Michael Burry, the value investor immortalised in Michael Lewis's The Big Short, famously sought stock that had an intrinsic value that outweighed its current price, even if that price reflected short-term scandal or negative publicity.
So, would Westpac Banking Corp (ASX: WBC) be in Burry's portfolio?
Damaged goods?
How damaging are 23 million transactions alleged to have breached anti-money laundering and counter terrorism finance laws to a bank's share price?
In particular, and in Westpac's own ASX announcement, how damaging are its alleged "failings in relation to correspondent banking, risk assessments, customer due diligence, transaction monitoring, record keeping and the passing on of certain data in funds transfer instructions"?
Will the fines and penalties cripple Westpac's operations to the extent it sees its profitability and market share recede?
Or will investors shun Westpac on moral grounds and sell off their holdings for whatever low bid is available? For them, any trading loss is cheaper than a moral failing.
The worst-case scenario for Westpac was outlined by ABC's business reporter Nassim Khadem, who concluded that "the bank's reputation is possibly irreversibly damaged — it will now always be known as the Australian bank that may have facilitated paedophiles."
Echoing this worry, former Labor senator and current Westpac shareholder Chris Schacht interrogated the Westpac board at last Thursday's AGM, asking "What are you going to do to [ensure] the restitution of our reputation?"
Of course, a rejoinder to this could be the distinction between attributing the alleged faults to Westpac itself – its immutable corporate nature – and attributing the faults to its current leadership team.
In the latter case, the departing implicated executives will take the stench with them; in the former case, the stench never goes away.
All this raises a question: what is the biggest risk to Westpac's share price – damaged reputation or the financial punishment the regulators will mete out?
Just today, banking regulator APRA ordered the bank to hold an additional $500 million in capital as a loss safeguard.
Further, will the fine impact Westpac for anything longer than the short-term?
Michael Burry and 'Roadkill' stock
In a letter to investors (as reported by Vanity Fair), Michael Burry explained the term 'ick investing'. Ick investing focuses on stocks that at first glance elicit a reaction of 'yikes' or 'ick'. The company is either suffering from negative press or the market has quarantined it due to its toxic reputation.
In early 2000s, Avant! – a semiconductor company – was accused of stealing software code from its rival, code that was fundamental to its business success. Criminal charges were brought against Avant!'s leadership.
But Michael Burry was not fazed; he decided to research Avant! further. He found that the company had $100 million in cash, still generated $100 million in free cash flow yearly, and had a market value of $250 million.
As the Vanity Fair article reported:
[Burry] was able to see that even if the executives went to jail (as five of them did) and the fines were paid (as they were), Avant! would be worth a lot more than the market than assumed. To make money on Avant!'s stock, however, he'd probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.
In line with this approach, some issues Burry would consider in Westpac's case are its capital raising and ability to pay off a fine estimated to be between $1–4 billion.
Parting gifts
A revealing quote that seems to echo Burry's focus on fundamentals over 'ick' reactions comes from Westpac Group's own Chairman, Lindsay Maxsted.
In a statement to the ASX following the allegations, Maxsted thanked the outgoing CEO Brian Hartzer, saying that "Brian leaves the Bank with a strong balance sheet, with each of our businesses number one or two in their markets."
The emphasis was more on healthy balance sheets and market leadership than probity and moral leadership.
Silver linings
On 1 February this year, the day Hayne's report was set for release, Westpac was trading at $24.05. As of the time of writing, Westpac is trading at $24.59, a 2.2% increase.
As of the time of writing, all of the 'big four' banks – even Westpac – are up, year-to-date. The royal commission's findings did not sour investors' moods.
In fact, some argue the royal commission had a positive effect on the banks' share price, as it forced the banks to improve.
As the UNSW Business School's Associate Professor of Finance Mark Humphery-Jenner said in an article published by The Conversation, "[i]mproving governance and internal controls could in fact ultimately help shareholders. The royal commission could have been much worse for banks. Some of it might actually be good."
In a similar vein, in an address during the recent AGM, acting Westpac CEO Peter King confirmed the implementation of rectifying measures.
These included "closing products and reporting outstanding historical files related to AUSTRAC's IFTI claims", "recruiting an additional 200 people in compliance and financial crime areas", and establishing a Board Financial Crime Committee.
Westpac fundamentals
Acting CEO King described Westpac's FY19 financial performance as "disappointing."
Net profit for 2019 was $6,784 million, which was down 16% compared to 2018. Net interest income increased $402 million, or 2%, from 2018, but this was driven by a reclassification of line fees from net fee income to interest income. Excluding the reclassification, net interest income was flat compared to 2018.
The bank's Australian housing loans category increased by only 1%, while Australian personal loans decreased by 8%, with Australian business and institutional loans down 1%.
Net wealth management fees and insurance income were down a substantial 50%, or $1,032 million, compared to 2018. Westpac attributed this reduction to provisions for customer refunds and associated costs as well as litigation costs worth $531 million.
Operating expenses increased $540 million, up 6% compared to 2018. The main contributor was a $349 million increase in provisions for customer refunds and associated costs.
Further, as acting CEO King admitted, Westpac's exiting the personal finance advice sector "improved the company's sustainability but came at a significant cost to both revenue and expenses."
A question a long-term investor like Burry might ask is: how fixed or common are the costs and factors weighing down Westpac's performance?
Will interest rates be this low in 5 years? Will Westpac have to continue allocating hundreds of millions to customer refunds and litigation costs each year? Will Westpac suffer intense regulatory scrutiny and 10-figure fines yearly?
In other words, is Westpac sailing through a vicious – but temporary – storm, or is it marooned in bad weather forever?
Outlook for 2020
Westpac's own acting CEO, Peter King, did not sugarcoat matters.
Addressing shareholders, King soberly predicted "operating conditions to continue to be soft, with growth remaining low, interest rates expected to fall further, and regulatory intensity" to persist.
That regulatory intensity soured King's positive forecast of "balance sheet growth without significant deterioration in credit quality", with the acting CEO predicting regulatory intensity to bring extra costs.
Further, Westpac's FY19 report included forecasts by Westpac Economics, predicting Australian economic growth to remain below trend, inflation to rise from 1.6% to 1.9%, and the cash rate to go further down to 0.50%.
There is also the Reserve Bank of New Zealand (RBNZ)'s announced changes to the capital adequacy framework.
According to Westpac's own calculations, on a pro forma basis, Westpac's subsidiary WNZL would require a further NZ$2.3–2.9 billion of Tier 1 capital to meet the new requirements that are fully effective in 2027.
For Westpac Group, the changes are estimated to 'reduce Westpac's Level 1 capital on a pro forma basis as at 30 September 2019 by NZ$1.2–1.8 billion.'
However, the 7-year grace period softens the impact and was enough for Goldman Sachs analysts to conclude the RBNZ changes would not rock Westpac's share price too much.
Foolish takeaway
Currently, the Wall Street Journal (WSJ)'s average stock price target for Westpac sits at $25.80, with a High target of $30.50 and a Low target of $22.40. Of the 15 analysts surveyed by WSJ, 9 rate Westpac a Hold, 3 a Buy, and the remaining 3 a Sell.
As of 6 December, Goldman has a 'Neutral' rating on Westpac, with a 12-month price target of $25.58.
Macquarie is in agreement on Goldman's 'Neutral' rating, but with a 12-month share price target of $26.00.
As for a meticulous value investor like Michael Burry, he would most likely not consider the negative sentiment fatal. However, he would ponder whether Westpac is trading at a significant enough discount.
As ex-CEO Mr Hartzer himself said in a November interview with The Sydney Morning Herald, banks are in a "cyclical downturn … where growth rates are low, credit demand is low and interest rates are very low", all the while "significant investment is required in regulatory and compliance matters."
By and large the market has baked these considerations into the banks' prices so there is little discount room.
While Burry's Avant! had ample cash on hand and surging cash flow even after paying its fines, Westpac's already existing vulnerability to economic downturn, low rates, and flagging credit demand will make resilience to the piling up of penalties and capital requirements much harder.
