EXECUTIVE SUMMARY: As contrarian investors we are always on the lookout for shares that we can buy at a significantly lower price than we believe they are worth. Thus, with banks in many developed markets coming under pressure, we launched a concerted research effort to see if we could uncover any investment opportunities. Spanish Bank, Banco Bilbao Vizcaya Argentaria (BBVA), presents one such opportunity as it has some specific features which we believe make it an attractive investment. Chris du Toit and Tamryn Lamb elaborate.
News flow drives market movements in the short term. People tend to overreact to both good and bad news, which creates opportunities for contrarian long-term investors like Orbis and Allan Gray. More often than not it is the bad news that attracts us, as our philosophy leads us to buy shares that have recently fallen out of favour and where we are able to build conviction in a view that is different from that prevailing in the market. Clients have come to know this philosophy well and often ask us to explain our research process and give them examples of where we are seeing such contrarian opportunities.
The research process
Our research process starts with identifying potential opportunities through a combination of qualitative and quantitative screening tools. Screening for shares where the price has fallen significantly and where current operating metrics appear inconsistent with the company's long-term track record helps uncover opportunities. In such instances, we look to build conviction that the current issues causing the share price to fall are temporary in nature, and that the business' franchise and underlying competitive positioning are not materially damaged. As long-term shareholders in these companies, we are reminded of Winston Churchill's quote that 'difficulties mastered are opportunities won'.
The critical question is how the fall in the share price compares to the permanent fall in the intrinsic value of the business. If the fall in the share price is greater than the fall in intrinsic value an interesting investment opportunity may arise. However, the market is often right and the current price is in many instances a fair reflection of the underlying value of the business. Given the inherent uncertainty of investing, we look to mitigate this risk by requiring a 'margin of safety' in case our assumptions turn out to be wrong. Simply put, we always look to buy shares that trade at a significant discount to our estimate of intrinsic value.
WE ALWAYS LOOK TO BUY SHARES THAT TRADE AT A SIGNIFICANT DISCOUNT TO OUR ESTIMATE OF INTRINSIC VALUE
Putting processes into practice
Following the financial crisis of 2008-2009, shares of banks in developed markets were under severe pressure. While the sector did experience a recovery off the lows tested in early 2009, many banking shares, particularly those in Southern Europe, came under pressure again, largely due to fears of contagion from Greece's fiscal deficit issues to other countries such as Portugal, Spain and Italy. Against this backdrop, we were conducting a concerted research effort to see if we could uncover any attractive investment opportunities.
BBVA - a contrarian investment opportunity
Banco Bilbao Vizcaya Argentaria (BBVA) is a Spanish bank focused on the retail market. Sentiment towards Spanish banks in general has turned extremely negative, due to concerns about the state of the Spanish banking system and economy. Although we too are concerned about the Spanish economy and the risks facing the bank's Spanish operations, we believe this company has some specific features which make it an attractive investment.
BBVA is listed in Spain but is a globally diversified bank, with only 37% of its operating income coming from Spain and Portugal. BBVA's market share of lending in Spain itself has fallen over the last 12 years (see Graph 1), a comforting trend given the low quality of lending that took place in the market.
The biggest protagonists in the explosive loan growth seen in Spain in the years running up to the onset of the global financial crisis were the Spanish savings banks or 'cajas', which are controlled by the respective local and regional authorities. These cajas pursued market share aggressively with seemingly little attention paid to risk-adjusted returns. The Spanish government is now in the process of restructuring its banking system and is facilitating a merger and rationalisation process, which we anticipate will result in a significant number of cajas disappearing, and a potential closure of up to 20% of Spanish branches. These formerly aggressive, pure domestic rivals will thus be focusing on recapitalisation and restructuring. This means that BBVA, with its high cost efficiency and national presence, is well positioned to benefit ' in much the same way as healthy institutions benefited from the Savings and Loans crisis in the US in the 1990s.
But it is the non-Spanish opportunity which is even more intriguing. While its share price has been pummelled along with its local peers, the market appears not to have taken account of BBVA's attractive franchise outside Spain. It was the first international bank to develop operations in Mexico and has a strong competitive position, holding 34% market share. The level of loans in the Mexican economy is still very low compared to other countries (household debt is only 13% of GDP, compared to 80% in Spain). Furthermore, the size of the bankable population and its income is expected to grow over the next 10 years. All this is good news for Mexican banks. Mexico and South America already account for approximately 45% of BBVA's operating income, and over our investment horizon we expect this to increase further.
BAD NEWS AND SHARE PRICE DECLINES OFTEN SHOW US WHERE TO LOOK, BUT THE KEY IS STILL THE RESEARCH PROCESS
Further loan losses remain a risk. However, our analysis indicates that BBVA is profitable enough to withstand severe loan losses, comparable to those that occurred during the Great Depression and the property market collapse in Japan in the early 1990s. The bank is trading on a price-earnings ratio of only six times our estimate of normal earnings, which we believe suggests that many of the market's fears about banks are now reflected in the price. This makes BBVA an attractive longterm investment.
We may be too early (or indeed, wrong). However, instead of unduly focusing on the short-term timing, we believe our clients' interests are best served by us maintaining an unerring focus on our long-term horizon. At the end of September 2010 BBVA made up 2.4% of the Orbis Global Equity Fund.
Performance does not come in a straight line
While we have confidence in the long-term viability of our research-intensive process, it is critical for observers to note that the benefits of this approach do not come in a straight line - we can, and do, have periods of underperformance which can last longer than just a few quarters.
Although buying shares below what they are worth means our ideas will always be contrarian, we will not buy every share that is underperforming. We are not contrarian for its own sake, but use our broad research team to probe for situations where we can distinguish between price and value. Bad news and share price declines often show us where to look, but the key is still the research process.