Blue Tower Asset Management annual letter for 2014 discussing the fund’s positions in Sberbank.

See Part I, Part II and Part III here.

Blue Tower Asset Management – Sberbank of Russia

While Nicholas Financial has been a successful investment so far, I would like to also discuss the investment which was the greatest detractor to performance in 2014. I initiated a position in Sberbank of Russia for investors on March 7th, 2014 due to what I felt was an unfairly low valuation given to both Russian equities in general and Sberbank specifically.

The majority state-owned Sberbank is the largest bank in Russia and one of the largest banks in Europe with the company holding $553 billion in assets at the end of 2013, accounting for 29% of Russian banking assets. They are well-diversified with significant retail deposits, retail loans, loans to corporate customers, and public security investments.

The recent crisis with Ukraine and fears of sanctions led to capital flight across Russia and a weakening of the ruble. Russia’s stock market has become the second-cheapest in the world and offers an impressive margin of safety to investors who have the fortitude to buy when others are paralyzed with panic. Furthermore, Russia has significant natural resources, very large foreign currency reserves, and minimal government debt.

When I initiated the position in Sberbank on March 7th, I thought that the fear of major sanctions on Russia were overblown due to the dependence of the German economy on Russian gas imports and the benefit the British investment management and real estate sectors gain from Russian oligarchs depositing their wealth. German business leaders had been lobbying that strong sanctions on Russia could lead to the loss of over 300,000 jobs in Germany (http://bit.ly/1p6CUBn). I thought that some limited sanctions on individuals similar to the ones enacted by the United States under the Magnitsky Act were far more likely. That part of the thesis has proved false with sanctions following after the unexpected downing of MH-17. Later in the year, the crash in global oil prices caused a currency crisis for the ruble. It is important to remember regarding the Russian ruble that the currency is tied to oil and not much else. During the last 15 years, the Brent Crude price and the real effective exchange rate of the US dollar to the ruble has had a correlation of over 90%.

Regardless of the political conflicts in Europe and the crash in oil prices, Sberbank is still a very strong company. Sberbank is critically important to the reputation of the Russian business community and Russian government officials will be hesitant to do anything that would be abusive towards minority shareholders. The company has made a major effort to improve the image of their company and transparency to investors. The company has created a committee to represent minority interests and has enacted many of the recommendations of the committee. Their financial reports are audited by Ernst & Young rather than by a domestic auditor.

The current CEO of Sberbank is Herman Gref who earlier in his career was the Minister of Economic Development and Trade for several years and earned a reputation as a liberal reformer in the Russian government. Since becoming the CEO in 2007, he has led Sberbank in a major improvement of their operational efficiency, technology, and profitability. He may be hoping to use his record of successful stewardship of Sberbank as a pivot towards future political positions. Additionally, he is close friends with President Putin which may make Putin less willing to take actions with the bank which could harm his friend.

The significant size of Sberbank has given it a “too-big-to-fail” status within the country. In 1998, during the Russian Ruble crisis, the government gave depositors the option to transfer their deposits to Sberbank with a government guarantee of deposits on Sberbank only. The government guarantee cemented Sberbank’s deposit base and reputation as “the safe bank”. Therefore, in times of economic crisis, I would expect Sberbank to be able to outperform its rivals as investors move their deposits in a flight to safety. In addition, Sberbank has the largest retail footprint in Russia with almost 18 thousand branches within the country. These funding advantages and large retail footprint have led to Sberbank being able to borrow money at unparalleled low rates within the country. As of the date of their last annual report, this gave Sberbank a net interest rate margin of 5.9%, a return on equity of 20.6%, and a return on assets of 2.2% which are among the highest in the global banking system.

Sberbank’s revenue growth has been tremendous over the last few years with a trailing 3-year compound annual growth rate of 27.0%. Much of this growth has been due to the overall growth of the Russian banking sector which remains quite small relative to the GDP of the country. In 2012, domestic loans to the private sector as a percentage of GDP were 48%, compared to 179% for the UK and 194% for the US. Sberbank is a great company from a value perspective, growth perspective, and a quality perspective, and I’m happy to have it in our investor accounts despite the large losses it has produced in 2014. These large losses are due to macroeconomic effects caused by the decline in oil and sanctions that I failed to forsee. I believe that once oil prices return to higher levels, the ruble will regain lost ground, and Sberbank will turn profitable for our clients. Value investing often takes many years to bear fruit and that may be the case with Sberbank.

I hope this explanation of our results for 2014 and investment process has communicated the care taken by Blue Tower in the protection and investment of our clients’ capital. I continue to be grateful and humbled for the trust placed in me to manage these assets and am confident that this trust will be rewarded.

Blue Tower Asset Management Long Sberbank