Our largest position is Bank of New York Mellon (BK). Starting with the business, despite having the word “bank” in its name, Bank of New York Mellon is not a bank in the traditional sense but instead primarily provides a range of processing, custody and investment management services to corporations, governments and financial institutions. While absolutely essential, these services are not easily understood by the layman. To use an analogy, if the financial markets are like a thriving city, then Bank of New York Mellon would be the local electric utility, a necessary but unglamorous element of the city’s infrastructure. The two largest segments (comprising approximately 55% of total company earnings) are asset custody (where it holds $26 trillion in assets on behalf of customers) and issuer services (where it acts as trustee for approximately $11 trillion of debt securities and more than 1,300 depository receipt programs). To put these numbers in perspective, the market capitalization of the entire S&P 500® Index is about $15 trillion and the total government debt outstanding (federal, state and local) in the United States is about $20 trillion. Each of these businesses is an oligopoly in which Bank of New York has a leading position with durable competitive advantages derived from economies of scale, the costs of switching and customer loyalty.
In addition to the base fee income earned in its investment services business, the bank generates ancillary revenue from foreign exchange trading, securities lending and the interest rate spread on approximately $220 billion of low cost deposits on which the bank currently pays an average interest rate of less than 0.1%. The “moat” around the investment services businesses is evidenced by the high returns on tangible equity that Bank of New York earns—currently in the mid-20’s and historically in the mid-30’s.
Bank of New York also has a more traditional investment management business that represents approximately 30% of total company’s earnings. This business is made up of a diverse collection of equity, fixed income, alternative asset, and money market management services with an aggregate of $1.4 trillion of assets under management. The investment management business also offers an inherently high return on capital, though the moats surrounding it tend to be lower than for the investment services business. Bank of New York’s diversity of asset classes offers some protection from the ebbs and flows of investor sentiment.
In general, each of the bank’s major businesses should grow in conjunction with the continued increase in the amount and value of debt and equity outstanding globally, with only modest incremental capital needed to support that growth.
In terms of people, CEO Gerald Hassell has held that position since 2011, and prior to that had been president since 1998. Since assuming the role of CEO, he has focused the company on improving operational efficiencies and on the disciplined allocation of capital. Having built up its regulatory capital levels over the last few years to comply with Basel 3 rules (voluntary global regulatory standards developed in response to the global financial crisis of the late 2000’s), Bank of New York is today allocating approximately 70% of earnings to share repurchases and dividends (after already returning some $3 billion to shareholders in the last two years), with the balance retained to support largely organic growth at high incremental rates of return. Given the utility nature of this business, the bank does not need a visionary leader but rather a disciplined one, a description that seems to fit Mr. Hassell. Past leaders have pursued expensive acquisitions and poorly thought-out strategic expansions. Current management seems to understand this well and has wisely set their attention on execution and cost discipline.
As for price, Bank of New York Mellon is valued today at about 13 times this year’s earnings or nearly a 7.5% earning yield. As mentioned above, the majority of these earnings are distributable to shareholders as the company is extremely well capitalized (or will be by the end of this year, depending on some clarification of regulatory standards) and can grow with relatively small amounts of retained capital. Further, we consider these earnings somewhat understated because today’s low interest rates have forced the bank to waive money market fees and have depressed interest margins. We estimate an increase of 100 basis points in interest rates could increase earnings by about 15% and reduce the valuation multiple to only 11 times earnings.
Finally, we must consider the risks. When presenting the rationale for an investment, it is common to hear all the reasons the investment will be successful. As a central part of our investment process, we want to examine all the reasons an investment could fail. With acknowledgement to the wonderful behavioral economist Daniel Kahneman, we refer to this exercise as a “pre-mortem.” For any company, the most dire risks might be called “existential risks.” These are the risks of some event or series of events entirely wiping out existing stockholder value. In recent years, existential risks have tended to be caused by either leverage or obsolescence (usually resulting from technological innovation). Although Bank of New York Mellon is certainly leveraged in that assets significantly exceed equity, these assets are predominately government securities and deposits rather than loans or securities subject to credit risk. In fact, in the draconian stress test laid out by regulators, which assumes a 5% decline in GDP over two years, an unemployment rate of 12%, a stock market decline of 50%, and residential and commercial real estate declines of 20%, Bank of New York Mellon would actually make more than $5 billion before taxes. As for technological obsolescence, the very fact the bank is well into its third century of existence would seem to indicate a relative low risk of obsolescence, which is true. As with an electric utility, the services provided by the bank are essential and irreplaceable.
Although such existential risk is low at Bank of New York Mellon, there are other important risks that could hurt our investment. The largest of these may well be a matter of national security. Although the bank maintains outstanding computer systems and other safeguards, a significant disruption, most likely in the form of a cyber-attack, of the bank’s computer operations could result in substantial losses given the sheer number of transactions processed every hour. At a less esoteric level, the bank is regulated as one of the world’s most significant financial institutions. As such, missteps with the regulators or inappropriate conduct toward customers (as happened several years ago when the bank was accused of pricing foreign exchange trades in a misleading manner) could result in significant fines, legal liability or higher capital requirements. Although the bank operates in an oligopoly in most of its businesses, another risk is that participants in an oligopoly do not always behave rationally. Certainly, in recent years a tendency toward undisciplined pricing has permeated this industry, though we hope this trend is diminishing. Finally, we must consider the possibility of the bank making a large, dilutive acquisition. Despite overwhelming data indicating that such acquisitions rarely create value, we are continually surprised by how often companies are tempted by the siren song of investment bankers. Fortunately, we consider this risk a remote one under current management.