In this article Kokkie Kooyman explains why, with rising interest rates and the recent crypto market price falls as context, ‘sane’ investors in the financial sector are currently spoilt for choice.
Warren Buffett has been warning investors for some time that rising interest rates are akin to markets like the force of gravity is to matter – they pull them down. Sure enough, after a long period of low and negative interest rates, the hiking of interest rates by the US Fed and other central banks is having that effect on equity, bond and crypto markets.
The first quarter of 2022 was one of the worst quarters on record for equity and bond markets (measured on a combined basis), whilst in May we saw the collapse of the Terra Luna stablecoin. This combination of events led to severe price falls in the whole crypto market.
Luna fell within days from $85 to $0.0002c (having peaked at $117) whilst the price of bitcoin is down from a high of $67,583 in November last year to $30,321 (as at 30 May 2022). These massive price falls have led investors to question, ‘Is now the time to invest again?’ Rather than investing in crypto, at the lower prices, Buffett bought a 2% stake in Citigroup. Why? Because ‘a bird in the hand is worth two in the bush’.
A bird in the hand means you know exactly what you have – a high probability of a certain return. For Buffett, Citi was that (high degree of certainty) bird. When markets are falling the best opportunities are those that give a high degree of certainty and low risk, compared to those with the uncertainty of a potentially higher return.
Investing in crypto comes with uncertainty.
The development of blockchain (and bitcoin), and smart contracts using the blockchain technology (Ethereum), created a faster and potentially cheaper way of storing and transmitting money and currencies across boundaries. (Read Beyond Bitcoin: Decentralised Finance and the End of Banks by Steven Sidley and Simon Dingle). This and the creation of cryptocoins, decentralized autonomous organizations (DAOs) and non-fungible tokens (NFTs) on a decentralized finance (DeFi) system attacked the weaknesses of traditional finance (Tradfi) and fiat currencies. For more on this, listen to our February podcast with Steven Sidley on DeFi and how it will affect banks and investors.
The attractiveness of DeFi has been the anti-government and anti-control dream: It’s ‘trustless’ and ‘permissionless’.
1. A trustless system is one where investors don’t have to trust (or pay) intermediaries such as banks (part of the Tradfi or traditional finance system).
Instead, trust is placed on smart contracts on blockchain and the view that bitcoin and other cryptocoins would be a store of value and used as a currency to make payments. But the volatility of their prices led to the demand for a more stable type of cryptocurrency: stablecoins.
We’ve seen the growth of three kinds of stablecoins.
- Stablecoins linked to fiat currencies or assets (like the US dollar or Japanese yen)
- Algorithmic stablecoins, where their values are derived through algorithms
- Stablecoins linked to the values of other cryptocoins – which is a great concept when the price of bitcoin and other cryptocoins go up, but not so great when they collapse).
Algorithmic coins, Terra and Luna, caused a 15% fall in the crypto markets, which accelerated the decline that started when the Fed started hiking interest rates. Terra and Luna’s link was broken due to a few large investors unexpectedly selling off Terra coins. The link, and its promised 20% yield, proved to be a mirage.
2. Permissionless refers to the lack of regulation.
While it’s the investor’s dream to not have to deal with regulatory interference, the lack of regulation also means no consumer protection. On a positive note, with no regulation or ‘big brother’ to stymie innovation, the crypto industry developed and grew quickly. The nirvana of permissionless innovation – good for advancing and testing; not good for widows and orphans to invest in.
New technologies create immense value over time, but the gold rush of ‘develop now and test later’ brings significant risks.
Investors ignored the shortcomings and structural weaknesses of the new industry. A combination of FOMO (the fear of missing out) and good marketing drove the market cap of crypto currencies to $1.8 trillion in February 2022 and bitcoin to $67,583 in November 2021.
To a certain extent, all bull markets are driven by Ponzi-like behavior – paying existing investors with money from new investors. Deutsche Bank wrote an article on this recently, in relation to crypto markets, referring to the ‘Tinkerbell Effect’. Prices go up as long as demand exceeds supply due to imagined or real value of assets. The problem is that crowd behavior often pushes valuations of mirages too far. (I recommend John Kenneth Galbraith’s book, A Short History Financial Euphoria.)
Over the past 10 years, negative interest rates gradually led to the rise of ‘silly’ investing. When interest rates are low or negative, it seems almost rational to invest in (future) growth. Valuation doesn’t seem to matter when money is free. In other words, buying bitcoin at a higher price but receiving no intrinsic value seemed rational. The higher price was driven by the difference between its limited supply and strong demand when the price was going up. The new environment of higher interest rates is bringing that illusion to an end.
To do well in investing you don’t need to be smart, just sane.
Buffett re-iterated this at the Berkshire Hathaway annual shareholders’ meeting in April. Sane for him meant investing in Citi. Citi trades at a P/NAV of 0.56x and is generating a return on equity of 10%-12%. This means Berkshire Hathaway’s investment in Citi could generate a return on investment of around 20% per annum – even if it doesn’t re-rate.
The certainty associated with this potential return is fairly high. Citi is far advanced in the process of disposing seven non-core business units across the world (from their previous global growth focused era). It could take up to 12 months to get regulatory approval for each sale, but as they get approval their cash balance will grow and can be used to buy back shares or pay dividends. Their core business is doing well. Higher interest rates mean higher returns on their portfolio of assets (both loans and other investments). There is a risk of higher bad debts in a recession, but our opinion is that the tight labour market and strong consumer and corporate balance sheets means the risk of bad debts is adequately reserved for and low. Low enough to make Buffett buy a 2% stake.
The Denker Global Financial Fund also owns Citi, it is in fact one of our top five holdings.
The changing environment of higher interest rates is presenting many opportunities in the global financial sector.
But this calls for being sane, not greedy. Sanity tells you that when you invest in well-run companies with good track records and you invest in them when they’re trading below intrinsic value (and even better, below historically average valuations), then you do well over time. And, there are many such companies out there.
We’re very excited about the prospects for investors in financials.
We do believe blockchain technology is here to stay and will increase efficiencies for the financial and other sectors. For that reason, for example, we’re using the opportunity to add to our Signature Bank holdings – one of the leading crypto-based deposits and lending banks, which was sold down along with the crypto market to a P/NAV of 1.4x from its peak to 2.8x.
At the same time, there many other financial sector shares that will benefit from higher interest rates which have recently been pushed down on the fears of a recession. At the moment, we are spoilt for choice.
Click here for the latest minimum disclosure document of the Denker Global Financial Fund.
The information in this material belongs to Denker Capital (Pty) Ltd (Denker Capital). This information should only be evaluated for its intended purpose and may not be reproduced, distributed or published without our written consent. While we have undertaken to provide information that is true and not misleading in any way, all information provided by Denker Capital is not guaranteed and is for illustrative purposes only. The information does not take the circumstances of a particular person or entity into account and is not advice in relation to an investment or transaction. Because there are risks involved in buying or selling financial products, please do not rely on any information without appropriate advice from an independent financial adviser. We will not be held responsible for any loss or damages suffered by any person or entity as a result of them relying on, or not acting on, any of the information provided.
This information does not constitute financial advice as contemplated in terms of the South African Financial Advisory and Intermediary Services Act of 2002 (FAIS Act). Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision as not all investments are suitable for all investors.
The Denker Global Financial Fund is a sub-fund of Sanlam Universal Funds Plc, a company incorporated with limited liability as an open-ended umbrella investment company with variable capital and segregated liability between sub-funds under the laws of Ireland and authorised by the Central Bank. The Manager of the fund is Sanlam Asset Management (Ireland) Limited (Beech House, Beech Hill Road, Dublin 4, Ireland, Tel + 353 1 205 3510, Fax + 353 1 205 3521) which is authorised by the Central Bank of Ireland, as a UCITS Management Company, and an Alternative Investment Fund Manager, and licensed as a Financial Service Provider in terms of Section 8 of the FAIS Act. Sanlam Collective Investments (RF) (Pty) Ltd is the South African Representative Office for these funds. Deemed authorised and regulated by the Financial Conduct Authority. The nature and extent of consumer protections may differ from those for firms based in the UK. Details of the Temporary Permissions Regime, which allows EEA-based firms to operate in the UK for a limited period while seeking full authorisation, are available on the Financial Conduct Authority’s website (notes 1, 3 and 4).
The Sanlam Universal Funds Plc full prospectus, the fund supplement, the minimum disclosure document (MDD) and the KIID are available free of charge from the Manager or at www.sanlam.ie. This is neither an offer to sell, nor a solicitation to buy any securities in any fund managed by us. Any offering is made only pursuant to the relevant offering document, together with the current financial statements of the relevant fund, and the relevant subscription/application forms, all of which must be read in their entirety together with the Sanlam Universal Funds Plc prospectus, the fund supplement the MDD and the KIID. No offer to purchase securities will be made or accepted prior to receipt by the offeree of these documents, and the completion of all appropriate documentation. A schedule of fees and charges and maximum commissions is available on request from the Manager.
Collective investment schemes are generally medium- to long-term investments. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments / units / unit trusts may go down as well as up. Changes in exchange rates may have an adverse effect on the value, price or income of a product. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of the portfolio and the investor will differ depending on the initial fees applicable, the actual investment date, and the date of reinvestment of income as well as dividend withholding tax. Forward pricing is used. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The performance of the portfolio depends on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-div date. The Manager has the right to close any portfolios to new investors to manage them more efficiently in accordance with their mandates. Lump sum investment performances are quoted. The portfolio may invest in other unit trust portfolios which levy their own fees, and may result is a higher fee structure for our portfolio. All the portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No 45 of 2002 (CISCA). The portfolio management of all the portfolios is outsourced to financial services providers authorized in terms of the Financial Advisory and Intermediary Services Act, 2002.