Wednesday, March 5, 2014

The Widows’ and Orphans’ Portfolio and US Banks

Regulatory Risk.

The “widows’ and orphans’ portfolio” introduced in the January 9, 2011 posting entitled “Investing PART 9: One version of the ‘Unfinished symphony” is intended to be a long-term investment portfolio.  The type of adjustments that one would expect were summarized in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?”  Generally, they should be adjustments in portfolio weights.  However, as mentioned in the January 26, 2014 posting entitled “What is to be learned for 2014 planning?” when a portfolio objective cannot be achieved by adjusting portfolio weights, there is always the possibility of adding a new holding.

The possibility of not being able to achieve portfolio objectives by adjusting weights was made in connection with a restatement of the portfolio objective:  “Stability, simplicity, profitability, and low risk are not the only objectives of the portfolio.  As the name widows’ and orphans’ implies, dividends are an important consideration in the design and objectives of the portfolio.  Dividends interact with stability and low risk, but the more important point is that, for this portfolio, they are an objective in-and-of-themselves.”
“…one would want to … increase the average yield of the portfolio....  Hopefully, that can be done within the portfolio.  If that is not possible, some additional companies could be added to the portfolio.”

Currently, the objectives of stability, low risk, and dividend yield necessitate a significant change in the portfolio.  As the title of this posting implies, it concerns the US bank held as a part of the portfolio.  When the portfolio was initially introduced, the Bank of New York Mellon (BK) was identified as a core holding.  As explained below, that posture is no longer sustainable.

One should not misinterpret this shift in the portfolio.  As was stated in an earlier posting “…the Bank of New York Mellon is particularly well situated going into 2014.”  However, as it also has been noted, “…it has one of the lower yields of the portfolio holdings.”  Consequently, from the perspective of portfolio management, “…one would have to be very confident that it will be able to increase its dividend in order to justify anything more than just automatic dividend reinvestment.” 

It is with respect to increasing its dividend that the problem with holding Bank of New York Mellon as a core holding first surfaces.  However, the problem is broader than just the dividend.  As the subtitle, “regulatory risk,” implies, the US government has introduced a new dynamic into planning any investment in a US bank. 

First, just from the perspective of dividend increases, Bank of New York Mellon is not going to be able to increase its dividend based upon its own assessment of its business.  That is a problem in the short run and totally unacceptable over the long run.

In April it will undergo a round of stress testing supervised by the government.  Based on how pleased the government is with the results, the regulators will determine how much the Bank of New York Mellon dividend can be increased.  A good guess is that the government will allow the Bank of New York Mellon to increase its dividend (or stock buybacks) by somewhere around 20%. A 20% dividend increase is not to be dismissed lightly.  But even with a 50% increase, Bank of New York Mellon would still have one of the lower dividends yields in the portfolio.  Thus, in the short run, the Bank of New York Mellon cannot achieve the dividend yield appropriate for the portfolio.

Over a longer period of time, the dividend will increase, but it will be based upon political considerations to an unacceptable extent for the widows’ and orphans’ portfolio.  The Hedged Economist has worked with regulators and banks for much of his career.  That experience makes one thing very clear: regulators are no better at forecasting and scenario analysis than banks.  What is even more concerning is that the current administration seems to be regulating by whim.  It is unlikely that regulators are sufficiently independent to avoid being drawn into the process of regulation by whim.  The widows’ and orphans’ portfolio should be made up of financial investments, not a political bets.

With respect to the dividend, both the process by which the dividend will increase and the amount of the increase justify looking for an alternative bank investment.  If the dividend were the only issue, supplementing the Bank of New York Mellon holdings with another bank would be a viable strategy (e.g., Wells Fargo—WFC-- was mentioned when the widows’ and orphans’ portfolio was first introduced). 
Second, dividends are only a part of the objectives of the portfolio.  Stability and low risk are also important considerations.  The Bank of New York Mellon had traditionally been a relatively stable bank because of its dependence upon fee-based services like trust management.  Those fee-based services tended to make the earnings and the stock price relatively stable.  In the current environment, that is no longer the case. 

An administration that acts upon whims does not facilitate the stability or low risk sought for the widows’ and orphans’ portfolio.  The Bank of New York Mellon has become a high beta stocks relative to the rest of the portfolio.  In fact, by some measures it is the most volatile stock in the widows’ and orphans’ portfolio, and although its stock may appreciate, on a risk-return basis it cannot justified as a portfolio holding.

Third, lawsuits designed to extort money from the banking system seem to have become extremely stylish.  Led by the state and national regulators who find banks an easy mark, the legal profession has come to realize that all they need in order to make fat legal fees is someone to play the role of plaintiff.  The widows’ and orphans’ portfolio appreciates stylishness, but it missed the memo indicating that wearing a target was stylish.  Put differently, investing in a large US bank involves assuming considerable headline risk, a risk the portfolio does not need.

Fourth, regardless of how one feels about all or any specific regulations that have been enacted, one cannot deny that they have added complexity.  From the very start of this blog, The Hedged Economist has pointed out that complexity creates its own risk.  Thus, the regulations themselves are creating new risks.

At the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31, the Bank of England's Director of Financial Stability, Andrew Haldane, made a presentation entitled "The Dog and the Frisbee."  The speech and the supporting research provide evidence that as regulations become more complex, they also become less effective.  The research also points out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that cannot provide accurate measurements of a bank's health.  So, the additional regulations are not necessarily reducing risk.  At the same time, the regulations are making it harder to identify what risks do exist.

For a brief summary of the speech consult the WALL STREET JOURNAL of September 13, 2012.  The article was entitled “Complexity and Risk Management.”  For an updated discussion of the topic, consult the December 20 WALL STREET JOURNAL article entitled “Andrew Haldane: The Banker Who Cried 'Simplicity’.”  It is based on an interview of Mr. Haldane.  For a non-technical discussion of why the metrics developed by regulators are often counterproductive, consult the January 4, 2013 WALL STREET JOURNAL column by The Numbers Guy.  The article entitled  “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees and professional researchers are too easily impressed by math.  Behavioral economists have been able to show that is true when applied to financial decisions.  However, their focus has been narrower than the generalized statement of the article. 

If one wants a fuller explanation and longer history of how regulation has created risk in the banking system, one might want to read FRAGILE BY DESIGN: THE POLITICAL ORIGINS OF BANKING CRISES AND SCARCE CREDIT by Charles W. Calomiris and Stephen H. Haber.  Despite the title, the thesis of the book is not that regulators intentionally design an unstable system.  Rather, they focus on the political motivations that lead to regulations that have unintended and largely unanticipated consequences.  If history is any guide, the regulators are creating risks that they do not understand.

The net effect of regulation by whim and the regulatory landslide that has occurred is that all US banks now contain a level of uncertainty totally unrelated to the economy or their operation.  A quote from the conclusion in a previous posting is appropriate: “… about the nature of the relationship between politicians and Wall Street. It isn’t always easy to tell who is using whom. That implies that avoiding situations with Washington-based headline risk is an effective risk reduction strategy for most investors.”

The unavoidable conclusion is that Bank of New York Mellon has to be replaced in the portfolio.  To summarize in terms of the objectives: 1) Dividend yield --The dividend yield is too low and the company's performance cannot be relied upon as a basis for increasing the dividend.  2) Stability-- The price of the stock has become far less stable and is exposed to considerable headline risk.  3) Low risk-- The Company is exposed to significant new risks, some of which are identifiable and others are not even known.

From a portfolio perspective, finding a suitable replacement is problematic.  While many of the arguments for dropping Bank of New York Mellon applied to any US bank, not all banks have experienced the effect to the same extent.  For example, Wells Fargo, mentioned when the widows’ and orphans’ portfolio was first introduced, has been more successful at maintaining its dividend, and the price of the stock has been more stable (e.g., it has a lower beta).  If it were used as the banking component of the portfolio, dividend reinvestment might be all that would be required.  However, that would still leave the portfolio exposed to regulatory risk.  Put differently, it is impossible to guess when our government or a group of trial lawyers will decide that Wells Fargo would be a nice target for extortion.

Fortunately, an investor does not have to be exposed to the types of risks that have been introduced into the US banking system.  Our northern neighbor, Canada, has a far more stable banking system than the US.  Thus, Canadian banks provide excellent candidates for substitution for the Bank of New York Mellon.  Further, many of the Canadian banks have US subsidiaries.  Consequently, the investor does not have to give up exposure to the US economy totally in order to reduce the exposure to regulatory whim and legal extortion.

One of the nice things about focusing on Canadian banks is that there are not too many of them.  One can fairly quickly narrow the field of consideration down to two or three banks.  The Hedged Economist’s screens narrowed the field to The Royal Bank Of Canada (RY) and Toronto Dominion (TD).  As stocks, both pay healthy dividends, have histories of raising the dividends, and have betas that are lower than Bank of New York Mellon.  Both have healthy financials and strong businesses.

For the widows’ and orphans’ portfolio, Toronto Dominion was selected.  Its dividend is slightly lower, but not significantly lower.  By contrast, its beta is significantly lower, and that is an important consideration for this portfolio.  Both are financially strong banks, but TD Bank seems to be more successful at building a strong brand around the “America's most convenient Bank” theme.

Investing in any company that operates in multiple countries involves some currency risk.  That is true of the TD investment.  It would also be true of an investment in the Royal Bank of Canada.  A totally domestic US bank would not involve currency risk to any appreciable extent.  However, any large bank whether US or Canadian embodies some currency risk because of the nature of the assets it holds.  Thus, it would be easy to overestimate the extent to which the purchase of TD Bank increases the portfolio’s currency risk.  When compared to the currency risk involved in the investments in the other multinationals held in the widows’ and orphans’ portfolio, the currency risk embedded in TD is acceptable.

In order to acquire the Toronto Dominion shares, all shares of Bank of New York Mellon were sold.  In addition, the small position in Newmont Mining, discussed in a previous posting as primarily held as an indicator, was also sold.  The combination of the two sources provided adequate funds to achieve a more desirable dividend yield for the portfolio (2.5%) and brought banking as a portion of the portfolio (4.9%) closer to the desired level.  At some future date, dividends from the portfolio will be used to bring both the dividend flow and portion of the portfolio completely up to the desired levels.

The effect of this trade is to bring the portfolio much closer to balance.  Only minor adjustments should be required for a fairly long time.  The stock portion of the portfolio is summarized in the table below.  The first column is the stock symbol.  The second column is the portion of the portfolio represented by that stock.  The third column is the dividend yield (i.e., the rate at which dividends are paid based on current prices).  The third column shows the portion of the total dividends derived from the specific stock identified in column 1.

The price appreciation in PPG has brought it to a level that some investors view as an upper bound for a portfolio weight.  By contrast, PPG is not overly represented as a portion of the dividend yield.  The inverse situation is characteristic of Verizon (VZ).  As a portion of the portfolio, Verizon shares do not represent a very large portion of the holdings.  However, because of its higher dividend rate its contribution to dividends is about appropriate.  GE and TD Bank are the two portfolio holdings where both the portion of the portfolio and the contribution to dividends need to be enhanced.  Unless something unanticipated arises that will be a principal focus for the balance of the year.

A disclosure, as mentioned in “A Core of MutualFunds: Part 2,” a number of mutual funds are also held as a core portfolio.  Thus, the portion of the portfolio and the portion of dividends attributable to any individual stock are both allowed to fluctuate within fairly large bands.  However, in keeping with the idea that the portfolio is a source of income, the portion of dividends attributable to any individual stock is more tightly monitored than its portfolio weight. 

However, since some people prefer stocks and others prefer mutual funds, in The Hedged Economist’s postings, core portfolios of either are presented as standalones.  When that is not the case, it will be quite explicitly stated (e.g., “Funds for Asset Class Diversification”).  When the discussion is about acquiring or selling non-core holdings, there will be no reference to how they fit in a portfolio (e.g., “Without the Glitter, An Alternative to Trading Bonds”).  It should also be understood that references to a position as core or non-core should be viewed as relating to a portfolio.  A non-core holding referenced in a posting may be held for multiple years (e.g., the Kimberly-Clark stock purchased for reasons discussed in “Wall Street doesn’t run the world” has been held continuously since March of 2010) or it may be sold very shortly after acquisition (e.g., some of the alternatives to bonds mentioned in “AnAlternative to Trading Bonds”).

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