Synchrony Continues To Move In The Right Direction

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Note: Before I get into Synchrony, I wanted to make a quick comment about Brexit. This vote shocked the markets and has added instability into Europe. This was a non-binding referendum. The UK may or may not begin a 2-3 year process of renegotiating its treaties with the EU. I don’t think anyone knows what is going to happen. The tough thing about all of this is a minority of 37% of the population (52% of 72% voter turnout) have made a monumentally important decision on behalf of the majority. 

Trade between the UK and the US represents just 0.5% of US GDP. I don’t think this number will change much. Markets responded unfavorably after the vote primarily because of the ripple effects and future instability caused from it. I am not very worried about this vote as a U.S. investor. There is actually a possibility that investments will flow out of Europe and into U.S. equities which will help performance. The U.S. economy continues to grow at a moderate pace and is doing much better than Europe or Asia. I believe most of the worry is overblown and our markets will calm down in the coming weeks. As a long term value investor, this event won’t cause me to change my portfolio. However, it will give the gloom and doom crowd a chance to scare people for a while. I don’t really see a reason to be scared as interest rate hike expectations have now been pushed out into 2018.

Synchrony Financial is the largest provider of private label credit cards in the United States based on purchase volume and receivables. The company provides a range of credit products through programs it has established with a group of national and regional retailers, local merchants, manufacturers, buying groups, industry associations and healthcare service providers. The company’s revenue activities are managed through three sales platforms: Retail Card, Payment Solutions and CareCredit. It offers its credit products through its subsidiary, Synchrony Bank. Through the Bank, it offers a range of deposit products insured by the Federal Deposit Insurance Corporation (FDIC), including certificates of deposit, individual retirement accounts (IRAs), money market accounts and savings accounts. The Company offers three types of credit products: credit cards, commercial credit products and consumer installment loans. It offers two types of credit cards: private label credit cards and Dual Cards. Synchrony’s active accounts represent a geographically diverse group of both consumers and businesses, with an average FICO score of 715 for consumer active accounts at December 31, 2015.

Operating Segments

SYF 1

Retail Card

Retail Card’s platform revenue consists primarily of interest and fees on loan receivables. The company has Retail Card programs with 22 national and regional retailers, which have approximately 40,000 retail locations and include department stores, specialty retailers, mass merchandisers, e-retailers (multi-channel and online retailers) and oil and gas retailers. Synchrony is known for developing deep relationships with their partners. The average length of relationship with ongoing Retail Card partners is 17 years. Below is a screenshot of some of their major partner relationships.

SYF 2

90% of their contractual relationships will expire in 2019 or beyond which should add stability to revenues. They have a strong portfolio of partnerships. I can’t help but wonder if they were close to getting the Costco deal. Today is actually the last day my Costco AmEx will work. Tomorrow everyone will switch to the Citi cards. Anyway, SYF’s five largest partners are Gap, JCPenney, Lowe’s, Sam’s Club and Walmart. These five accounted for 49% of total revenue for the year ended December 31, 2015 and 51% of loan receivables at December 31, 2015.

Payment Solutions

Synchrony offers promotional financing in a variety of ways, deferred interest (interest accrues during a promotional period and becomes payable if the full purchase amount is not paid off during the promotional period), no interest (no interest on a promotional purchase) and reduced interest (interest is assessed monthly at a promotional interest rate during the promotional period). During the promotional period SYF does not generate much if any interest income. However, promotional financing can boost the loan receivable balance and they will generate fee income on late fees on required minimum payments. This segment accounted for 15% of total revenues in 2015. Synchrony uses promotional financing for big-ticket items where financing could help customers make a purchase.

CareCredit

CareCredit is similar to the Payment Solutions segment except it is exclusively for healthcare procedures, products and services. This service is utilized in the dental, veterinary, cosmetic, vision, and audiology fields. About 63% of the revenue from this segment comes from the dental industry. This is partially due to SYF’s partnership with the American Dental Association.

Economic Drivers

Synchrony is affected by the general economic conditions in the U.S. In the event that the economy worsens, their delinquency rate would rise. In December 2009, the company’s charge-off rate was 11.26% compared to 4.33% as of December 31, 2015. General economic conditions in the U.S have shown signs of improvement. However, growth has been slow throughout the economic recovery. As shown by the screenshots below, consumer spending has continued to grow and people are continuing to consume more goods.

Retail sales

Personal consumption expenditures

In the first part of 2016, we saw many economists begin to call for a recession as several economic indicators flashed warning signs. The ISM and PMI indicators worried many. Since then, the price of West Texas Intermediate (WTI) has rebounded and so have the economic indicators that were flashing warning signs. Q1 GDP was a lackluster 0.5%. However, Q2 is expected to be much better as the economy has rebounded. The most recent GDP estimate is for the economy to grow 2.8% in Q2. This is being driven by increased consumer spending. See screenshot below:

GDP

The economy continues to grow at a slow pace. Interest rates remain low which helps boost investment from companies. As the price of WTI continues to find equilibrium, I expect the economy to continue to grow at a moderate pace as interest rates slowly rise. For SYF, this means that consumers will continue to spend and their net charge-off rate should remain low.

Asset Quality

Synchrony’s overall credit performance has drastically improved throughout the economic recovery.charge-offs

The charge-off ratio has drifted lower each year. 2016 could be a different story though. In Q1 the charge-off ratio actually increased to 4.7% from 4.53% as of December 31, 2015. On June 14th the company disclosed that they are forecasting the charge-off rate to rise another 20-30 basis points over the next twelve months. They added that they will be increasing their allowance for loan losses balance in anticipation of this deterioration of credit. The stock got crushed on this news because it completely contradicted the tone portrayed during the Q1 conference call. This news is quite confusing considering they expect the consumer to increase spending over this time period. So is their credit quality really as good as they say it is? Company expectations are for the charge-off ratio to rise from 4.53% as of December 31, 2015 to possibly 5% at the end of 2016. A move like this should not happen unless economic conditions deteriorate. This move could be the result of excessively easy credit standards. The alternative theory is that management wanted to lower the expectations for the company over the next year.

Synchrony speaks to its asset quality very often. It is always a point of improvement for the company. As of Q1, 28% of their portfolio was made up of sub 660 FICO scores. See screenshot below.

SYF 3

Sub 660 FICO’s are not a problem. These individuals need credit cards too. The problem becomes when they become delinquent and lenders realize their risk model did not work properly. When lenders do not charge enough interest for the risk they are taking it becomes bad for investors. Synchrony warned that this could be the case when they announced last week they would be adding the their allowance for loan losses balance. This is the bank’s safety net for when people default on loans. The stock fell 12% on the day they made the announcement and has fallen an additional 7% since then. This might be an opportunity for investors. Even if charge-offs increase over the next year, this will be partially offset by the amount of retail share agreement payments that SYF pays to its partners. If net charge-offs increase, profitability of the card program will decline, and thus the retailer share agreement payment will also decline. There is a natural hedge built into these agreements where SYF will pay out lower amounts if profits fall. This is only if charge-offs actually increase.

Competitive Advantages

Synchrony is able to have long lasting partnerships with great companies because of their value proposition. Retailers that have a partnership with Synchrony do not have to pay interchange and exchange fees for in-store purchases as a result of their closed loop network. Customers find value using Synchrony from the purchase discounts offered by the retailers. These purchase discounts incentivize larger purchases and customer loyalty for the retailer and SYF.

When partners sign with Synchrony, they usually develop long lasting relationships. There are two primary reasons the average partner relationship is 17 years. First, the costs of switching are very high. The closed loop model Synchrony uses is unique and switching to a model that potentially has a different, bank, network, and issuer is a real headache. Secondly, Synchrony signs retail share arrangements that pay retailers once the economic performance of the program exceeds a contractually defined threshold. These retail share arrangements incentivize their partners to continue to grow sales on Synchrony’s platform.

Management

SYF’s management has done a tremendous job transitioning away from GE Captial. They have added several new retail partners during their transition period. Additionally they have continued to manage credit quality in a slow growth environment. Management is now focused on growing the digital part of the company and thinking about the future of payment platforms.

Valuation

SYF 4

Synchrony’s valuation metrics appear to be very reasonable. Today they do not pay a dividend or execute any buybacks. Synchrony will try to obtain approval from the Federal Reserve Board in 2016 for a dividend and/or a buyback. I expect them to begin paying a dividend in the next twelve months which could be a catalyst for the stock. The margins of the company are very strong. With 90% of their partnership contracts extending to 2019 or beyond, revenues should be fairly stable.

Balance Sheet Leverage

A common phenomenon with these types of businesses is leveraged balance sheets. Synchrony has one of the better balance sheets among its direct competitors. Discover Financial for example, is much more leveraged with a debt/equity ratio of about 2.2x. This makes SFY’s 1.6x look better. However, 1.6x is an uncomfortable amount of leverage. When looking at other competitors like Visa and MasterCard, they sell at nearly 3x the valuation of SYF. This large variance is the result of wider profit margins and less balance sheet leverage. Both trade with debt/equity ratios of about 0.5x. During Q1, Synchrony paid down a significant amount of long-term debt. This lowered their debt/equity ratio from 2x to 1.6x. Continuing to dig themselves out of debt in the next couple of quarters should have a material impact on the valuation the market places on the stock. With a debt/equity ratio closer to 1, this would be a terrific business. Prior to declaring a dividend, I hope they use their free cash flow to pay down their debt.

Analyst Estimates

If analyst estimates are correct, SYF is cheap. Analysts expect the company to make $3 per share in 2017. This means the stock trades at 8.5x forward earnings. This is less than half of the 18x forward earnings estimate of the S&P 500. The company is expected to grow at a 6% annualized rate over the next several years.

Conclusion

Synchrony is a solid business with competitive advantages. They have a terrific portfolio of retail partners and continue to add to it. Management has done a good job since the IPO of running the business while transitioning away from GE Capital. I really hope they have been paying down more debt in Q2. They will be trying to get approval from the Federal Reserve Board this year for a dividend and/or a buyback. Improving the balance sheet before asking for approval would make sense and they have plenty of cash flow. I currently do not have a position but will look to take one this week as the stock is close to its 52 week low.

Disclosure


 

No Position

 

 

 

 

Indexing’s Effect on Market Efficiency

Index-Words

Over the last thirty years, the strategy of indexing has rapidly been adopted. Indexing is appealing to investors because they can achieve the return of an index while having low fees. Various studies have shown the advantages of low cost indexing. However, there is a certain myth around indexing that should be addressed. Indexing is widely considered to be a passive investing strategy but I would rebut this belief. Passive investing is not just about reduced activity, low fees and tax efficiency. A stock picker who picks one stock and buys and holds it can be just as inactive as someone who buys one index and holds it. In reality, they’re likely to be more fee efficient than the indexer because there is no recurring cost to holding stock. An index like the S&P 500, however, is an actively selected basket of companies that represent a slice of outstanding global stocks. Because nearly every index is a small piece of all equities, it is actively managed and adjusted. This calls into question whether indexing is actually a passive strategy.

Market Efficiency

There has been extensive research into market efficiency and the efficient market hypothesis. Perhaps the most well known paper was published by Paul Samuelson and Eugene Fama in the 1960’s. A market commonly is described as efficient when prices fully reflect all available information. There are two pieces that make up market efficiency. 1) Informational efficiency 2) Fundamental value efficiency. Informational efficiency represents how quickly prices respond to new information. Informational efficiency, alone, does not imply that market prices respond to new information correctly or even that prices respond at all. This brings us to fundamental value efficiency. Markets are efficient in the fundamental value sense if prices respond to new information not only quickly but accurately. Both pieces of market efficiency operate independently and both must be present for market efficiency.

It is important to weigh the type of information that is being priced into a security. What happens when new information becomes available but investors must invest substantial time, trouble, or money to get it? What happens when the information is technical and difficult to understand? Do prices still change quickly? In short, the answer is “no.” Certain types of information seem to be absorbed into prices far more slowly and incompletely than the efficient market believers suggest. A phenomenon that has been studied over the last 30 years is “post-earnings-announcement-drift.” An unexpected announcement of increased corporate earnings tends to be followed by atypical positive returns over the next several months, while firms that announce unexpectedly poor earnings see atypical negative returns over an extended period. This is evidence that the initial price response to the new earnings information is unfinished, and that the full implications of the new earnings information are priced in by the market far more slowly than previously assumed.

A recent paper, Konchitchki, Lou, Sadka & Sadka (2013) studied the explanation of the post-earnings-announcement-drift. Among their findings is that investors tend to underreact to new information in earnings. It often will take investors a period of time to incorporate the current earnings into future expectations which causes a drift. The complexity of the information can also impact the drift. This research is indicative that markets are not always efficient.

Indexing and Momentum Investing

Indexing has become more popular with the objective of replicating a particular market index. Using this investment approach, money is allocated by the proportion that a particular stock represents of the index. As such these investors pay no attention to information about a company (other than its market capitalization), much less whether it is fairly priced. Investors utilizing indexing strategies allocate capital using mostly investor flows or index changes instead of new relevant information. An increase in indexing and the consequent decrease in investors making decisions based on the fair value of stocks has the potential to make markets inefficient.

The U.S equity market grew from $11 trillion in 2002 to over $30 trillion in 2014. In that same period, the value of passive funds went from $710 billion to over $7 trillion. As a percentage of the equity market, passive ownership went from 6.50% in 2002 to 24.34% in 2014. The growth in the trend of investing while ignoring new information and valuations is worth noting. Today we have a market where trillions of dollars have been invested by uniformed market participants leading to inefficient markets. A significant proportion of investment funds have been moved into “the market portfolio” in that they are invested on the basis of the proportion that a particular stock represents of the index with no reference to valuation. As such, opportunities are being created for investors who use all available information in their investment analysis.

Momentum investing is another strategy that has grown in popularity.  It has been exhibited that momentum investing consistently generates excess returns suggesting a market inefficiency. Momentum comes in different forms with it being measured using past price movements, past returns, or changes in earnings.  In most markets, momentum investing plays a role in the management of upwards of 50% of the actively managed funds. Momentum investors represent another large proportion of the market that is in the hands of investors who make no reference to valuation when making their investment decisions. Therefore, they play no role in correcting any market mispricings. An argument could be made that momentum strategies destabilize the infrastructure of the market because they exacerbate existing trends. When investors are attentive to investing in trends and using momentum, they frequently drive the price beyond fair value until the demand from the fundamental investors causes a mean reversion in prices. These mean reversions differ in size and can cause investors to become fearful.

Some researchers believe that indexing can become self-defeating as more and more people adopt it. As the percentage of indexers grows, the markets become more inefficient as the number of investors who perform fundamental analysis shrinks. If everyone adopted indexing, the markets would likely not move much due to the lack of inflows. If there were to be a decrease in indexing, it is likely that equities in the most popular indexes would underperform those that are not in an index.

A self-reinforcing feedback loop has been created by indexing. The performance of indexes has been boosted by indexing which has led to more indexing. However, if this behavior begins to unwind the performances of indexes could suffer compared to the rest of the market.

Conclusion

Markets have demonstrated on multiple occasions in recent years that they are not perfectly efficient. When complex information is introduced to markets, it will often take a period of time to be priced in. Sometimes, it can take a substantial period of time. It is common for investors to underreact to new information which leads to a post-announcement-drift. During this period, investors price in the new information.

People have turned to indexing because they believe it is a good net of all fees strategy. However, not many have thought about the circumstance where indexes underperform the rest of the market. The major indexes like the S&P 500 are often used as a performance benchmark. What happens if the major indexes begin to underperform? Will investors adjust or will they just assume they are still performing with “the market” benchmark? Trillions of dollars have been invested into various indexes while ignoring new information, valuations, growth ect. It is certainly possible that investors who use all relevant information when making investment decisions will favor equities outside of the major indexes due to their discount to those within. This situation would lead to the major indexes underperforming and potentially a reversal of the indexing craze.

 

 

 

 

 

 

Quantitative Easing and Negative Interest Rates

QE 1

“Quantitative Easing” is a form of monetary policy the Federal Reserve executes to help meet its policy objectives. QE has been widely talked about since QE1 was announced in November 2008. The Federal Reserve has always had policy targets and has used various forms of monetary policy to reach them.

QE is a type of open market operation that alters the reserves in the banking system. The altering of these reserves helps the Fed achieve its target interest rate. Before I go too far into the intended effects, I would like give a basic example of the QE process.

A Quantitative Easing Transaction Example

The primary transaction that has occurred is when a bank sells t-bonds to the Fed.

Federal Reserve Balance Sheet

Change in Assets = +$100M t-bills

Change in Liabilities = +$100M reserve liabilities

Change in Net Worth = $0

Banks Balance Sheet

Change in Assets = $0(t-bond is swapped for reserves)

Change in Liabilities =$0

Change in Net Worth =$0

After this transaction is complete, the bank still has the same net worth as before QE. The medium switches the composition of the balance sheet assets, but does not add assets. The process changes the composition of private sector balance sheets. The Fed, through open market operations, is switching private sector assets from t-bonds to reserves. In theory, it would be like me giving you five $20 bills for a $100 bill. Your net worth will have not changed as a result of this transaction. Although you might have more liquidity.

So how does QE help the Federal Reserve achieve its target policies? By shrinking the supply of US government bonds, the Fed is putting downward pressure on interest rates by increasing the demand for other bonds. The increased demand can lead to price increases and portfolio rebalancing. This phenomenon is often referred to as “wealth effect” which could lead to an increase in private sector net worth through asset appreciation. The interest rate channel can also spur investment by helping to maintain an accommodative interest rate structure.

The psychological impact of QE is one of the most important and unpredictable impacts. QE has the potential to cause asset price appreciation as monetary policy remains accommodative. The private sector might feel more comfortable to invest while the Fed is accommodative. The largest effects of QE are indirectly caused by bond purchases.

Many people have called quantitative easing “money printing” and some have gone as far to say the U.S is monetizing its debt. However, the execution of QE would have been exactly the same even if the U.S where to have a budget surplus. If we would have performed QE while having a budget surplus, we would not have heard the claims of the U.S monetizing its debt. Many individuals have bought into the debt monetization myth. However, the Treasury is not financing the government’s spending. This can be seen by looking at the QE impact on the Fed’s balance sheet. The idea of debt monetization would give me concern for inflation. However, this is not a concern because the Fed is buying bonds on the secondary market that have already been purchased. Further, it is implementing these transactions, not because there is a lack of demand for t-bonds, but because the Fed is trying to reach its policy targets.

What is the theory behind QE? The theory behind the mechanism is banks will have more reserves which will spur them to lend out more money. Fundamentally, there is a bit of an issue with this theory. Banks do not lend out reserves to the public. Before a bank makes a loan, they never check their reserves. They make loans to qualified applicants and reserves are continually managed. If a bank needs more reserves, they can obtain them from the central bank after the fact. Bank lending is not restricted by the level of reserves. Consequently, increased reserves will not translate into more loans unless there is an increase in qualified loan applicants. Bank lending is driven by creditworthy applicants. A greater supply of reserves does not necessarily mean that more loans will be made.

When the Federal Reserve shifts assets around in the private sector, it can cause investors to move from one asset to another. This behavior can push asset prices higher as investors rebalance portfolios. Although asset prices rise, the underlying fundamentals of the assets may not improve as much as the market is pricing. It is unknown if the rise in asset prices is justified. Investors will find out as time goes on. The psychological and behavioral effects are prominent as investors have felt increased confidence from an accommodative Federal Reserve. The obsession with forward guidance and the Fed’s dot plot has been beneficial in setting expectations but it has also put a spotlight on the credibility of the Fed. There is a risk of a scenario where the Fed’s forward guidance is inaccurate and they are forced to act in accordance with it even though circumstances have changed. Alternatively, they risk shocking the market and revising forward guidance. These circumstances are indirectly caused by QE.

Conclusion

The effects of QE are still predominantly unknown. The operation helps the Federal Reserve achieve its target policies similar to other forms of monetary policy. QE can be executed in many ways by adjusting the asset being purchased. This can alter the effects of the operation. Many central banks around the world are now experimenting with QE in various ways. Only time will tell if there will be long-term consequences to these monetary policy actions.

Negative Interest Rates

Negative interest rate policy (NIRP) is a much easier concept than Quantitative Easing. The idea is that central banks will charge banks interest for holding reserves; incentivizing them to lend more. Many foreign central banks—such as the European Central Bank, the Bank of Japan and the Swiss National Bank—have implemented negative interest rates on bank reserves as a policy tool. This central bank policy forces banks into a corner. The banks are left with a few different options. 1) Lower interest rates on loans in hopes of increasing demand. 2) Charge customers a fee for holding deposits which passes the cost onto them. 3) Charge customers higher fees for processing loans, passing the cost onto them. 4) Do nothing and have lower net income which will hurt their stock prices. As previously mentioned, bank lending is driven by creditworthy borrowers. Charging banks interest on reserves will not alter the population of creditworthy borrowers. No matter which option each respective bank chooses, the end result is a tax that reduces interest income for the private sector.

The scary thing about negative interest rate policy (NIRP) is it pushes banks to lower lending standards. Because the population of creditworthy borrowers will not change, they must change the definition of “creditworthy” to shift the demand curve. This is obviously dangerous as the interest rates of new loans will not align with the risks the bank is taking.

As of today, the Japan 10 year government bond (JGB) has a yield of -0.12%. Why would someone buy a bond with a negative yield? Investors chasing short term performance believing yields will continue to fall might purchase bonds for the price appreciation. In the long term, the issuer of the bond will still be paid the negative yield. However, investors betting on deflation and lower rates might purchase these bonds for short term performance.

The world has now been exposed to NIRP for long enough that banks are beginning to react to the policy. As mentioned, they are being put into a corner and must decide the best course of action. We have seen numerous banks begin to charge clients for deposits. Negative interest rates have started a game of hot potato within the banks. As one bank begins charging customers for deposits, the customers move deposits to another bank. Deposits move from one bank to another as more implement charging for deposits. Many economists believe that banks can’t force depositors to hold less deposits. I would argue there is a tipping point but we have no idea where it is. Warren Buffett commented on this issue after the Berkshire Hathaway annual meeting last month. He said “It’s a different world. If you have a lot of money in euros, as we do … you’re better off putting it under your mattress than in a bank.” This is indicative of the hot potato being passed around. Ultimately, deposits held in banks will essentially be taxed and money will flow from the private sector to governments. If depositors pull their currency out of the banking system, they are exposing themselves to having their money lost or stolen. The question is, how much can people be taxed on their deposits before they pull them out of the banking system?

Conclusion

Negative interest rate policy is a scary operation to continue. Bank dynamics contradict the policy’s theory. Incentivising or pushing banks to lower lending standards to spur lending seems dangerous. In the end, the result of the operation is the same, interest is flowing out of the private sector to the government. Whether banks decide to pass the cost onto their depositors is their choice. However, someone in the private sector will have to foot the bill.