GREK: Greece Summons Hercules

Summary

• GREK follows one of the most undervalued markets globally.
• There are significant risks associated with the country, including high government debt, a broken banking system, and shouldering the brunt of migration into Europe.
• Greece calls on Hercules to address non-performing loans.
• ETFs may carry certain risks that investors should consider carefully.
• GREK is undervalued but speculative, and its weighting in Contra’s portfolio is low.

Introduction:

The Global X MSCI Greece ETF (NYSEARCA:GREK) tracks a basket of equities listed in Athens. It seeks to mirror the performance of the MSCI All Greece Select 25/50 Index and has been listed since 2011. According to the latest fact sheet, the three largest sectors in the ETF are financials, energy, and consumer discretionary, at 30.7%, 16.9%, and 16.5% respectively.

Source: Global X MSCI Greece ETF Factsheet as of June 30, 2019

The five largest individual securities in the ETF include Hellenic Telecom (OTCPK:HLTOY), Alpha Bank (OTCPK:ALBKY) EuroBank Ergasias (OTCPK:EGFEY), OPAP, and National Bank of Greece (OTCPK:NBGIF).

Source: Globalxetf.com GREK overview

Here at Contra the Heard Investment Newsletter, the Vice President’s Portfolio purchased GREK in late 2015 at an average price of $9.31. Since then the price has bounced all over the place, and the valuations have remained low. The current weighting is approximately 2.3%, representing a small sliver of the overall portfolio.

GREK’s Investment Thesis: Contrary, Unloved, & Undervalued:

According to StarCapital, Greece is one of the five most undervalued stock markets in the world; the other countries rounding out the unloved list are Russia, Turkey, Italy, and Israel.

Source: StarCapital’s September 30, 2018 Global Stock Market Valuation Table

These nations don’t exactly inspire confidence. Imagine a financial advisor enthusiastically calling a client and exclaiming, “I’ve invested your hard-earned money in five super-cheap international ETFs: the Global X Greece ETF, the iShares Israel ETF (NYSEARCA:EIS), the iShares Turkey ETF (NASDAQ:TUR), the iShares Italy ETF (NYSEARCA:EWI), and the VanEck Vectors Russia ETF (NYSEARCA:RSX).”

What would the client’s reaction be? “You’re fired!” comes to mind as a possible outcome, as does a long period of silence due to a heart attack. Whatever the details, it probably wouldn’t be good. This hits on a major psychological issue associated with value investing. Buying cheap securities is uncomfortable and lonely. No one wants to invest in countries like this because it’s scary – plus the headlines are terrible, and if you’re wrong you can look stupid because “everyone knew” it was a bad idea. Even beyond this, low valuations can persist for a long time, and that can test the nerves of even the most patient investor.

Nevertheless, we invested in 2015 precisely because of the country’s low valuations. Other considerations, including international diversification and overly bearish political headlines, also factored into the purchase decision, but the main reason was valuation – plain and simple. The old, if overused, adage “buy low and sell high” is what we’re hoping for here.

GREK’s Big Fat Risks:

Though Greece emerged from the Eurozone’s bailout program in 2018, federal debt remains a huge risk and annual budgets remain at the mercy of the European Commission. According to Trading Economics, debt to gross domestic product is 181.1%, second to only Japan. Furthermore, sales, corporate, and personal tax rates are already higher than they were in 2008. This means the government may not be able to increase taxes further without causing more damage than they can fix if the economy contracts. Ironically, cutting taxes to stimulate private sector activity may be limited as well, given the massive debt burden. Greece lacks a central bank, a printing press, and its own currency too. While this gives the Hellenic state access to the Eurozone club, it also means that Greece cannot devalue its currency in order to restore competitiveness or inflate away its debt.

The mountain of debt, limited tax modification room, and inability to control its own currency means that Greece is fragile and will have little room to maneuver in the face of economic shocks. This is bitter news for the centre-right New Democracy Party, which handily beat the far-left Syriza Party in the July 2019 election. Fortunately, unlike Japan, or the United States and Canada for that matter, the new government is inheriting a healthy and growing budget surplus, and government spending as a share of GDP has fallen since 2008. Capital markets, after being closed for years, reopened to the Greek government in 2017, the cost of borrowing has declined dramatically since 2012, and the yield on a 10-year bond is now roughly 1.30%. In fact, in early October, Greece joined the negative yield party when it raised €487.5 million selling a 13-week treasury bill at a yield of -0.02%. Although finances have improved over the last five years, the risks of default or a painful restructuring remain distinct possibilities.

Another significant risk is the state of the banking system. According to the Bank of Greece, in June the ratio of non-performing loans to gross loans was a staggering 43.6% or €75.4 billion. This is an improvement over the 49.1% recorded in late 2016 and early 2017, but is miles away from being healthy. For contrast, during the peak of the Financial Crisis, America’s non-performing loans were roughly 7.5%.

To address this problem, the government recently announced a program called “The Hercules Asset Protection Scheme”. Hercules should be in action by the end of the year. It will see the state shoulder some of the risk associated with the loans while collecting a small fee from the banks, and is the first stage in the government’s goal of reducing non-performing loans by €30 billion, or roughly 40%. The program’s details are complex, and it will operate for at least 18 months. The timing here is important; in 2021, lenders including Piraeus Bank SA (OTCPK:BPIRY), Eurobank Ergasias SA, Alpha Bank AE and the National Bank of Greece will need to have reduced non-performing loans by around €50 billion to meet new regulatory guidelines.

The banking system is so broke, and so broken, that Hercules may need help. Perhaps Achilles and Ajax will have to join the battle, or Odysseus will have to engineer another cunning solution. If all else fails, Leonidas and his 300 Spartans may have to step forth to the rescue. Greek mythology aside, however, the ratio of non-performing loans truly does present investors in GREK with huge risks, especially given that financials are the heaviest weighting of the ETF’s assets, at 30.7%. That said, material progress in reducing bad loans would be welcome news, and should be bullish for GREK. Watching the Hercules Asset Protection Scheme will be important; we’ll be keeping a close eye on it here at Contra.

Despite the banking challenges, a declining outlook in Europe, and the collapse of Thomas Cook, which impacts the country’s all-important tourism, business and consumer confidence in Greece are at post-crisis highs, and business competitiveness has improved since 2015. Unemployment is still at 16.9%, but is much better than the 27.8% notched in 2013. If these trends continue, addressing the mountain of non-performing loans may be made a little easier.

Greece is also bearing the brunt of migration into Europe from war-torn countries like Syria, and has a tense relationship with Turkey. The wave of refugees has strained the country’s resources – especially on remote islands in the east of the Aegean Sea – and has generated tensions with other EU states. Perhaps ironically, Greece faces demographic challenges. Young and skilled workers have left for better prospects in the rest of Europe since the Financial Crisis started, and since 2011, Greek death rates have exceeded birth rates. Like many European nations, total fertility rates are falling. Maybe the migrants can help to juice the economy in time, but for now that does not appear to be the case.

Many of these risks have persisted for years, since before we invested in Greece back in 2015. It’s likely that they continue far into the future, and investors should consider this carefully before building a position. These risks suggest that Greece is speculative, which is the reason why GREK represents only 2.3% of the Vice President’s Portfolio here at Contra the Heard Investment Newsletter.

A Word on ETFs in General:

Although ETFs are useful for generating overseas exposure, fund managers can adjust an ETF’s sectoral weights by modifying the underlying index the ETF tracks. This is often done annually and is called “rebalancing” – and means that investors may not end up owning what they anticipated. This Greek ETF has modified its weightings in the past. Seeking Alpha contributor Martin Vlcek wrote about this rebalancing issue years ago in his article GREK Rebalancing: The Trojan Horse Has Just Been Delivered.

In addition to the rebalancing problem, The Big Short maverick Michael Burry has taken issue with index funds. According to Burry, index funds have removed price discovery from equity markets. Instead of price setting based on security level analysis, indexes determine a security’s price based on capital flows – but these flows are blind to an asset’s underlying value, financial risk, and growth prospects. To him, this looks a lot like the collateralized debt obligation bubble that underpinned the subprime mortgage crisis. Add on a liquidity disconnect between the billions linked through ETFs to stocks that trade at a fraction of that volume, and he thinks it will end in disaster. Is he right? We don’t know, but internally we have discussed the issues of liquidity and limited security level price discovery often.

It’s also worth noting that Michael Burry is not alone in pointing out issues with ETFs. Howard Marks has compared an ETF’s price discovery mechanism to buying assets on auto-pilot, and warns that they are not as liquid as they appear. Others have argued that ETF flows have driven up the valuations for the “fantastic four” (McDonalds, Caterpillar, Boeing, and 3M) as if they were FAANGS, despite deteriorating growth prospects. The late Godfather of ETFs, Jack Bogle, was concerned by the proliferation of ETFs using leverage, or ETFs that focused on narrow niches too. Even Moody’s issued a warning earlier this year about ETF liquidity. Perhaps a “buyer beware” sticker on these products is a good idea.

Conclusion:

GREK tracks the performance of the MSCI All Greece Select 25/50 Index. According to the ETF’s latest fact sheet, the three largest weightings are financials, energy, and consumer discretionary. There are many significant risks associated with GREK, including high government debt, a hobbled banking sector, and poor demographics. There may also be issues associated with holding ETFs in general. This prompts the question “why invest?” The simple answer is valuation. Greece has some of the cheapest prices in the world today. As value investors, we want to buy low and sell high, and have tried to balance these risks against the potential rewards with a modest 2.3% weighting in our portfolio.

Disclaimer:

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research; it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

Analyst’s Disclosure: I am/we are long GREK. 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.