Seth Klarman's Favorite Stock

Value investor loves Synchrony Financial, but should you?

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Feb 13, 2017
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Seth Klarman (Trades, Portfolio) is one of the world’s most respected value investors. When he enters a position, it doesn’t take long for the value investing world to assess the opportunity on offer and consider whether it is worth following.

While you should never blindly enter a position without first conducting your own due diligence, as one of the world’s most respected value investors who has a reputation for only investing in securities when the margin of safety is suitably wide, following Klarman into trades may not be as risky as following other hedge fund managers.

Recent positions

Within Klarman’s Baupost’s most recent 13-F position filing with the SEC (Sept. 30, 2016) a position in Synchrony Financial (SYF, Financial) is disclosed. After languishing around $27 for much of 2016, when Klarman’s position was revealed, shares in Synchrony jumped as high as $37 – an all-time high for the consumer finance company. The big question is, do the shares still offer value and should investors piggyback on Klarman’s coattails?

Time to buy?

During the third quarter of 2016, Klarman built a position in Synchrony Financial, which grew to 7% of his equity portfolio. With the allocation going from 0% to 7% in a single quarter, it’s clear this is a high conviction position for the billionaire value investor.

Klarman is known for his ability to spot value where others believe no value can be found although with Synchrony it’s immediately apparent that the stock is cheap. The shares are trading at a forward price-earnings (P/E) ratio of 11.7 and a price-to-free cash flow ratio of 4.4. The firm has compounded book value per share at an average CAGR of 27.2% for the past six years. Earnings per share are expected to grow 21.5% during 2017 and 11.3% during 2018. Looking at these figures alone, it is immediately apparent that Synchrony is a cheap compounder. A return on equity over 20% for the past five years has helped the group build book value and increase its asset base to generate additional growth.

So what does Synchrony do? The company provides a range of credit products through programs it has established with a group of national and regional retailers and local merchants. Additionally, the group owns a bank which provides products insured by the Federal Deposit Insurance Corp. (FDIC) as well as additional credit products.

The ownership of a bank that accepts deposits gives Synchrony a cheap source of capital. Deposits accounted for 72% of the group’s funding sources at the end of 2017. The group’s common equity tier 1 capital ratio came in at 17.2% at the end of the period and liquidity was 22.5% – incredibly strong financial metrics.

What’s more, during 2016 Synchrony reported a net interest margin of 16% in a period when most banks are reporting a net interest margin of no more than 3%; this figure is difficult to believe. A wide net interest margin is not the only figure on which Synchrony excels . The group’s efficiency ratio was 31.1% for 2016, and loan receivable growth exceeded high-end projections by 300 basis points. For 2017, the group is expecting loan receivables growth of 9% at the top end, a net interest margin of 16% and a net charge-off rate of 5% of the high end.

How these outlook figures will change as interest rates tick higher during the course of the year is hard to tell, but it is unlikely Klarman is betting on macro factors such as interest rates.

Instead, it is likely Klarman sees value in the company in its current form, and higher rates will only add more meat to the investment case. It’s easy to see why he likes the business; Synchrony in a financial business thriving in an environment that has proven tough for all financial businesses to operate within. The group’s net interest margin is one of the best around, and the balance sheet is strong. If the firm continues to compound shareholder equity at 27% per annum going forward, shareholders will be well rewarded in the long term. Tailwinds from an improving macro environment will only add to the investment case.

Disclosure: The author owns no stock mentioned.

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