Stocks and Shares

How to lose friends and alienate the Germans

“How to win friends and influence people” is a famous book that’s sold over 30 million copies since 1936. Unfortunately, none of those copies seem to have found their way into the offices of the US Department of Justice. Currently the DoJ is intent on inflicting major damage on two of the largest German corporations, despite Germany being an essential US ally. One of these is Deutsche Bank, which I’ve written about before. The question is whether it’s still a buy.

The US Department of Justice is known for being a pretty vicious organisation. A personal contact, who is CEO of a US company, previously told me how the DoJ nearly bankrupted his business over misdemeanours committed by previous management that he had sacked.

In the end they backed down, but by then the damage was already done. He’d been hit with legal defence bills running into tens of millions of dollars, which had drained his company’s cash reserves. Not to mention spending around two years battling the DoJ instead of running his business.

News came out on 15th September that the DoJ has demanded a US$14 billion fine from Deutsche Bank AG (Xetra:DBK / NYSE:DB). This relates to misdemeanours related to the bank’s sale of residential mortgage backed securities (RMBS) between 2005 and 2007.

RMBS are bonds made up mortgage loans. Back before the financial crisis banks like Deutsche were busy with the lucrative business of aggregating lots of loans together and selling them to investors like pension funds.

The problem was that a lot, or even most, of the loans were junk. But the bonds that contained them – through the magic of financial engineering – were supposed to be high quality.

Deutsche Bank was one of many US and foreign banks that came under investigation. The fines and the lawsuits began to fly.

When the house of cards collapsed the recriminations began. Deutsche Bank was one of many US and foreign banks that came under investigation. The fines and the lawsuits began to fly.

Deutsche Bank, unsurprisingly, has said it has no intention of paying so much. Other banks in similar positions have settled for much lower amounts. Most people seem to expect the final number to be more like US$5 billion, but no one really knows. Deutsche Bank has already put aside billions to cover this and other ongoing cases.

This is the opening salvo in a negotiation, but the stock price has taken a big hit nonetheless. The market is factoring in the worst case scenario, and hedge funds have been selling the stock short to drive the price down.

(Short selling means selling a stock you don’t own, borrowing it from someone else to deliver to the buyer, and hoping to buy it back at a lower price in future.)

I wrote about Deutsche Bank stock back in July (see here, here and here). I thought it could be a highly profitable turnaround story for investors, over a four year period. Since then the euro share price is down 12%. But despite the latest news and the price action I still hold the same view, as I’ll explain in a minute.

But first, there’s another big German corporation in the DoJ’s cross hairs. That’s Volkswagen AG (Xetra:VOW3 / PINK:VLKAY). The DoJ is considering the level of fine to impose on Volkswagen for rigging the emission data on its diesel cars.

In this case, according to a report by Bloomberg, the DoJ wants to extract as big a fine as possible without putting the car maker out of business. In other words, it won’t be based on the seriousness of the crime but on the ability to pay. It’s expected to run to tens of billions of dollars.

Now let’s be clear here. I’m not trying to excuse the behaviour of either Deutsche Bank or Volkswagen. Both have been caught breaking the law in past years and should pay some kind of penalty.

But the question is about the size of the penalties, and also about whether this is actually in American interests. Let’s ponder that for a minute.

Volkswagen is the biggest car company in the world. Even after the scandal it’s still outselling Toyota. It has 610,000 employees around the world, and about a third of those are in Germany.

Despite the share price being cut in half since the emissions scandal it’s still around 3% of the value of the MSCI Germany index of large stocks. Clearly it’s a major national industrial champion in Germany.

Meanwhile Deutsche Bank is Germany’s most important bank, if not necessarily in the home market. Its assets are around 1.7 trillion euros (US$1.9 trillion), which puts it in the same league as US giants like Bank of America, JP Morgan Chase and Citigroup.

If Deutsche Bank goes down, so does the whole house of cards. And that means the US financial system, not just the German or European one.

It’s intricately interlinked with the entire global financial system. Inability to pay its banking counterparties would have huge knock-on effects. If Deutsche Bank goes down, so does the whole house of cards. And that means the US financial system, not just the German or European one.

The bottom line is that the DoJ is being highly irresponsible. Its massive opening bid in the fine sought from Deutsche Bank creates huge and unnecessary fear in markets that there could be another banking crisis.

Its idea to punish Volkswagen to the max just looks like vindictive behaviour, or simply trying to bring a great company to its knees for the advantage of US competitors.

But whatever the rights and wrongs, whatever the motivations, this is highly unlikely to win the US any friends in Germany. Attempting to bring two national champions to their knees simultaneously is not going to be conducive to relations.

This abuse of power does the US no favours abroad, and is counterproductive. But, for now at least, it is what it is.

I’m not saying either company should get off scot free. But it’s all about keeping things in proportion. Unfortunately, the good people of the DoJ appears to be ingesting a diet of Dali and LSD.

Let’s get back to Deutsche Bank and whether or not you should still buy the stock (or keep it if you already own it). This is a turnaround story, pure and simple. And the CEO, John Cryan, is probably the best person in the business to make it happen. (See previous analysis here, here and here.)

Cryan has set profitability targets for the year 2020. If he achieves them I estimate the bank will be worth a price-to-book (P/B) value of 0.7 if investors will accept a 12% annual return (5% growth plus 7% dividend yield). If investors will accept 10% return (5% growth plus 5% dividend yield) the P/B would be 1.

As of today the share price is 10.41 euros (US$11.65). At that level the P/B is just 0.27. Yes, that’s 73% below liquidation value.

In other words, if Cryan’s targets are reached I estimate the stock is worth between 2.6 and 3.7 times as much as today. The mid-point is therefore 3.1 times today’s price. That would be a gain of 210% over four years, which is equivalent to 33% a year with compounding (profits on profits).

Clearly that’s a tantalising prospect, albeit not for the faint hearted. This is a bank after all. And the rumours continue to swirl that Deutsche Bank will have to tap the markets for a capital shortfall.

The bank continues to deny that it will have to raise new capital, even with the latest DoJ news. But let’s assume it does eventually issue new stock to pay its fines and shore up the capital position.

Under a worst case scenario let’s say it raises the full US$14 billion that the DoJ seeks (this won’t happen, but let’s consider it anyway). That’s 12.5 billion euros.

The current market capitalisation is 14.25 billion euros, meaning the market value of the company at the current share price. If shares worth 12.5 billion euros were issued at the current price then existing shareholders would lose 47% of their portion of ownership. In other words their ownership would be “diluted” by almost half.

Even so – and remember this is an extreme scenario – if the profit targets are reached and my mid-point valuation is achieved by 2020 – that would still mean a gain of 67%. That’s 13.6% a year with compounding. Not nearly so great, but still a decent profit in a worst case scenario.

If the bank raises US$10 billion the gain would be 92%, or 17.8% a year compound over four years. If it raises US$5 billion the gain would be 138% or 24.2% a year.

In the end this all boils down to whether John Cryan can turn Deutsche Bank around in the next few years. I believe he will, or at least if he can’t then no one can.

Even if the bank is punished excessively by the DoJ, and has to raise some capital – perhaps US$5 billion – Deutsche Bank stock looks extremely cheap. Of course there are no guarantees that this will work out. It’s an investment bank after all, with all the risk that that implies.

This is no investment for the faint hearted. But the odds still look like they’re stacked in the favour of big profits for investors who can handle significant price volatility, and who have the patience to wait a few years.

For these reasons Deutsche Bank remains a buy. Just don’t bet the farm.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.
  • Justin

    This was a great call… Did you hit the very day of the bottom? All of my most profitable investments have come from purchases made at points of maximum pessimism such as this.

    • Thanks Justin. And yes, you’re right that when there is huge pessimism it often means huge opportunity. This call was made on 29th July 2016 (after some earlier analysis and once second quarter results were out https://www.ofwealth.com/stock-alert-hell-fire-hell-yes/#.V_zYHZMrK9Y). It’s trading up 6% in euros and flat in US dollars so far (11 Oct 2016). But this is one to own for 3-4 years, so I wouldn’t draw much conclusion from less than three months. Shareholders should expect a lot of price volatility from time to time.

  • Justin

    This was a great call… Did you hit the very day of the bottom? All of my most profitable investments have come from purchases made at points of maximum pessimism such as this.

    • Thanks Justin. And yes, you’re right that when there is huge pessimism it often means huge opportunity. This call was made on 29th July 2016 (after some earlier analysis and once second quarter results were out https://www.ofwealth.com/stock-alert-hell-fire-hell-yes/#.V_zYHZMrK9Y). It’s trading up 6% in euros and flat in US dollars so far (11 Oct 2016). But this is one to own for 3-4 years, so I wouldn’t draw much conclusion from less than three months. Shareholders should expect a lot of price volatility from time to time.