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O'Keefe: Look for Financials with Fee Income

Greg Carlson

Greg Carlson: Hi, I am Greg Carlson, and I am a fund analyst with Morningstar. I'm joined today by Dan O'Keefe. He is the Co-Manager of Artisan International Value and Artisan Global Value. Dan, thanks for joining me today.

Daniel O'Keefe: Thank you. I'm glad to be here.

Carlson: Now, Dan, in both of your funds you have a fairly large weighting, relatively speaking, in financials. However, this is not what a lot of people might consider a typical financials exposure. Can you expand a little bit on that?

O'Keefe: Yes. So, as you know, Greg, we're focused on four key characteristics: We're focused on buying businesses at a discount to their intrinsic value; we're focused on financial strength; we're focused on superior business models; and, of course, we want to buy that within the context of the management team that's working in our interest.

And we generally gravitate within financials towards businesses that have some type of competitive advantage, some type of edge. And in financial services, generally, banks often don't meet that criterion because banking is frankly often a commodity business. So we tend to prefer fee-generating businesses, businesses that operate in areas where there is maybe an oligopolistic market structure, where there is less pricing pressure than often what you see in the traditional banking area, and again therefore, we often focus on these fee-generating businesses.

So, in Global Value today, for example, some of our largest holdings are American Express, which will be characterized as a financial but which is primarily a fee-generating business. Also we own Bank of New York, which is not really a bank; it's a trust bank, which means that it generates most of its profits and its revenue from the fees associated with holding assets in custody and servicing assets for their clients. Also Marsh & McLennan is another interesting company. It's a broker. It's an insurance broker. So it doesn't underwrite insurance, but it provides brokered services to clients who are buying insurance. So those are some of the more predominant financials within our portfolio, again fee-generating businesses versus traditional leveraged financials.

You know as we were walking over here before the interview chatting, we were talking about the fact that we have actually recently been dipping our toe more into some of the traditional levered financials, like a traditional bank like Lloyds Bank in the United Kingdom. We've also recently initiated position in Chubb, which is one of the world's largest property and casualty insurance businesses. While certainly not a traditional leveraged financial, it is an insurance business, which can be a leveraged business.

I think Lloyds is very interesting. So, despite being in the banking industry, it occupies a privileged position within its market, which is United Kingdom. And Lloyds is the largest retail and commercial bank in the United Kingdom and it's a very rational industry structure. There is only a few other players of any significant scale. And as a result of the financial crisis, we were able to buy it after it was recapitalized a number of times, so financially very strong after a lot of marginal competitors have been taken out of the industry because of the crisis, and at a price that significantly undervalues the franchise. So we were able to buy at around 80% to 85% of book. So, that gives you a good spread of the types of things that we're looking at from fee-generating businesses to now dipping our toes into some more traditional financials like Lloyds Bank.

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Carlson: And with traditional financials, I know you said the business model is often a concern. You've got a commodity business, but the credit situation that has kept you away from a lot of those companies too, correct?

O'Keefe: That's right. Well, we didn't own any traditional banks before the crisis or going into the crisis because when we looked at them, we saw that they were trading at significant premiums to book value, and we thought their capital situation was not particularly healthy, especially within the context of what had been a long-lived credit cycle boom, and so the reserves on their balance sheet for the inevitability of the debts going bad was insufficient, so the capital base was not particularly strong.

But as we moved through the crisis, banks started writing off loans. They started raising capital. In many cases some of them effectively went bust a number of times over. Lloyds certainly engaged in a number of capital raisings to prevent insolvency. And as their provisions were elevated and as the capital was raised, interestingly the banks became much safer in our view and they went from multiples of book value, two to three times book value, with highly levered capital basis to trading at substantial discounts to book value now with a very healthy capital basis.

So, you want to buy a bank when it looks at its worst, when it's losing money, when the provisions are bad, when they're writing off loans, not when they are earning peak earnings and at the peak of an economic cycle. So, we stayed away during that time and as things got bad and as the industry recapitalized and all the bad news was out on the table and the dangers of banks became evident to everyone, then we started to engage.

Carlson: Now American Express, which you mentioned is a fee-generating business, but they did obviously have some credit issues at one point?

O'Keefe: Yeah. Well, American Express is, as you pointed out, they make the majority of their revenue from the swipe fees, someone purchases something with American Express, a certain percentage of that transaction goes to American Express in the form of fees. Now if that same person decides not to pay off the monthly balance, they can revolve the balance and hold the credit and pay interest on the credit. So, in American Express's case it's about 80% fees, maybe 15% to 20% credit. Now, as we've gone through the recession, the losses on their credit portfolio have become very, very elevated and took the earnings of American Express down significantly.

But underlying this, you have this fee-generating stream, which has started to grow again towards the middle and back-end of the recession, and their credit losses have started to shrink as they quickly clamped down on their underwriting standards and started to write off all of the bad debt.

And now what we're seeing is we're seeing the fees growing again as Amex's core affluent customer base is spending at a greater rate than the economy in general. As people start to use plastic more than paper currency, which is a secular trend within the economy which American Express will benefit from for many years, and as those credit losses come down, you have that growth in those fees, you're now seeing the business return to earnings growth. And so post-crisis, the business is now frankly stronger than it was when it went in and it's trading at a very modest multiple of maybe 11 times earnings.