Otis Redding (1947-1967), also known by some as the King of Soul, is an icon of the 1960s musical era. One of my favorites is a 1965 writing collaboration with Jimmy Butler, “Been Lovin’ You Too Long To Stop Now” and reminds me of my selection of BGC Partners (BGCP) as a major investment in the financial sector.
It is important to acknowledge that I believe the best place for investment dollars in the financial sector is not in the traditional banking sector. I own investment bankers, insurance firms, private equity firms, niche financial services providers, and Oppenheimer Financials Sector Revenue ETF (RWW), a financial sector revenue-based ETF leveraged to insurance over banking stocks. While my personal equity portfolio exposure to the financial sector is 13%, vs 16% for the S&P 500, less than 1% is invested in major money center banks.
As a strategic allocation decision, my subdued banking exposure is from a belief that traditional, major banks could be subjected to severe disruption, and not in a good way. Within business development, there are disruptors, those that disrupt the status quo, and disruptees, those that get disrupted as they are the status quo. Banking firms are ripe for being considered as distrupees. As investors know, being a distrupee is not necessarily good for business. While some US investors could phoo-phoo this risk as not being relevant in this bull market, an ostrich approach is not conducive to uncovering Alpha opportunities.
Janus Henderson Investors, in an article published earlier this month, outlined several investment themes for 2019, especially in Europe. John Bennett, Director of European Equities, Janus Henderson, is quite vocal of his belief that fintech, or financial technology, will be the great disruptor with traditional banks being vulnerable to a substantial slide in business.
Fintech is going to disrupt your bank stocks and, in my experience, most bank companies, most bank managements, are legacy management, legacy-type people running a legacy-type asset, legacy-type IT, and too many IT platforms.
In addition, the economic cycle is a headwind for the industry. Mr. Bennet uses the interesting strategy that investors should “rent and not own” bank stocks, and that based on our late-stage economic cycle, it’s time to un-rent bank stocks.
According to a series of articles offered by Bain & Company in their monthly newsletter, traditional banks are very ripe for disruption both from a technological and customer loyalty vantage points. Bain offered two articles last fall (Sept 2018 and Nov 2018) that reviewed the potential of the banking sector being “Amazoned” and the issue of waning bank customer loyalty.
The following two graphs should quickly answer the questions of how vulnerable banks are, starting with a customer loyalty score.
In summary, the Sept article, Bain posturizes:
For retail banks, the key lesson is that their main competition consists not of traditional banks, but rather the large technology firms such as Amazon that have upended entire industries. Tech firms have already reset customer expectations for what a good experience feels like, and Amazon’s expected entry into core banking heightens the urgency of accelerating work to improve the customer experience, largely by making it simpler and more digital. This might include connecting products and customer support to Alexa, Amazon’s cloud-based voice service.
In the Nov article, Bain reviews how well banks deliver on five Elements of Value: Quality; Saves Time; Simplifies; Reduces Anxiety; Heirloom. Respondents were asked to rank their primary bank in delivering these elements of perceived value as compared to popular retail tech firms. Of concern to bankers should be their relatively poor showing.
Banks have also been slow in updating their Internet-based platforms for ease of use. According to Bain, an overwhelming percentage of bank customers desire better, easier, and more complete online banking experience than their current bank offers. It is the lack of customer loyalty combined with a lack of platform/technology advancement that will feed a disruption of traditional banking relationships. The most recent regional banking merger supports this premise as management of the new combined bank plans on investing $1.2 billion of post-merger synergy savings not in shareholder rewards of higher dividend payouts driven by lower costs, but in upgrading their technology. Banks are starting to feel the pressure of non-traditional competitors nipping at their heels.
Under the surface are additional and interesting negative tidal movements within the banking sector. These include a deterioration of the value of leveraged loan portfolios and a resetting of bank loan covenants during the negotiations to adjust LIBOR-based floating bank loans.
In an article last Dec, SA contributor Wolf Richter offers a salient review of the leveraged loan market. With the sudden unpopularity after years of playing the pageant queen, leverage loan funds started to experience withdrawals in Oct of last year. In order to meet redemptions, these funds started selling their portfolios, causing weakness in the leveraged loan markets. The graphic below from his article indicates the Leveraged Loan Index quickly declined to wipe out a year’s worth of appreciation.
Since the graph’s publication with the lows of last Dec, the Index has rebounded to 2132, or equal to prices of last August. Richter believes the recent weakness is a forecast of what lies ahead and was the first step of investors getting cold feet. Banks are an integral part of the leveraged loan market, and a wholesale decline in value would negatively impact banks.
Another area of concern is in 2021 banks will no longer be required to quote LIBOR as the benchmark in their variable rate loans. Most all floating rate provisions use LIBOR and its abrupt discontinued use is upsetting the banking industry. It is estimated that upwards of $350 trillion in financial instruments are tied to LIBOR pricing. According to a Sept 2018 report by Franklin Templeton, syndicated bank loans are susceptible to loan agreement changes which may not be in the best interest of the banks.
Specifically, an issuer’s administrative agent can now identify future LIBOR benchmark replacements, but without giving lenders any say, or giving them just five business days to decline it. In the latter case, unless a majority of lenders in a syndicated loan reject the proposed LIBOR replacement in writing, the new benchmark rate becomes effective at the agent’s discretion.
Franklin’s research is somewhat alarming as it relates to the presumed investment returns and security of bank loans during these LIBOR-related renegotiations.
We do not believe these provisions in new or amended loan documentation are in the best interest of our clients. That’s why one of our conditions before investing is that credit agreements give lenders the right of prior consent to any LIBOR changes. In several instances where we’ve seen unfavorable provisions regarding LIBOR introduced in loans we currently own, we have either eliminated or dramatically reduced our exposure to these borrowers. By par value, only 17% of our current bank loan holdings have objectionable LIBOR replacement language. By comparison, we currently estimate that 50% of the broader loan market contains this language.
Franklin Templeton managers have been quite vocal on this issue of changing loan agreements and the negative impact on syndicated bank loans. Another LIBOR report by Franklin Templeton worthy of reading for bank investors is found here.
Within the financial sector are several non-bank industries. These include stock exchanges, insurance companies, and fintech companies such as credit card and payment processors, investment managers and their management tools, online accounting software. One of my favorite non-bank financial stock selections is BGC Partners, a spin-off from privately-held investment banker Cantor Fitzgerald.
As a niche financial firm, BGCP has an interesting approach to its business and to its shares. Howard Lutnick, its CEO, also heads up Cantor and is the Chairman of its newly spun-off real-estate business, Newmark Group (NMRK). BGCP and Cantor are connected at the hip, and Cantor is one of the most esteemed investment bankers on Wall Street.
Investors should appreciate management’s approach of using BGCP shares as a compensation tool for its employees. According to their latest investor presentation, as of Sept 30, 2018, 54% of shares were owned by the public, 26% by employees and 20% by Cantor Fitzgerald. Virtually all BGC employees are considered partners and sign long-term employment contracts. BGCP has several classes of stocks, with Class A representing the publicly traded shares. In addition, there are Class B and Partnership Units representing the interests of insiders and Cantor. Fully diluted, there are 488 million shares outstanding, with Class A representing 263 million. This is important because as employees are compensated using shares, investors should expect a growing number of shares outstanding over time.
BGCP offers brokerage services for fixed income, credit instruments, currencies, and commodities. Its clients are usually broker/dealers, banks, and financial institutions, and include trade execution and back office services. BGCP also offers proprietary analytics and market data to institutional investors. The company uses the product names FENICS, BGC Trader, FENICS Market Data, BGC Market Data, Capitalab, and Lucera brands. Recently, management has been expanding into the commercial insurance and marine brokering businesses.
Since 2005, BGCP has made 25 different financial services acquisitions, not counting the real-estate businesses which were just separated. Management has a strong history of expansion through acquisition, and these acquired firms all have one common thread – a strong business model with the major corporate asset being high quality, specialized personnel. This wraps back to the strategy of using BGCP shares as a compensation and retention tool. Below is a list of financial services acquisitions made by BGCP since 2005. 3rd qtr 2018 revenues indicate the international scope of BGCP’s financial services. From their presentation, 55% of revenues were generated in Europe, Middle East, Africa, 14% from Asia Pacific, and 11% from North and South America.
Newmark represented about 44% of BGCP’s pre-spin-off earnings. Management in Dec offered an update to the spin-off with guidance for 2018 financial services pre-tax post-spin, adjusted earnings growth of mid-point 31% compared to $299.6 million in 2017. Using a 21% tax rate, which may prove to be high, and 488 million shares outstanding, eps for 2018 should be around $0.63, with roughly $0.15 generated in the 4th qtr. Earnings per share estimates for 2019 are in the $0.70 to $0.75 range, but the upcoming quarterly and year-end report and conference call should provide better 2019 guidance.
BGCP pays a hefty qualified dividend at a rate of $0.56 annualized for a 9.3% yield, based on a price of $6.05 per share. If earnings per share for 2019 are in the low-$0.70s, at a discount-to-market PE of 12x, share prices could trade up by 40% to the $8.50 range. As such, BGCP should be attractive to both income and capital gain focused investors.
Of interest to me is the expansion into the fragmented industries of commercial insurance brokerage and marine brokerage services. Over the past two years, three of the last six acquisitions have been with this focus. It should be interesting to see how Mr. Lutnick interweaves these businesses in the future in such a manner as to maximize their value to shareholders.
I consider BGC Partners to be an “Otis Redding” selection, based on being a long-term investor. I have owned BGCP since 2012, and agree with the lyrics to “I’ve Been Lovin’ You Too Long To Stop Now”:
My love is growing stronger as our affair, affair grows old,
I've been loving you a little too long, long
To stop now, Oh, oh, oh.
I've been loving you a little bit too long,
I don't want to stop now, no, no, no
Here is a YouTube of this soulful ballad from the live performance at the Monterey Jazz Festival in 1967.
Investors looking to expand their financial sector holdings should look at BGCP. I really don’t mind being in the rumble seat of this Howard Lutnick-driven investment, especially with Otis Redding blaring from the in-dash cassette player.
Author’s Note: Please refer to my profile page for the necessary and required disclosures.
Disclosure: I am/we are long BGCP,NMRK, RWW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.