Friday, October 10, 2014

The Strange Tale of UBS

UBS, as a global bank, has enjoyed a cachet among its high net worth customers in the wealth management and asset management businesses, while U.S. investors have never warmed to its name as a core holding in their institutional portfolios.

Today's New York Times has a disjointed piece on UBS which does nothing to make the investment case for the 'new' UBS, and it shows the continuing disjunction between traditional banking businesses and investment banking.

We learn that in 2011, the current CEO Sergio Ermotti embarked on a strategy to reduce risk-weighted assets that was mandated by Basel regs.  A foundation for accomplishing this was to cut costs, exit capital intensive businesses, and to focus the portfolio on businesses like wealth management and asset management, alongside a smaller, more focused investment bank.

In 2012, we learn that the CEO recruited Andrea Orcel, a long-time Bank of America executive, to head up its investment banking operation.  Here is Morningstar's take on the recent history of the investment bank's contribution to consolidated UBS financial results:
" Investment banking is a risky activity that can cause very large losses. Between 2007 and 2009, UBS lost nearly CHF 30 billion and required a government bailout as a result of its investment banking losses. In addition, losses in investment banking indirectly affect the private bank. UBS was among the banks hardest hit by asset write-downs, which has damaged its reputation as a competent asset manager, and the 2011 rogue trader scandal set back its recovery. UBS suffered nearly CHF 400 billion of net asset outflows as a result of its damaged reputation. UBS' move away from the riskiest investment banking activities, especially those with long tail risks, should help to reduce the risk of further damage."
Naturally, the investment banking business had the normal global, economic cycle rebound in worldwide fee revenue, and it led to Mr. Orcel becoming the highest paid corporate executive in the bank, despite the fact that apart from some some timing and cost-cutting he hadn't done anything very extraordinary. We've written about cultural problems when global investment banks are put together with more traditional banking activities, like client wealth management services.  Shareholders haven't done well, even recently.

Morningstar notes that for the fiscal 2014 second quarter,
 "Return on equity was disappointing at 6.4%, and excluding the litigation provisions doesn’t help much--we estimate that pro forma return on equity was 8.1%, well below UBS’s 12% cost of equity."
So, no EVA inside this combined operation.

We learn that an activist shareholder with 1% of the equity, wants to have two securities, one for the investment bank and the other for the wealth management and asset management businesses; the shareholder could then decide which business they really wanted to own and sell the less desirable one.

The CFO responded,  “We have zero intention of changing our strategy,” said Tom Naratil, UBS’s chief financial officer. Of course not.  The current deal is unbelievably cushy for the entrenched management and board, and it's unlikely that given the regulatory scrutiny on the combined entity along with the history of prior management turnover, another change would be countenanced by shareholders.  The company's presentations assert that financial results would be stronger in a rising rate environment that could come by mid-2015, if Fed watchers are right.

So, investors have a Wealth Management business with extremely attractive returns, According to Morningstar, returns on attributed equity in the Wealth Management business are regularly in the 40% range, and even during the heart of the crisis they were in the mid-teens!  This is a business to own. Investment Management is also a fine business with excellent margins and sticky customers.

Investment banks should be run as partnerships, as they were in the good old, white spats days.  This would, of course, shrink their global reach and risk-based prop trading, but for the public shareholder these aren't attractive businesses to own because of their high fixed costs, volatility, and capacity for major surprises, not to mention a heightened regulatory scrutiny.

Morningstar's Stewardship rating for UBS went from Poor to Standard.  I guess that's progress.

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