Jason Stipp: I'm Jason Stipp for Morningstar. As concerns grow over a possible Greek default and sovereign European debt concerns broadly, we're checking in today with David Herro, Oakmark International manager, and also named Morningstar's Manager of the Last Decade. He's going to tell us a little bit about his take on the European situation and how his portfolio is positioned today.
Thanks for coming in, David.
David Herro: Happy to be here, Jason.
Stipp: So, I'd like to talk about the potential for the Greek bankruptcy and the knock-on effects. You have several European bank holdings in the portfolio, and I think a good way to talk about this is to talk about your holdings.
As you're thinking about the possibilities that could unfold in Europe, how are you thinking about the potential for those holdings right now and the risks for those holdings?
Herro: Clearly, we do believe, there is a high degree of risk that the Greeks will not be able to pay most or all or any of their debt. Who knows? Probably they could pay for some of it, but clearly, they cannot pay for the nominal value of their debt. There's $400 billion in debt, 14 million people. They haven't shown propensity to go through austerity. By the way, we have seen this in places like Ireland, where they quietly have done the things necessary to get through their economic crisis. So, Greece is a problem.
However, the rest of the PIIGS countries, if you look at Italy, Spain, Portugal, Ireland, we do not view as major problems. Portugal has to be watched, but recently, their new government passed measures. So, that is the overview.
So, our main concern is the exposure to Greece and Greek debt among of the banks and the financials that we own. At this stage, if we look through all our holdings--and our biggest holdings in Europe are companies like Intesa Sanpaolo, Credit Suisse, Santander, and BNP Paribas, the French bank that's in the news today. None of these financial institutions have a major exposure to the Greek problem.
BNP has around $3.5 billion worth of exposure to Greece. However, pre-provisioning profits for that institution are over $20 billion. So they've already written down probably a third, 40% of their exposure. So we think they are in very good shape. BNP is very well capitalized, and we don't think there's real issue with them in Greece.
However, what happens is, because Greece is problematic, people have automatically extended this to all the other peripheral countries, and I think this is the big mistake. The other countries are not in the same situation as Greece, and the market is lumping them all together, and there lies an opportunity as well.
Stipp: So you mentioned BNP there, and it has some exposure to Greece. When you are thinking about that bank and all the bank generally, do you have a sense of what would be a best-case scenario, a worst-case scenario from the situation, and then also what do you think is the most likely scenario to come out broadly and also specifically in how it could affect those banks?
Herro: Well, the best case scenario is no Greek debt, no any sovereign debt, write-offs--best case scenario, that's not going to happen. I don't believe that's going to happen. Greece is going to have to write-off some of their debt. They don't have the capability to pay it back.
I think the rest of Europe can. So the worst-case scenario is, if the rest of the Europe can't, if for some reason, Italy can't; Spain can't. Something happens to France or Germany can't, can't. Worst-case scenarios--extremely unlikely, and improbable. France by the way is still a AAA-rated country, unlike United States. So the worst-case scenario, I think, has a very, very low probability. The best-case scenario has a low probability. I believe what's actually going to have to happen is there will be a haircut on Greek debt, and when all the dust settles, all the trauma that's happened to the European financial system will eventually work itself through. You will not have huge write-offs on the major banks book values, for instance, though the price to book values of these businesses have dropped to the degree that many of these banks are trading well below half book. I think the good news is, that book that's being priced is not going to take a big hit, because they just don't have that kind of exposure to where the problems are.
Stipp: Now you mentioned the banks that you own and what their exposure has been and what their financial strength has been. It implies to me that it’s important to be selective as you’re looking at Europe. And I think you could say, Europe’s had a lot of problems, but there should be some opportunity there if you’re smart.
How are you being selective? What are you looking for as you’re going into the European market? What has been your focus there?
Herro: It’s a great question because all banks are not created the same. All else being equal, we’d love to see banks that have large asset management businesses. And thus we have companies like Credit Suisse as one of our larger positions. It has a huge annuity coming from their private bank. It’s very profitable, it’s very stable. Net new money into the private bank has consistently averaged 4% to 6%. So those types of businesses add an annuitylike factor of stability to the earnings flow; we like that.
We like a source of funding that is a high deposit-to-loan ratio or a low loan-deposit ratio. So we like banks that have good deposit franchises. And if you look at Intesa Sanpaolo, in Italy, for instance, it’s a bank based in Northern Italy. It’s overcapitalized and over a 100% of its loan book is covered by its deposits. Even BNP Paribas is 125% loan-to-deposit ratio, especially when they did a deal with Fortis, they were able to get all kinds of deposit-gathering institutions under their umbrella.
And the third thing, of course, is balance sheet strength. We want capital strength. We want high Tier 1 ratios. Especially with new Basel III coming, we want to make sure that the banks we’re invested in are in good capital positions.
So those three factors: good ancillary businesses like asset management, good source of funding, good deposit franchises, and good capital ratios, and then I would add diversity in businesses. You have a company like Santander, based in Spain but less than 30% of its operating profits come from Spain. Great exposure in Brazil, Mexico, U.S., U.K.; that also helps the situation as well.
All banks are very, very different from each other. However, they seem to be priced in this trauma that’s happened in July and in August and even today in September, we seem to see all price reacting in a lock-step fashion, though all banks are not similarly when you look at those various characteristics.
Watch the second installment of this interview, Herro: Quality Has Been Trampled On.
