Here’s another reason to admire ace equity income investor Neil Woodford: he sold out of the big banks in 2002, a full five years before they coined the phrase ‘credit crunch’.
He has kept a close eye on the sector since the financial crisis, but decided it wasn’t for him. The quality of loan books, capital adequacy and high leverage ratios all convinced him to steer clear.
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With one recent exception: HSBC Holdings (LSE: HSBA) (NYSE: HSBC.US).
Big Beast Buys Big Beast
Woodford bought into HSBC because it was “a very different beast”. “It is a conservatively-managed, well-capitalised business with a good spread of international assets. As chief executive, Stuart Gulliver has done a great job over the last four years, making a very complicated organisation much simpler to understand.”
Woodford also praises HSBC for “robustly” navigating through the headwinds that have blighted the banking industry, and says it has returned to a more attractive valuation level in recent years, regularly trading at around even below its book value. Its yield was attractive, too.
He started to build a position in HSBC for some of his portfolios in May 2013, and included it in the portfolio of his new fund, CF Woodford Equity Income, at launch.
And then he changed his mind.
Fine Time
Woodford’s worry is what he calls “fine inflation”, as regulators slap ever bigger penalties on the banks. In 2012, HSBC was fined $1.9bn for failing to prevent Mexican drug cartels laundering money through its bank accounts.
Last month, Bank of America agreed to pay $16.7bn for selling toxic mortgages in the run up to the financial crisis, the largest single federal settlement in the history of corporate America.
Woodford is worried that fines are being sized on a bank’s ability to pay, rather than the extent of the transgression. This leaves HSBC exposed to significant financial penalties for its historic manipulation of Libor and foreign exchange markets.
A substantial fine could hamper HSBC’s ability to grow its dividend, and that’s why he sold.
All The Fun Of The Four
Woodford defends his U-turn by quoting John Maynard Keynes: “When my information changes, I alter my conclusions. What do you do, sir?”
Here’s another thing Woodford has done.
He has invested in stocks that look “significantly below fair value”, and names four of them: AstraZeneca (LSE: AZN), BAe Systems (LSE: BA), Drax Group (LSE: DRX) and Legal & General Group (LSE: LGEN).
Keep Good Company
Woodford has long been a fan of AstraZeneca, rushing to its support during the ultimately doomed Pfizer takeover bid. Its share price is up 40% in the year, so it now trades at 15 times earnings and yields a relatively modest 3.7%, but the great man sees strong growth prospects.
At 10.6 times earnings, BAE Systems looks nicely valued. Sales and profits have fallen lately, but the share price is on the mend as investor confidence grows, and a progressive dividend policy leaves it yielding 4.5%.
Investors in Drax have had a tough six months, the share is down 22% in that time. To me, it still looks pricey at 17.8 times earnings, especially after it lost a government subsidy last month to convert a second unit of its coal-fired powered power station to burn biomass. But what do I know?
Like the great man, I’m a big fan of Legal & General, whose share price has grown 210% in five years. Given its explosive growth, I’m impressed that it trades at only 15.9 times earnings, and I’m in Woodford’s corner with this one.
You will have your own views on these stocks. But if you’re tempted to buy, you’re in good company.
