US Reporting Underway - Week 1

Week one of US reporting season is now out of the way. Whilst a lot of market participants know that Alcoa (Ticker – AA) starts US reporting season, it is actually US banks that lead the charge from a sector reporting perspective.

With only limited data at this stage, the “state of play” is as follows:

As of Friday, 21 companies representing 13% of S&P earnings have reported.
S&P 500 bottom-up EPS climbed to $28.62 from a low of $28.56 mid-week, but remains below the $28.67 expected at the start of July.
Results were dominated by banks, the majority of which beat expectations despite a tough market backdrop.
Consensus earnings growth is -5% YoY (+2% ex-Energy), a pick-up from 1Q. Sales growth is flat YoY (+3% ex-Energy), also a pick-up from 1Q. (NB: we will update this as we go through the season).
This week another 28% of earnings across nine sectors are expected to report (see below)

STOCKS THAT ARE IN THE MORPHIC PORTFOLIO:

Whilst it is interesting what the overall picture is, we ultimately care most what is in our portfolio. The fund has exposure to a number of idiosyncratic regional US bank positions, as well as exposure to Wells Fargo. We give below a snapshot of the “good the bad and the ugly”

Wells Fargo:

The good: strong liability franchise with plenty liquidity and growing deposits
The bad: weak organic commercial and industrial loans (C&I) and commercial real estate organic loan growth
The ugly: Mortgage Servicing Rights, a major business for WFC, from 3rd party clients declining and in-house origination cannot keep up.

Market didn’t like the result. Whilst the report was in line for the quarter just ended, no more reducing provisions and a reassessment by analysts has seen 2017 forecasts fall by 5% after the result. The stock fell 2.5% on the day. We find it difficult to be as pessimistic with valuations where they are: On a P/E of 11x; a dividend yield of 3.5% and a large share buyback, valuation would seem supportive here.

Bank of the Ozarks:

The good: 46% annualised loan growth with an attractive loan-to-value and yield mix
The bad: liability franchise gathering more expensive Certificate of Deposit funding
The ugly: uncertainty over integration costs of two large acquisitions that close at the end of the month

We have long owned a small regional bank based out of Little Rock, Arkansas. Bank of Ozarks operates in what is seen as the risky area of lending to property developers, for which it receives a high margin. The remarkable thing is the GFC, which should have seen it suffer badly, didn’t affect it badly, suggesting an ability to lend to go borrowers.

The stock has been under attack from short sellers. We took the unusual step of going to meet with Carson Block himself in San Francisco to hear his side of the story We say unusual as he said no long manager had been to see him! Morphic is more pragmatic and want to hear other sides. After all we could go short if we agreed with him.

After 2 hours, whilst acknowledging some of his points, we remained unconvinced. It seems the story is more predicated on a USA macro slowdown. So we waited to see what the quarterly results had to say about some areas he was concerned about. After reading the result, we have re-entered with a small position for now.