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Investing in the Banking Revolution

Greg Carlson

Greg Carlson: Hi, I'm Greg Carlson with Morningstar. I'm joined here at the Morningstar Investment Conference by Dan O'Keefe. He is the comanager of the Artisan Global Value and Artisan International Value. Both funds have excellent long-term records.

Dan, thanks for joining me today.

Dan O'Keefe: Thank you for having me. It's great to be here.

Carlson: Now, your funds have held up well this year, but I want to start out by touching on a sector that's been a difficult one, financials. You have a couple of holdings there that we want to discuss today. One is Royal Bank of Scotland and the other is Citigroup. Can you give me your updated thoughts on those two?

O'Keefe: Yeah. Well, I think, saying that it's been a difficult area of the market is a tremendous understatement to be perfectly frank. As everyone knows, financials have been a terrible investment over a long period of time and have gone through one of the largest dislocations, economic and market dislocations, of any industry over the last 10 years. And as you probably know, from having followed us for many years, we really stayed away from banks for many years and it was not until the financial crisis that we began to build a position, a meaningful position, in banks and we have now accumulated roughly 15% of our assets across both funds in banks.

So, the very logical question is, why? And you have to understand the way the banking industry has been completely revolutionized from before the financial crisis to today to understand our interest.

The first thing that you have to consider, number one, the most important thing is valuation. So, before the financial crisis banks traded at multiples of 2, even to 3 times tangible book value. Today the banks that we own--I think you wanted to talk about RBS you mentioned; there is another one I'll mention, Citigroup--they both trade for between 60% and 70% of tangible book. So, a huge devaluation relative to pre-financial crisis. But valuation is not the sole consideration.

Banks have been completely revolutionized in terms of the quantity of capital that they hold, so therefore the safety of the business model. Before the financial crisis it was not unusual for banks to run with core equity Tier 1 ratios of 5% and in some cases, less than 5% on a comparable current Basel IV regulatory basis. Today, the capital levels that they hold are in multiples of that. So, RBS' core equity Tier 1 before the financial crisis we calculate on a same basis was 3% or 4%; today, 15%. Citigroup would have been low-single digits; today, strong double digits. So, we've got huge discounts to tangible book. We have very strong and very high-quality capital levels that are multiples of what they were before the financial crisis.

In addition to that, we have higher asset quality. So, banks have been deleveraging for several years and they have been purging their books of the toxic assets that they ventured into leading up to the financial crisis during the leverage bubble. Now, their balance sheets are very strong with bad assets having been written off, balance sheets having been deleveraged, loan books having been seasoned.

In addition, low valuations, strong capital, high asset quality, we also have very liquid and very well-funded balance sheets. So, deposits largely fund Royal Bank of Scotland as well as Citigroup. They have excess liquid assets on the asset side of the balance sheet. So, really with those characteristics what you've seen is a complete revolution of the banking business model, and we think that that conglomeration of factors, valuation all the way through balance sheet quality, asset quality, liquidity, funding, makes for a pretty interesting investment case and as a result, we've committed meaningful assets to that area.

Carlson: So, the next question there is, why hasn't the market caught up on these stocks? Why are they still down? RBS in particular, I guess, still has some outstanding issues in your view?

O'Keefe: They are two separate issues, banks in general and RBS. So, I think banks, in general, I'll just make a general comment. I think people are afraid, right? People and investors today lived through the financial crisis and they saw how dangerous banks can be. But the starting point matters, right? When you start at a core equity Tier 1 ratio that we make up a number of 3% or 4%, you have an over-levered balance sheet, you have a poor funding structure, and an illiquid balance sheet, going into a crisis is a disaster. Now, a bank today that's well-funded, that's well-capitalized and has good asset quality going into a recession is going to hold up much better than in the prior recession.

So, I think something like a Citigroup, which had to be bailed out by the government during the financial crisis, I think it would weather a financial crisis similar to the one we saw in '08 or '09 perfectly well. Let's not forget that JPMorgan was profitable every single quarter going through the financial crisis. Why was that? It's well-funded; it had enough capital; its asset quality was good; its balance sheet was liquid. So, I think JPMorgan shows you if you have those characteristics, you can go through a difficult period and protect shareholder capital, book value per share. So, I think people maybe don't realize how much the industry has changed and been revolutionized relative to the financial crisis. And with all of the macroeconomic gyrations and fears that we're confronted with from negative interest rates to Europe continuing to bounce around recession, Japan unable to stimulate its economy out of recession, people are just afraid and I think that is why they are so cheap.

Now, RBS, as you pointed out, has had many troubles, and I won't go through all of them but I think what I'll do is I'll summarize and I'll just say it's been one of the largest restructuring stories in the banking industry anywhere in the world over the last, well, almost 10 years now because we're coming up on the financial crisis having been almost 10 years in the rearview mirror. And RBS is still restructuring. So, that's very frustrating. And investors give up after such a long period of pain. But my view is that RBS is almost through that restructuring process. 2016 should be the biggest year of restructuring. They are winding down some activities. They are writing off some of the assets that they need to write off and this should be the last heavy year of it. And what lies at the end of the rainbow of RBS at the end of this really brutal restructuring period is a core retail and commercial banking franchise in the U.K. that is very valuable. They have dominant positions in commercial as well as very strong number-two positions in retail banking. It's a plain-vanilla bank at its heart. So, it makes mortgage loans and loans to business and it's funded with a strong deposit franchise, and it has very good equity capital base, as I said, a roughly 15% core equity Tier 1 ratio. Now, that represents around 25% of its market cap in excess capital that it holds. So, it has more than enough financial resources, I believe, to weather it through this next year of restructuring and then hopefully, the sun shines and the rainbow appears.