In September, respected fund manager Neil Woodford revealed that he had sold his fund’s holding in HSBC (LSE: HSBA) (NYSE: HSBC.US), despite having only started buying 18Â months earlier. The reason for his change of heart? Despite praising HSBC’s attractions in glowing terms, Mr Woodford was concerned about one particular risk which he dubbed “fine inflation”. The size of fines levied by regulators on banks appeared to be increasing, and sized on a bank’s ability to pay rather than the scale of the transgression.
Firing line
As the world’s second-largest bank, it’s easy to see how HSBC is in the firing line. Lo-and-behold, its third-quarter results disclose an eye-watering increase of $1.8bn in the amount set aside for regulatory fines since June. They comprise:
- $0.7bn for UK customer redress – mainly PPI mis-selling where ambulance-chasing claims companies have bumped up the level of settlements;
- $0.5bn settling with the US Federal Housing Finance Authority, one of HSBC’s more obscure regulators, over mis-selling of mortgage-backed securities;
- $0.4bn providing for UK regulatory fines for LIBOR manipulation;
- $0.2bn further provision arising from errors in the small print of UK personal loan statements.
These charges reduced HSBC’s underlying profit for the last quarter by nearly 30%, from $6,251 to $4,409m, completely changing the mood-music surrounding the results. It’s easy to see how Mr Woodford’s concerns arise.
The long and the short of it
But it’s instructive to contrast his observations with those of his colleague Stephen Lamacraft, reviewing the Woodford fund’s holding of Rolls-Royce (LSE: RR). Both are top-quality companies whose shares have gone backwards over the past twelve months. Rolls-Royce’s stock is down over a quarter after two profit warnings reflecting softening of its end markets – most recently, it has been indirectly affected by trade sanctions against Russia. Yet Mr Lamacraft regards this as ‘exactly the sort of market inefficiency that we aim to exploit [as long term investors]’.
How does a long-term investor distinguish between short-term headwinds and long-term value destruction? I suppose in the Woodford view of the world, HSBC’s regulatory fines fall into the latter because:
- He expects fines will be an ongoing issue ;
- Fines reduce the capital available to support growth (though this is a marginal factor);
- The valuation doesn’t compensate for the potential downside risk.
These are fine judgment calls. What is clear is Mr Woodford’s respect for HSBC otherwise, which he describes as ‘ a conservatively managed, well-capitalised business with a good spread of assets’. What’s more, with the shares trading at book value and yielding 4.9% they look cheap, absent the escalation of regulatory fines that Mr Woodford fears.
So I’m happy to hold on to my HSBC shares. But I’ll be a glad as him when banker-bashing eventually falls out of fashion.