Lloyds Bank

Quick Notes on LLoyds Bank in the UK.

Competition

Lloyds is the largest local bank with a 16-19% share in mortgage lending, the next largest is NatWest (formerly RBS) at 12-13%.  The largest 5 banks have a 60% market share.  Lloyds has ~20% market share of current account balances.  From these numbers, the UK market has 6 large players with > 5% market share.  So there's limited competition, but its not as comfortable as the Australian or Singapore market, controlled by 3-4 banks.

What do they do?

• They primarily make their money from interest (~70% of their Net Income in 2Q).  Primarily mortgages (book size of 307m mortgages, 40m other retail loans and 88m commercial).   Their deposits are 2/3rds retail, 1/3rd commercial (slide 16).  All pretty standard stuff - they are a traditional bank doing savings and loans.
• For their ~30% non-interest income ("other income - slide 18"), 75% of it is from commercial and retail banking.  I assume bank fees.  The remainder is Insurance, Pensions and Investments.

Balance Sheet

• CET1 ratio is 14.1%.  But they want to reduce it to 13% by 2026 and return excess capital to shareholders (slide 24).
• Loan to deposit ratio is 95%, which is on the high side compared to Singapore (low 80s) or US banks (10-year average of 72%).
• They have a large "structural hedge" (slide 17) from the pre-covid zero-interest rate period.  It yields around 1.35% interest, as the hedges expire in a 4% interest rate environment they'll yield more.  The hedge reduced 2023 profits by an estimated 800m (page 4), or 10% of 2023's PBT.  It depends what the interest rates are (actually what the forward curves are) when they expire.

Risks

Digital banks like Starling, Monzo and Revolut have been growing and taking market share.  Especially among young people.  Now 10-15% of the population has bank accounts with each of them.  Lloyds bank fares badly in customer satisfaction, trailing behind them.  But I'm not sure how much money they manage to capture, or how many people use them as their primary bank account and deposit salary - banking is a 2-sided market and you need scale to be profitable.  Only Starling is profitable.  Although the newcomers have made banking easy with mobile app features, its not a moat and can be copied by the incumbent banks.  (FT article).

The UK has been suffering through a recession in the past 2 years.  I think they will tax dividends on foreign shareholders.  Its a no brainer.

Biggest risk is the UK's long term prospects.  It has recovered from its recession, but may continue with weak (below 1%) growth as the past 2 years.  The UK's long term prospects look gloomy due to cheap energy from the North Sea running out, the end of Russian gas, and Brexit.  Politically and economically, they are probably going to become the 51st state - not a bad thing, but a big step down from being Europe's financial centre, or the old "empire on which the sun never sets".

Capital allocation

I like their capital allocation:

There are around 66bn shares issued (p302).  Buying 2bn pounds per year at a price of (lets say) 1 pound each removes 3% of shares every year.

Business Cycle

Banks are cyclical.  Where are we in the business cycle?

UK has been in a tough spot due to rising energy prices from the Ujkraine war and Brexit.  You can find YouTube videos of boarded up sops and houses.  They do have some structural problems to work through.

1Q24 just exited a recession, putting an end to almost 2 years of low/negative growth:

Source: Trading Economics

Hedgeye predicts the UK will have increasing yoy GDP growth in the second half of this year.  But that can change tomorrow.

Valuations

Price to book is 0.85.

At 70p, it would have a 1H annualised PE of 10.2.

Using 2023 numbers (a period of sub-1% growth but very high rates), the PE would be 9.2

Summary

The leading bank in a not-too-competitive market.  Its been recovering and recapitalising from its 2008 blow-up, and is now starting to return money to shareholders.

The stock shot up 6% yesterday when results were released.  I may be late to the party, is a recovery already priced in?  Biggest risk is that the UK recovery is weak.

Quick Updates (July and August)

Quick updates to my portfolio, stuff I did a while ago, nothing to do with Trump's shooting.

Future quick updates I'll just append to the end of this post, rather than cluttering things up.  These are all small moves around the margin.

• Bought 4% Exxon Mobil (XOM)
• Cut BTC on 21st and 24th June at a slight loss.  Its fallen since then.  Better a small loss than a big one.
• Sold Gold miners on 29th June.  Small loss

The market has been range bound.  Hard for a long term investor, or someone obeying trend following signals.

Review of Williams Companies (WMB)

Williams Companies (WMB) has doubled since I bought it in mid-2020.  Should I sell it?

Business Segments

What do they do again?  And how are they affected by energy prices and inflation?

Based on 1Q24 EBIDTA (slide 8):

• 39%: Interstate Gas Pipelines.  Mostly Transco (30%) running through the east coast, bringing gas from the Appalachians and GoM to consumers and LNG export terminals.  Smaller pipelines in the Northwest.

Regulated long-term contracts: "The rates are established primarily through the FERC’s ratemaking process, but we also may negotiate rates with our customers pursuant to the terms of our tariffs and FERC policy."   In general, FERC gas-transmission rates are often adjusted for cost-of-service (bottom p1), so its like a "delayed" inflation adjustment.

• 38% Gathering and Processing from gas fields.  Collecting and treating gas (eg: removing NGLs) from producing fields so it can be transported in pipelines.  Mostly volume based.  So indirectly affected by price (eg: revenue drops during warm winters).  Management mentioned these contracts are often inflation protected (bottom p19).  A few of them have exposure to gas prices (bottom p18).

• 13% Gathering and Processing from oil fields: onshore (7%) and GoM (5%)

• 4% Marketing.  Deliver gas to customers, bear the risk of price movements in-between the time of order and delivery.  Very volatile.  Was 10% of EBIDTA in 2023, -ve in 2022, and negligible in 2021.

A 2022 Fitch Report estimated that 50% of revenue was from regulated or take-or-pay contracts.  so rough guess: maybe a quarter of their G&P revenue is covered by take-or-pay. 

Cashflows

CFO covers dividends.  But not always CFI and dividends together.  ie: They are investing for expansion:

They rarely sell assets, last made substantial disposals in 2018: 

Maintenance capex was 820m in 2023, and is guided at 800m and 1.2b for 2024 and 2025 (p11).

Growth

Growth capex was 1.9bn in 2023, and is expected to be 1.6bn in 2024 and 1.8bn in 2025 (p11).

The above "growth capex" excludes acquisitions of new businesses.  Following this, I'll take the words "capex" or "growth capex" in this post to exclude acquisitions, which is pretty strange.

Lets put it in a table.  AFFO below is CFO (excluding some working capital changes and minus a few things) - think of it as "Smoothed CFO" ¹:

AFFO easily covers maintenance capex plus growth capex, and almost covers dividends after that too.  It doesn't cover acquisitions in 2024, so debt will go up.

They say they've gotten 19.5% ROIC on their 2019-2022 investments (p12).  Seems ridiculously high, but these are usually small "bolt on" projects.  e.g.: small pipelines adding off their main lines, adding new takeaway or feeds to new customers.  Or adding incremental G&P capacity to their existing network.

And thats probably only for growth capex, as recent acquisitions were bought at 7-10X EBITDA (1), (2).

Overall they aim to grow EBIDTA and dividends by 5-7% in the next 2 years.

The background is growth opportunities from the expected US LNG export boom (slide 16):

Management comments on the urgency of this (p17): "Our issue is that our customers, which are some of our best and biggest customers on Transco are –their demands are very urgent. And for us to sit around and wait to finalize any more of the demand that was pending out there, really, it doesn't serve those customers very well." 

To summarise, they are still growing, and taking on debt to afford to both pay dividends and make acquisitions.  At some stage of the cycle - years later - that may become a bad thing, but its good today.

Valuation

Taking FCF to be "AFFO minus maintenance capex" ², it is projected to average 4.2bn over 2023 to 2025. At a share price of $42.5, thats a price to FCF of 12.x.  Fairly priced for a long term growth rate of 5-7%.

The yield is 4.5% before tax (or 3.1% after tax for me).   AFFO payout ratio is just under half.

Conclusion

Its not cheap anymore - growth is priced in.  I wouldn't buy now, but its not clearly overvalued so I'll hold.  We're probably still at the beginning of the US natural gas export boom.

1 AFFO is defined by them as "cash flow from operations excluding the effect of changes in working capital and certain other changes in noncurrent assets and liabilities, reduced by preferred dividends and net distributions to noncontrolling interests. AFFO may be adjusted to exclude certain items that we characterize as unrepresentative of our ongoing operations".^↩

2 Their definition is different - slide 34^↩

Investing for the next Decade of inflation

These interviews from Lyn Alden and Luke Gromen explain why we'll get high inflation this decade.  US Federal debt is too high and must be reduced by inflation - financial repression - where interest rates are lower than inflation for a long time.  Cash holders will suffer and bondholders will get screwed.  But not in a straight line, it bounces around.   Its a more rigorous and nuanced description of Kuppy's Project Zimbabwe diatribe.

Key Points:

• (6:19) US has entered Fiscal Dominance, meaning govt spending affects the economy more than interest rates.  Because:
• High Federal Debt means that they are paying interest to someone (bondholders or savers) which becomes income.
• Low Private Sector debt means there is not much bank debt to reduce.

So high rates might actually stimulate the economy, of the income from high rates is more than the reduction in debt.

• (10:00) Fiscal and Monetary dominance is a continuum.  If true interest expense (minus entitlement paygo) goes to 100% of receipts, you are heading into Fiscal Dominance.  (12:06) We flip back and forth between them in a cycle:
• As you near fiscal dominance, the global dollar market gets crowded out,
• USD goes up, EMs get pressured to sell treasury bonds to defend their currencies...
• leading to an increase in treasury supplies, treasury market gets dysfunctional...
• so the Fed supplies liquidity, market calms down...weaker dollar.
• Bond and stock markets go up, assets up, higher tax receipts, no longer in fiscal dominance.

• Its a stop-start process.  (13:53) Its a function of the dollar - strong USD leads to crisis that must be fixed by Fed.  The Fed intervened several times before:
• 3Q23 (raising front end rates while keeping the long end stable)
• 3Q22 (Yellen running down TGA)
• So its a stop start process of: whenever a problem in the bond market occurs, Fed will buy US treasuries to lower the US dollar to stave off the crisis.  Cannot afford to let the price of US Treasuries be set by market forces alone.
• In another podcast he mentions DXY of above 1.05 (today's price) there'll be a treasury supply problem, "or if it goes to 1.04 to 1/03 it'll probably be OK", if it goes to 1.00 it'll be fine but with higher inflation.
• So in the long run, the price of US treasuries is held artificially low.  This is financial repression, LT bond holders get fucked.
• (19:40) Maybe the government tries to obfuscate it. eg: change SLR rules: fund banks to hold more treasuries.  When they have to choose between a financial crisis or inflation, they will choose the latter (eg: covered depositors in Silicon Valley Bank instead of letting them be wiped out).
• (24:30) When does the deficit start to matter?  Answer: We've already seen it in the markets, eg:
• Gold no longer correlating to real rates (Chart at 2:46).  
• 3Q2020 Treasury market crashed along with stock market - for the first time in 40 years.
• The process has started, and is accelerating.
• (29:07) The big deficit (rising debts) in the 80's were offset by falling interest rates and globalisation (cheap energy from Russia and cheap goods from China).  These 2 things have now reversed, so government debt starts to matter.
• (38:53) Do we see any way it can reverse?  Generally no:
• Deglobalisation speeds up the process, as increasing inflation leads to increasing bond yields.
• New oilfield discoveries could help reverse it by increasing productivity and lowering inflation.
• Economies that have recovered from this before have been non-financialized.  US has a financialized economy - too much tax income is tied to asset prices.  Austerity would cause asset prices to fall, and lower tax receipts.
• A 'productivity miracle'.  But there's some nuance:
• It can't be too fast.  eg: If AI takes too many people's jobs, it will reduce tax receipts further. 
• AI is different from previous tech revolutions like the internet and cloud computing, as its energy intensive.  It could decrease service costs but increase energy costs.
• (1:25) Think we're in a Secular inflation environment: the debt of the reserve currency issuer is not sustainable without inflation being higher than interest rates for a sustained period.   The test is: what happens to inflation the in the next expansion?  
• (5:43) Views on oil?  Follow conventional view: range bound between USD 70-90.  70 is when US shale starts to be unprofitable.  90 is where it starts to affect inflation.
• Views on different assets in the next 12 months:
• (11:45) USD: lower in an orderly manner, or sideways,
• (14:17) Gold and Bitcoin: Both a lot higher.  Probably halfway through the bitcoin upswing. (18:10) Luke things gold is becoming an oil currency, replacing the USD.  (23:08) "You need to stay un-levered, because the cycle is so volatile".
• Views on interest rates: No view, rising rates no longer effective due to Fiscal Dominance.  The fiscal situation, and oil supply/demand affect the economy more. (28:05) From 3Q23, if the ten year goes to 5%, this creates problems which make the Fed step in, so 5% is a ceiling.  
• (31:28) Lyn: the 60:40 portfolio doesn't work in Fiscal dominance, suggest replace bonds with energy/gold/bitcoin.  To guard against inflation instead of recession.
• (34:20) Recessions.  Recessions are now probably sector specific (eg: CRE) because fiscal dominance stimulates parts of the economy.  Not gonna see a 2008 crisis recession, maybe get a 2001 (shallow) or 1970's (stagflation) recession.  (37:55) In a recession, we can still expect CPI prices and the stock market to rise, like an EM.

The above is just a framework to understand whats going on.

As always, the market can do whatever it wants.  I can be right and still lose money if my timing's off.

How do I use this in investing?  

Historically commodities worked best in past inflationary periods.  Buy anything that can't be printed.

When do I buy?  Hedgeye models the next several quarters as having increasing US yoy inflation (see graph at 16:33).  So now.

More color:

• 86% of my portfolio is "inflation resistant":
• commodity producers
• Gas pipelines - irreplaceable assets producing inflation adjusted cashflows
• Companies that have low material/labour costs harmed by inflation (eg: stock exchanges),
• or commodities themselves.
• My core positions make up 100% of my portfolio.  This is stuff I'm comfortable holding throughout the cycle:
• stocks that generate cashflows and dividends even at the low point of the cycle.  If they're commodity producers, they're low cost ones.
• Or sometimes they're just too illiquid to trade.
• Uranium, which doesn't generate cashflows, but which I hold cause it doesn't correlate with the markets and supply/demand is out of whack for the next few years.
• My non-core positions make up another 6% of my portfolio, bought with borrowed money.  I trade in and out of based on Hedgeye trend signals.  When they work well, these signals last for months or quarters.  When they don't, I get whipsawed.  This is for stuff I don't want to hold during downturns:
• Higher cost commodity producers in risky countries, like FCX
• Bitcoin: I'm a believer, but I don't wanna hold something that can drop 70% peak to trough.
• Industrial commodities: like nickel, silver, platinum.  They're volatile since they also depend on demand.  In theory I should put tin in here, but Malaysian Smelting Corp is too illiquid to trade.
• I may short long term bonds.  Following to the Hedgeye trend signals.
• 1/3rd of my portfolio is US Energy pipelines, susceptible to a decade-long 10-30% fall in the USD.   Its a risk, but the US is the cleanest shirt in the dirty laundry pile.

Quick Updates (May to Mid-June)

Small additions in last week's correction:

• Bought more gold, some GDX and GDXJ.  Would like to buy more but no money.  I'm also late to the party - everyone knows about gold's new highs - so keep it small.
• Shorted TLT

Other news:

• AEM (SGX) dives 15% after delivering a bad 1Q24 update.   Need to wait longer for the upturn.  Cyclicals are tough.
• Portfolio is up 1% last week.  

Its a very "risk on" portfolio.  My gut feeling is that the correction will continue, maybe triggered by Thursday night's inflation numbers.  Possible a falling SPY and rising VIX will drag down my portfolio, even though they are commodities and value which should benefit from inflation. Vol spikes, everything tumbles.

No plans to do anything, even if this happens.  Just pay off debt.  I'll only sell the short term holdings when the Hedgeye signals change.  If all goes well I won't be making any changes for a long time.

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Update 8th May 2024:

• Shorted another 1% TLT
• Portfolio has gone up another 1 or 2% again.

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Update 23rd May: Last night, commodities were hammered on talks of inflation concerns leading to possible higher rates.  My portfolio down 2%.

Tech (Nasdaq, BTC) were up, maybe because Nvdia beat expectations.

SPX is only down very slightly (-0.27%) and VIX is stable at 12ish.

I think this is a small correction, the commodities trade became too visible and was way overbought.  Need to shake out the speculators.

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Update 3rd June: Bought 2% Bitcoin last week.  Its consolidating.

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Update 10th June:

• Hedgeye's trend for oil turned bearish last week, I sold my weakest oil stock Acker BP.  Look to buy something else when it turns.
• Commodities hit hard last week, my portfolio down 1-2%.              

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Update 15th June: The correction continues.  Hedgeye now shows more sectors breaking down (eg: Europe, Financials).  Think the market is starting to price in stagflation instead of growth:

• Portfolio down another 0.5%.  Everything grinding down.
• Sold NIKL at a small loss as it broke trend
• Bought some more bitcoin as it was oversold.
• My trading positions are still bullish trend (FCX, SILV, Bitcoin, Gold miners).  Copper just barely.  In theory, industrial metals like copper and silver should not do well during stagflation.
• I'm holding my other positions throughout the cycle as they are either 1) companies that generate free cashflow and pay dividends even at low commodity prices, 2) too illiquid to buy-and-sell (Philippines Stock Exchange and Malaysia Smelting Corp), or 3) stock price should be more affected by fundamentals than the wider market (AEM:SGX and SPUT).

Quick Update - scary correction

After rising 1%  *per week* for several months due to rising inflation, my portfolio dived 1.5% last night.   Think its just the inevitable shakeout as the inflation trade became too crowded.  Last night, correlations went to one:

Sold all my bitcoin early last night as it was breaking Hedgeye trend.  I made decent money on bitcoin, over 25% in ten weeks on a 5% position.  For me BTC is purely for trading, not to HODL.

I bought some gold positions in past few days.  4% Gold, 1% Sandstorm and 1% GDX.  The stocks got crushed a couple of percent last night along with everything else.  Want to use the correction to buy more gold miners.  Keep positions small as I'm late to the party.

Short term, a lot depends on what Powell does tmr at 2pm.  Its his last chance to do anything before the Nov election.

Quick Update

Small changes around the margins:

• Sold bitcoin down to a 2% position.  Mixed signals.  I may buy it back, leave it, or sell it all.
• Cut platinum from 2% to 1%, not working compared to copper, silver and gold.
• Bought 0.5% position in Nickel Miners ETF (NIKL).  May buy some more.
• Bought 2% gold.  Would like to buy gold miners.

Long inflation.  Hedgeye predicts 9 months of rising yoy inflation.  I want to own a basket of commodities that perform well in inflation:

Source: Exhibit 9, The Best Strategies for Inflationary Times

Primarily Energy, but don't overdo it cause theres only a small sample size (8 cases above), and every time can be different.  So added precious and industrials.  Tough to own ags/softs/livestock or their producers, though I have United Plantations (palm oil).  I expect energy to perform well regardless of growth.  Gold to do better in stagflation.  And industrials to do better with inflationary-growth.  

And if I was really brave, I'd be shorting long term bonds to fund it all (see Exhibit 8).