In my opinion, whenever there is a major change in regulation, there is a magnified impact that ripples across markets, that could have long lasting effects on business models and stock prices for years to come. I saw this first hand in 2007 when I moved to Dubai from New York. Around that time, Dubai put in place a framework that gave foreigners the right to own property. Up until then, only locals were able to own land and property, so this was a massive change. I believe that opening up the property market had a major impact on transforming the country in a very short amount of time.
In 2007, I was still a newlywed living in NY where I worked for a large hedge fund alongside Lewis Johnson, CWA’s Co-Chief Investment Officer and President, Co-Founder, and Partner of Fundamental Global Investors. That year, I was recruited to turnaround an asset management company in Dubai, which was starting to show the impact of allowing foreign ownership in properties. When I arrived, they had barely broken ground on Burj Khalifa and the UAE had a population of around 5 million. Fast forward to 2018, and they are planning a new taller building and have a population of approximately 10 million. I believe the UAE easily could be the fastest buildup of a country in the history of the world, and it was wonderful to live and be a part of it. In my opinion, this rapid growth is the potential impact of positive regulatory changes.
Dubai Marina - 2003 vs. 2017
Back home in the US, there are currently two regulatory themes that we think could lead to equally stunning, before-and-after pictures. Each is on the opposite end of the regulatory spectrum. For example, one theme involves the legalization/de-regulation of sports gambling, and the other occupies the opposite end of the pendulum, which is the seemingly continuous regulation and re-regulation of banks. I believe that these two themes make for great examples of the powerful impact of changing regulations.
Rejoice sports fans, betting on games is no longer illegal!
On May 14, 2018, betting sports fans caught a break. On that day, the Supreme Court struck down “PASPA” (Professional and Amateur Sports Protection Act of 1992) ,the federal law that prohibited sports betting. Clearly, legalizing sports betting in the US is a very big deal.
The legal sports betting book in Nevada generated approximately $5 billion of wagers in 2017. Estimates of the size of the illegal sports betting book range from $50 billion to $150 billion. Following the Supreme Court’s decision, Paddy Power (PPB:LN), an online sports betting market share leader, acquired Fan Duel, adding to its US portfolio. This was the first transaction announced in the space following this ruling. Paddy Power currently generates total revenue of around $2.5 billion, mostly from sources outside of the US. Capturing even a small slice of the estimated $100 billion US market could transform its business. While no one can know the future, this possibility is definitely something to think about.
Banks on the other hand seem to get new regulation on a weekly basis.
At the opposite end of the regulatory spectrum stands the banking industry. I can’t name a single industry that has seen as many new regulations heaped upon its shoulders as the banking sector. Following the financial market crash in 2008 and the ensuing taxpayer bailout, it was expected that banks would be subject to additional supervision and scrutiny. I don’t believe that any politician would have been taken seriously if they thought to introduce looser regulations, regardless of whether it made sense or not.
Between Dodd-Frank and Basel III, these regulations not only govern which businesses a bank can be a part of and how much it can do, but they have also increased reserve minimums.
Since then, banks have gone through another round of regulations, Basel III, which broadly standardized risk measurement and increased the amount of capital required to be reserved against loans, which decreases a bank’s ability to employ leverage. In addition, Dodd-Frank introduced eight components designed to prevent another global financial crisis. The Dodd-Frank Act is so big that “The Volcker Rule” which we hear quite a bit about, is only one part of it. Between Dodd-Frank and Basel III, these regulations not only govern which businesses a bank can be a part of and how much it can do, but they have also increased reserve minimums.
If those were not enough, there are likely more coming.
Basel IV, the latest global banking convention, among other things, could further increase reserve requirements and could serve to depress bank profitability. Separately, MiFID 2 is a European regulatory initiative, which requires banks to unbundle the fees that they charge for research and brokerage. In my opinion, the primary conclusion from these regulations is that many aspects of the banking business, including what services a bank can offer, how much it can lend, and how much it can charge for its services are under some form of regulation. The recent flare ups in European bonds and bank shares should serve as a reminder that the pace towards more regulation may not slow.
I believe that one result of additional regulation, is seen clearly through the structural decline in the returns that banks are generating for their shareholders. For example, prior to 2008, many banks were generating Returns on Equity of approximately 18% (ROE=net income/shareholder equity). Sadly, many banks are now generating ROE’s closer to 8%. In my opinion, this decline in the industry-wide ROE, means that banks should generally be trading at 8-10x earnings, if there exists a possibility of generating a ROE of 10%.
The recent flare ups in European bonds and bank shares should serve as a reminder that the pace towards more regulation may not slow.
It appears that regulations also tend to move in one direction for long periods of time. For example, a few weeks ago, the UAE announced sweeping changes around foreign ownership of onshore companies. I believe that this announcement should further underpin the UAE’s next growth trajectory. Similarly, many investors are suggesting that the gaming industry could see a boost from what appears to be a loosening regulatory environment. On the other hand, it seems that banks may have less to be cheerful about. With fears of European debt growing, I think it is unlikely the next waves of regulation will be looser than what we have seen thus far.
Our research team is constantly on the lookout for opportunities that are created as and when the regulatory climate for an industry has changed or is about to change. We feel that the opportunity to profit and to protect capital exists in both ends of this spectrum. •
Picture Source: Dubai, Then and Now, http://www.the-wau.com/post/uae/emirates-tweeted-this-picture-of-dubai-then-and-now-and-the-transformation-is-mind-boggling/2813?pg=2