Secession Risk

We are officially in uncharted waters.  The biggest macro risk right now for the markets is not the Fed or European Central Bank…or ISIS, or even Vladimir Putin.  No, the biggest macro risk is the mood of Scottish voters.

Scotland’s referendum on independence from the UK will be held on September 18.  Up until very recently, the polls of prospective voters consistently predicted that the “no” camp—i.e. Scots that prefer to remain in the UK—would win by a fairly substantial margin.  But a poll released on September 7 showed the “yes” camp in the lead for the first time.

The latest compilation poll by ScotCen shows the “no” camp still in the lead, but with a week to go, it is far too close to call.

Scotland is a soggy, wind-swept country of less than six million people on an island an ocean away from us.  Why would Scottish independence matter to the capital markets…or to our portfolios?

There are the obvious “big picture” issues.  Without Scotland, the UK loses a fair bit of its clout and prestige…not to mention much of its nuclear arsenal in its current form.  This raises questions about the UK’s value as a US diplomatic and military ally, as an EU member, and as a permanent member of the UN Security Council.

But more than any of this, it brings uncertainty.  No one really knows how the capital markets will react to the disintegration of one of the oldest and most sophisticated financial powers in world history. The pound sterling has dropped about 6% relative to the dollar since early July, with about half of that drop happening since the start of September. And this despite a broad consensus that the Bank of England will be the first major central bank to raise interest rates. (All else equal, a rising benchmark rate leads to a stronger currency.)

A drop like that over such a short time horizon does not quite constitute a panic, but it definitely shows concern.  And the concern goes far beyond British shores.  On Tuesday, Spanish bond yields jumped by the most in four months.

Why? The closer Scotland comes to independence from the UK, the more Catalonia will agitate for independence from Spain…bringing back all of the uncertainties of the past four years of on-again, off-again sovereign debt crisis.

Should we worry here?

No.  But we should at least be aware.  We are sitting on fantastic profits in our two Spanish banking giants, Banco Santander (SAN) and BBVA (BBVA), and Telefonica (TEF) continues to be a great dividend payer for us.  I also expect our Spanish REITs to be big performers for us (more on those later).  So, we are heavily invested in Spain, to say the least.

If we hit our stop losses in any of these positions, we’ll follow our discipline and sell.  But I don’t expect that to happen.  A week from now, when Scottish voters go to the polls, I expect cooler heads to prevail and that the United Kingdom will remain united.  But in the event I’m wrong, we have our risk management rules in place.  In the meantime, use any small dips as buying opportunities.

Our timing was a little less than ideal on BP (BP).  Almost immediately after I recommended it, BP was found “grossly negligent” by a federal judge for its role in the Deepwater Horizon disaster and will be fined as much as $18 billion in Clean Water Act penalties. This is on top of the more than $40 billion BP has already spent or set aside due to legal judgments, fines and clean-up efforts.

Should we worry?

No.  I knew that BP was a litigation risk when I recommended it, and I was OK with that.  The price was cheap enough to compensate us for the risk, and nothing on that front has changed.

BP has enough cash in the bank to write a check for the amount—$27.5 billion, as of the most recent quarter. But this will be tied up in court for years, and the final amount may be significantly less.  In the last issue, I wrote that BP’s annual revenues are such that they can afford the continuing liability of Deepwater Horizon.

My view hasn’t changed.  BP is an attractive stock with a 5.2% dividend yield.  If you don’t own it already, you should.

I’m thinking about adding to my Spanish real estate investment. Would you suggest Lar España (Spain:LRE) or Hispania (Spain:HIS)?  I know LRE is cheaper and has dropped further in price. Also, when will they make dividend payouts?

Let me start with the dividend.  Neither REIT has declared a dividend yet, which is completely reasonable given their young age and given that they are still building out their real estate portfolios.  Until their portfolios are in place and cash flowing, any dividend would simply be a return of your own capital—which is pointless.

So, what should we expect for the timing of the dividend?  For this, I defer to management.  This is what LRE’s management had to say on the subject: “Under the Spanish SOCIMI [i.e. REIT] Regime, the Company will be required to adopt resolutions for the distribution of dividends…to shareholders annually within the six months following the closing of the fiscal year…”

Lar’s fiscal year ends December 31, and Hispania’s ends January 31.  So, at the latest, by next June and July, respectively, I would expect Lar and Hispania to have declared their first dividend.

As for the amounts, it is far too early to say based on the information available.  Spanish law requires a payout of 50% of capital gains on the sale of property, though given the young age of their portfolios, I wouldn’t expect to see much selling. Spanish REITs are also required to distribute 80% of all other profits as dividends.  We’ll have more clarity as to what that profitability looks like at their next earnings announcements.  Hispania’s will be at the end of November, and Hispania’s will be early next year.

As for the question of which REIT to buy, Lar is slightly cheaper, but I recommend buying both in roughly equal proportion.  Their portfolios are slightly different, and by owning both you get a broader exposure to Spain’s recovering market.

Lar’s portfolio is focused primarily on shopping centers, retail parks, and offices, with a smaller concentration (up to 20%) in residential properties.  Hispania is far less retail-focused.  Instead, its portfolio is concentrated in office properties in Madrid and Barcelona, 4- and 5-star hotels across Spain, and residential properties.

According to company materials, Lar has made eight major purchases since its IPO, consisting of five retail projects, two office buildings and one logistical center, with yields ranging from 5.5% to 10%.  There are six other major investments in the pipeline, consisting of four retail properties, one warehouse and one prime residential development.  Looking at euros invested, between current holdings and those in the pipeline, Lar will have allocated all of its €400 million IPO windfall, though it plans to raise more cash via debt issues (which is normal and practical for REITs).  68% of the value of existing assets and 46% of those in the pipeline are in retail.  22% of the existing assets are in offices (none in the pipeline).  10% of the existing assets and 54% of the pipeline are in “other assets,” which would include residential and logistical properties.

My information on Hispania’s portfolio is a little more dated.  Through July 31, Hispania had put about 58% of its IPO proceeds to work with a portfolio with a gross leasable area of 91,218 square meters in office space, principally in Madrid and Barcelona, 412 apartment units (213 in Barcelona and 199 in Madrid) and three hotels (one in Marbella, and the other two in Madrid).

So, as of this time, Lar is mostly an investment in retail properties, whereas Hispania’s portfolio is spread across offices, hotels and apartments.

I see a lot of potential in our Spanish REITs, and both are still very cheap.  If you don’t own them already, I would reiterate my “buy” recommendation.

That’s going to wrap up this update.  If we see any major seismic shifts between now and Scotland’s referendum, I’ll put up a special update.  Otherwise, we’ll pick this up next week.

Good investing,

Charles Lewis Sizemore, CFA

This article first appeared on Sizemore Insights as Secession Risk