for lower-quality tranches), it will end 2019 with a 15% NPE ratio (Pireaus 52%); better quality retained NPEs; higher capital ratios; and the likelihood of moving towards a c10% reported RoTE as soon as 2020.
Far fewer assumptions are needed than for Piraeus in terms of achieving RoTE targets (Piraeus is targeting high-single-digit by 2023) - really just the securitization deal being finalised at close to anticipated pricing - and bottom-line profitability and dividend-paying capacity will emerge as soon as 2020, and the stock is on about 6x FY20e. The company also has the same same opportunities for growth off that base through ongoing cost efficiency measures, and benefiting from a recovering Greek economy, as Piraeus. I personally think the extra two multiple points on core earnings vs Piraeus is well justified given (1) faster return to profitability and dividend paying capacity (from 2020) - i.e. the lack of that large effective non-interest-bearing liability I referenced; and (2) much less risk of further dilution/capital calls.
However, Eurobank's valuation appeal has nevertheless also meaningfully deteriorated vs. late 2018 levels. Not that much has fundamentally changed (despite progress being made, the securitization deal is still not yet complete), and the stock is now trading at 6x FY20e vs. 3.5x before. While the outlook feels better and safer, in reality the stock now has half the upside and twice the downside.
Meanwhile, European banks in general are not only cheap but have also recently got a whole lot cheaper. Italian bank Unicredit, for instance, has recently been hammered, and now trades for just 5x earnings and 0.5x TBV, and is further along with its capital/NPE resolution actions than the Greek banks, and is also already solidly and (probably) sustainably profitable (9-10% RoTE) and is back to paying dividends (30% payout, likely to move to 50% in next few years). It also makes 40% of its earnings in CEE, and also has a meaningful German business, so it's not even entirely an Italian bank! 1Q19 NPL trends across the Italian banks were also much better than expected, despite a softening in the economy, suggesting a decade of tighter lending standards is working well. And while Italian sovereign exposure is high, it is also high for the Greek banks, and yet Italian government debt to GDP of about 120% is meaningfully below Greece's 180%!
Why is Unicredit so cheap, and why has it fallen sharply despite demonstrating favourable operating trends of late? Because the narrative on Italy has now turned negative! At this stage, Unicredit appears to be a superior risk-reward to Piraeus in my view (although Eurobank still has an edge I think, because the Greek economy has superior recovery potential, as well as the potential for a more oligopolistic and profitable market long term as well). Accordingly, I've rotated some of my Piraeus proceeds into a new (albeit relatively small) position in Unicredit in the past few days. I've also reduced my Eurobank position meaningfully as the company's valuation appeal is no longer exceptional (although it's still cheap and no longer fundamentally that risky given its beefed-up balance sheet).
While other 'outlook and trend' investors are dumping Italy and moving into Greece, I'm doing just the opposite because that's what 'price and value' considerations suggest is the rational move.
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