Thursday 21 September 2017

In control at Bank of Ireland

A year after consortium acquires a 34pc stake in troubled bank, Canada's answer to Warren Buffett makes his move

Prem Watsa's appointment as a non-executive director of Bank of Ireland marks the changing of the guard at Ireland's oldest bank as its new investors take effective control.

Ever since a consortium of North American investors paid €1.1bn for a 34.9pc stake in Bank of Ireland in July 2011 the market has been wondering how long it would be before they made their presence felt.

After all, the individual consortium members, who apart from Mr Watsa, the 'Canadian Warren Buffett', also included veteran 'vulture' investor Wilbur Ross, have never previously been known to be backward about coming forward.

Was it a case, many wondered, of the consortium waiting for a suitably decent interval before asserting the level of control to which their shareholdings entitled them?

If so then the "decent interval" expired this week. On Wednesday, Bank of Ireland announced that Pat Molloy, the former chief executive who has served as its chairman since 2009 would be stepping down next week. Mr Molloy will be replaced by former Lloyds executive Archie Kane.

This means that all of the three remaining Irish-owned banks now have UK-based chairmen.

Interest

However, it was the bank's announcement of the appointment of two new non-executive directors that attracted the most interest. Both Mr Watsa and Mr Ross, the leading members of the consortium each of whom has a 9.3pc stake in Bank of Ireland, had been elected to the board at, as Bank of Ireland sources put, "their own request".

The appointment of Messrs Watsa and Ross to the board and Mr Molloy's replacement by Mr Kane means that the consortium is now very much in charge at Ireland's oldest bank.

His appointment to the Bank of Ireland board occurred on what turned out to be a very busy week for Mr Watsa. On Tuesday his Fairfax Financial Holdings announced that it had agreed to purchase UK insurance company Brit Insurance, which is in run-off, for approximately C$300m (€233m).

It looks like a shrewd deal for Mr Watsa. Brit has a book value of approximately C$530m (€412m).

Buying a discount to book value is what 'value' investors such as Mr Watsa always try to do. He is, like Warren Buffet and Cooley Distillery founder John Teeling, a disciple of Benjamin Graham (1894-1976). Professor Graham wrote that:

"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

Value investors, including Mr Watsa, believe that the market is inherently inefficient. He has been quoted as saying that:

"Sometimes it [the market] buys at a high price and sells at a low price. Don't ever think that it knows more than you."

Does Bank of Ireland meet the value investors' criteria? Although it is by far the least stressed of the Irish-owned banks, it had written off a total of more than €11bn of bad loans in the four years to the end of 2011.

It is difficult to see how Bank of Ireland could have survived without the Government's September 2008 deposit guarantee and state support in its 2009 and 2010 recapitalisations.

Collapse

As against that the Irish economic collapse and the huge resulting bad debts have led to an exodus of foreign banks from the Irish markets. When conditions do eventually begin to recover Bank of Ireland will face far less competition than it did during the go-go Celtic Tiger years.

In the immediate aftermath of last July's investment by the consortium the Bank of Ireland share price advanced strongly. By February it briefly hit 15 cent, up 50pc on the 10c Mr Watsa paid for his shares, giving him a paper profit of almost €150m. However, the Bank of Ireland share price has since gone into reverse and ended the week at 9.4 cent leaving Mr Watsa nursing a small paper loss.

While neither Mr Watsa nor the other members of the consortium are likely to be selling their Bank of Ireland shares any time soon, they will naturally be anxious to see the price move back up. Which almost certainly explains his and Mr Ross' decision to go on the Bank of Ireland board this week.

Despite the disappointing performance of the Bank of Ireland share price, the investment returns of Fairfax Financial, the investment company founded by Mr Watsa in 1985, have been stellar. Since then he has averaged compound annual returns of more than 27pc, a cumulative 24,424pc, more than justifying the comparison with Mr Buffett.

In an investment career spanning more than a quarter of a century, Mr Watsa has got most off the big calls right. A few weeks after the Dow Jones hit a record high of over 13,000 in April 2007, ironically in a speech to the Ben Graham School of Value Investing at his alma mater, the University of Western Ontario, Mr Watsa warned that: "There's a possibility of a one-in-50 or a one-in-a-hundred year storm coming. When the music stops it stops very quickly."

Mr Watsa practised what he preached. He had moved most of his company's C$16bn (€12.42bn) US portfolio out of stocks and into less risky treasuries and cash. He also bet on the collapse of the US housing market. A C$341m (€265m) bet on credit default swaps yielded a payday of more than C$2bn (€1.55bn).

A native of Hyderabad in India, Mr Watsa was educated at the elite Hyderabad Public School, of which his father was the principal. He then went on to graduate with a degree in chemical engineering from the Indian Institute of Technology.

However, he didn't fancy a career as a chemical engineer and his father encouraged him to emigrate to Canada where his brother was already working. Mr Watsa studied for an MBA at the University of Western Ontario's business school while selling air-conditioning part-time.

He then spent a decade as a research analyst with the now-defunct Canadian life company Confederation Life before leaving to set up Fairfax in 1985.

A belief in the tenets of value investing isn't the only similarity between Mr Watsa and Mr Buffett. Just as Mr Buffett has built his Berkshire Hathaway investment vehicle on the cash flows of its insurance operations, so has Mr Watsa with Fairfax, whose assorted insurance businesses now make it the largest property and casualty insurer in Canada.

However, one bad insurance acquisition almost did in Fairfax. In the late 1990s it paid US$847m (€674m) for New York insurer TIG. It turned out to be an absolute dog and Fairfax spent most of the following decade sorting out the mess. Even worse the TIG acquisition piqued the interest of short-sellers who began shorting Fairfax shares.

This resulted in Fairfax suing several hedge funds whom it accused of spreading malicious rumours. The cases have yet to be settled.

Apart from TIG, Mr Watsa's other questionable investment is RIM, the Canadian producer of the BlackBerry device whose raison d'etre has been called into question by the rise of the smartphone.

In 2010 Fairfax purchased over 26 million RIM shares at an average price of C$50 (€39). The shares are now trading at less than C$10 (€7.76).

Mr Watsa, who joined the RIM board in January, has said that turning RIM around could take years. Sounds a bit like Bank of Ireland.

Irish Independent

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