If you aren’t familiar with Close Brothers, it’s a FTSE 250 bank that was founded in 1878. It had (until recently) a long track record of progressive dividend growth and I added it to the UK Dividend Stocks Portfolio in 2017.
Thanks to the pandemic and an ill-judged acquisition, the last few years haven’t exactly been smooth sailing for this company, but things have now gone from bad to worse. In early 2024, its share price collapsed, falling from £8 in January to £3 in February. Shortly after that, Close Brothers suspended its dividend.
When one of my holdings cuts or suspends its dividend, the first thing I’ll do is follow the immortal advice of the Hitchhiker’s Guide to the Galaxy: DON’T PANIC!
The second thing I’ll do is decide whether I should sell the shares or not by answering a few pertinent questions, some of which you may find useful as an alternative to knee-jerk selling:
Was buying Close Brothers an avoidable mistake?
My ideal investment is a company with a multi-decade record of steady growth, a progressive dividend policy, consistently high profitability, a rock-solid balance sheet, durable competitive advantages and access to large and growing markets. The share price will also be low relative to past earnings and the dividend yield will be relatively high.
If Close Brothers didn’t fit that description back in 2017, then my analysis was weak and I shouldn’t have bought it in the first place.
Although my investment checklist and purchase reviews were significantly less detailed in 2017 than they are today, having reassessed my original review, I still think Close Brothers came fairly close to that ideal in 2017.
If you’re interested, here’s the full purchase review:
When I reviewed Close Brothers in 2017, it had held or raised its dividend every year for more than 20 years, growing the dividend at an annualised rate of 9% per year.
Chart by SharePad
That dividend growth was fuelled by consistently high profitability, with returns on equity averaging 15% in the decade before the pandemic. Dividend cover was also consistently robust, averaging two times.
Net interest margins (effectively profit margins for banks) were also consistently strong at about 7%. That’s significantly higher than all of the big UK banks.
As for the balance sheet, I measure the strength of a bank’s balance sheet by looking at the ratio of equity to loans. This is an important ratio because shareholder equity is a buffer that protects depositors from losses when borrowers default on their loans.
In this case, Close Brothers has a ten-year average common equity tier 1 ratio (CET1) of 14%. That means, very approximately, that 14% of its loans could go unpaid before the bank became insolvent, and that’s well above the regulatory minimum.
I also check the tangible common equity ratio (TCE), which is a simpler alternative to CET1. The good news is that Close Brothers has a TCE ratio of 15%, which is exceptional and far higher than you’ll find in most banks.
How has Close Brothers produced higher profitability than most banks while maintaining a stronger balance sheet?
The answer is that it has durable competitive advantages over its larger and primarily mortgage-lending peers.
The problem with mortgages is that most of them are virtually identical. They’re a commodity where price (the interest rate) is the main differentiator, and when your customers care almost exclusively about price, it’s very difficult to generate high profit margins and high returns on capital.
In contrast to the big UK banks, Close Brothers is much smaller (it’s in the FTSE 250) and mostly provides short-term loans (1-5 years) in niche markets that require speed, flexibility, dependability and domain expertise from the lender.
Close Brothers lends into a wide array of niche markets, but some of the main ones include:
- Asset Finance: Small and medium businesses (SMEs) that need funding to buy machinery or equipment
- Invoice Finance: SMEs that want to allow customers to buy using short-term credit
- Property Finance: SME property developers that need funding for developments and refurbishments
The company’s website includes case studies demonstrating the hands-on, relationship-based, flexible nature of Close Brothers’ approach:
- How a flexible approach enabled Cosworth to supercharge their capabilities
- Staveley Mill Yard: 1,533 solar panels powering businesses
- Ellers Farm Distillery: A carbon neutral distillery
- Seventh Developments: Building homes and investing in a local community
- Close Brothers Brochure: Modern Merchant Banking
These loans are often too small and/or complex for the big banks to bother with, so they’re happy to leave this field open for specialists like Close Brothers. That reduces competition which, in turn, improves profitability.
Of course, there are still competitors, but Close Brothers gains durable competitive advantages from its long-established culture of disciplined underwriting, prudence and long-termism, and its trusted reputation for supporting clients with funding through the deepest downturns (thanks to its strong balance sheet).
In summary then, I don’t think I made any obvious mistakes in my initial purchase and, given what I knew at the time, I still think it was the right decision.
Should I have sold before the dividend was suspended?
Good investments can turn sour if the company makes a serious mistake or its environment becomes extremely hostile. Sometimes, the related dividend cuts, cancellations and capital losses can be avoided if you spot the impending disaster early enough and exit the stock before the unmentionable hits the fan.
So, should I have seen this dividend suspension coming and, based on my piercing insights, sold Close Brothers in 2023 when the share price was above £8.00? Or perhaps I should have sold in 2021 when the share price was £16?
To answer that, we’ll have to look at the motor finance division because that’s where the problems began.
Close Brothers Motor Finance provides personal used car loans which are mostly sold by car dealerships that want to offer their customers finance.
Close Brothers has been doing this for decades, it’s a very established player in the market and the division is seen as a relatively low-risk source of consistently strong profits. So what went wrong?
The backstory is that between 2007 and 2021, the regulations allowed (under certain conditions) lenders to have discretionary commission arrangements (DCAs) with brokers, including car dealerships. These agreements gave car dealerships the ability to set the interest rate on loans, and the higher the interest rate they set, the more commission they’d earn from the lender.
In 2019, the FCA launched a review of DCAs as it thought they weren’t being used correctly, and that customers weren’t being correctly informed about the commission.
In 2021, the FCA concluded its review and discretionary commission arrangements were banned.
After DCAs were banned, the number of complaints skyrocketed (driven by no-win-no-fee legal firms), and in January the industry’s ombudsman sided with several complainants, ordering the lenders to pay compensation.
Because DCAs were standard practice across the industry for 15 years, the expectation is that millions of people who bought a car using finance between 2007 and 2021 may now be due compensation.
The FCA has launched another review, no-win-no-fee legal firms have gone into overdrive and the total compensation bill for the industry is expected to be at least £10 billion.
For Close Brothers, the bill is expected to be around £400 million, although there are significant uncertainties as the complaints will no doubt continue to flood in until the deadline in September.
One final complication is that Barclays has launched a legal challenge against the ombudsman’s decision, so perhaps there’s a slim chance the final compensation bill will be zero.
Here are some articles covering this mess in a bit more detail:
- Auto lenders could face £16bn in payouts from FCA probe
- UK car finance: ‘millions of drivers could get payout’
- Barclays mounts legal challenge over car finance claim
- Balance needed in motor finance investigation
£400 million is a lot of money, so Close Brothers needs to build up a war chest of cash and that’s why the dividend has been suspended.
Turning back to my original question: should I have seen this coming? I think the answer has to be no.
With hindsight, I think it’s likely that the growing risk for a material DCA compensation bill was one of the reasons why Close Brothers’ share price steadily declined from £16 in 2021 to £8 at the start of 2024 (after which it collapsed to £3 when the ombudsman publicly sided with complainants).
However, I don’t think anyone has a crystal ball powerful enough to know, with sufficient certainty, that events would unfold as they have. The FCA conducts many reviews and they certainly don’t all result in PPI-style compensation feeding frenzies, and selling because I have a vague concern about some uncertain future risk, or selling because the share price has halved, isn’t a habit I want to cultivate.
On that basis, I think it was the right decision to continue holding into 2024.
But the dividend has now been suspended and I don’t want to blindly hold onto underperforming stocks just to avoid crystalising a loss, so the next question is obvious.
Should I sell Close Brothers now and, if not, why not?
When it comes to selling, I have two rules of thumb:
- Sell a stock if I think it isn’t going to pay a dividend for the next three years
- Sell a stock if its share price is close to or above fair value
As a dividend investor, I have to draw the line somewhere, and while I can accept that cyclical businesses might occasionally (and temporarily) cut their dividend, I am far less forgiving when it comes to suspended dividends.
However, I’ve been around long enough to know that bad things can happen to good companies, so I don’t automatically sell just because a company suspends its dividend. But I do have to draw the line somewhere, so if a holding cancels its dividend and doesn’t quickly draw up a plan to reinstate it within the next three years (a kind of “three strikes and you’re out” rule), I’ll take the capital loss on the chin and move on.
My second sell rule covers the happier (and far more common) situation where a holding’s share price rises to the point where it meets or exceeds my fair value estimate.
Let’s start by addressing the question of when (or if) Close Brothers’ dividend might return.
In 2023, Close Brothers paid a total dividend of almost £100 million, so a £400 million compensation bill would be approximately equal to four annual dividends.
One obvious way to raise £400 million of cash would be to suspend the dividend for four years. However, most complainants would probably find a four-year wait unacceptable, so Close Brothers has devised a plan to raise the cash more quickly:
- Raise £200 million by cancelling the dividend for two years
- Raise £100 million by issuing fewer new loans and securitising some existing motor loans
- Raise £100 million by securitising or selling non-motor loans, or selling some of the smaller divisions
Given that this plan involves reinstating the dividend within three years, my first sell rule hasn’t been triggered.
However, the suspended dividend will reduce the company’s fair value, and if its fair value has fallen to the point where it’s close to or below the share price, this could be a reason to sell.
To estimate fair value, I use discounted dividend models. This involves estimating a company’s future dividends and then working out what share price would produce a historically average (ie “fair”) annualised return of 7%.
How do these models work? In a nutshell, just imagine modelling the income and growth of a savings account based on the interest rate and the reinvestment/withdrawal ratio. You can do the same thing for companies using return on equity and dividend cover.
For Close Brothers, my dividend model includes realistic but conservative assumptions about return on equity (10%) and dividend cover (1.7) for the next ten years, both of which are in line with the last ten years. I also assume that Close Brothers can grow by 3.5% per year over the longer term. These assumptions produce a model where:
- EPS grows by 4% per year, from 114p in 2024 to 158p in 2032 (compared to a record EPS of 134p in 2021)
- Dividends grow by 4% per year, from 67p in 2024 to 93p in 2032 (compared to a record dividend of 67.5p in 2023)
- EPS and dividends grow by 3.5% per year after 2032
If you want to see how these models work in more detail, have a look at my investment spreadsheet template.
Based on the above model, Close Brothers’ fair value would be £20.08 per share. As a sanity check, that would give the shares a 3.4% dividend yield based on the 2023 dividend, so that looks about right to me. £20.08 is also only slightly higher than the all-time high share price of £17.20, which is another sign that this fair value estimate isn’t wrong by a country mile.
One flaw with this model is that it doesn’t include the impending compensation expense. Of course, it’s impossible to know exactly how much that expense will be, or what timescale it will be paid over, but if I assume £400 million of compensation is paid in 2025, and that no dividends are paid in 2024 or 2025, then that has the following effect on the fair value estimate:
- A £400 million compensation expense and zero dividends in 2024 and 2025 would reduce my fair value estimate from £20.08 to £16.90
Here’s the final model:
On that basis, the current share price of £4.92 appears to be extraordinarily low. At that price, the shares are trading at a 71% discount to my fair value estimate, which is huge. To give you some context, I try to buy shares when the discount is at least 33% and ideally above 50%.
Lest you think £400 million isn’t conservative enough, I’ve also calculated a “doomsday scenario” where the compensation bill comes in at £634 million, or almost double the estimate of some analysts. And yet, even with such a colossal hit, my fair value estimate would only fall to £14.53 and the shares would still be trading at a 66% discount to that fair value estimate.
For all of those reasons, I am still not inclined to sell Close Brothers because (a) I expect the dividend to return, in some form, within three years and (b) the share price is trading at a huge discount to what I think is a conservative estimate of fair value.
Are there any lessons to draw from this episode?
I always try to extract productive lessons from every mishap and misstep, but in this case, there weren’t any obvious ones.
I don’t think I made an obvious mistake when I bought Close Brothers in 2017 and I don’t think I made an obvious mistake by holding on when the share price declined from 2021 to 2023. I also don’t think I’ve made an obvious mistake by continuing to hold the shares today, so from that point of view, there aren’t any useful lessons.
However, Close Brothers did suspend its dividend soon after Direct Line (another holding from the financial industry) suspended its dividend. That certainly got my attention. On top of that, most of my financial industry holdings have faced disruption and headwinds in recent years from changing regulations and negative sentiment. This has been a material headwind over the last few years because my portfolio has a fairly large 35% weighting to the financial industry.
And so, in the end, the lesson I drew from Close Brothers was to not invest too heavily in any one industry. Following that revelation, I’ve updated my diversification policy to diversify by industry and sector, with a new rule to not invest more than 20% in any single industry.
With 35% of the UK Dividend Stocks Portfolio invested in financial stocks, I expect to offload some of those as we exit this downturn and as their valuations improve.
Last but not least, I still hold Direct Line and the good news is that the company has reinstated its dividend, although there remains some ambiguity over whether that reinstatement is permanent.
The new CEO will announce his new strategy and dividend policy at a capital markets day on July 10th, so you can expect a full review of Direct Line in late July.
This article was originally published in UKDividendStocks and is republished here with permission.
