Bank Earnings: Why I Don't Trust Analyst Reports

Analysts are predicting continued positive earnings for Bank of America (BAC), but are wagering on another bloody quarter for Citigroup (C). The average of estimates for BAC’s earnings for Q2 is $0.27 per share, while the analysts predict C will lose $0.31.

Undoubtedly, over the next three weeks, numerous financial news pundits and other so-called experts will reference these analyst estimates countless times when telling investors whether they should buy, hold, or sell shares of these two firms.

But when I dive into the gory details, I find it hard to give any credence whatsoever to analyst estimates when deciding my investment strategy for companies in the financial sector. If you take a look at how skilled the analysts have been in predicting BAC’s and C’s price over the last four quarters, you too will likely decide their reports are not worth the paper they are written on.

Case in point, in the last four quarters the analyst estimates for Citigroup have been off by 18%, 14%, -86.3%, and 47.1%. Even worse, for Bank of America the analysts missed the mark by 36%, -76%, -700%, and 780%! (By the way, if you think this phenomenon is unique to these so-called “zombie” banks, on average the analyst estimates for Goldman Sachs (GS) and J.P. Morgan (JPM) over the last four quarters have missed their actual results by 45% and 67% respectively).

Granted, the entire market has been extremely difficult to predict since the second half of 2007. But in the age of Sarbanes-Oxley, with its emphasis on transparent disclosure of financial matters, it still amazes me that analysts can be so in-the-dark about the likely financial results of the companies that they purportedly cover in great detail. If the analysts – who are paid quite handsomely for their services – cannot accurately predict the financial results of the firms they evaluate (or at least come within 5 to 10% of the actual results), then what are they good for?

Even more astonishing is that despite the obvious fact that the average analyst estimates are rarely even close to actual results, the market still reacts with shock when a company fails to match the consensus view, often times driving down the share price ten, twenty, or even thirty percent and more. Of course, the inverse is true as well; when a company beats estimates the stock price may soar 20% or more in a single day.

Personally, I try to think longer term and decide whether fundamentally a company has the right stuff to succeed beyond the current quarter. In the case of C and BAC, much maligned as they are, it is still a fact that their Tier 1 Capital Ratios are now in the top 3 in the world, they have increased reserves for loan losses to levels beyond anything they have ever had before, and they have been on strict diets to cut expenses, shed non-core businesses and to rid their balance sheets of risk associated with a host of “exotic” products they have sold over the years.

The executives of these companies know without a doubt that their jobs (and all the cushy perks that go with them) are on the line if their companies continue to fail to perform, not to mention that much of their prior compensation was in stock options that have a long way to go before rising above water again. Their incentives now I believe are truly aligned with the shareholders and therefore they will do everything in their power to make their companies successful again.

By the way, for what it's worth I think BAC is going to meet the analysts’ expectations this quarter, and I think C is going to beat consensus considerably.

Disclosure: Long C, XLF

Comments

[Mad Hedge F...:]

Trust them as far as you can through them. I have really been avoiding financials for the last few months after they had their dead cat bounces. However, I had to listen to Midsouth Bank CEO Rusty Cloutier when he spoke on CNBC. His 24 branch bank, with a market cap of only $103 million, is based in Lafayette, LA, one of my old stomping grounds and home of the world’s greatest étouffée and shrimp gumbo. He says that “Unless we break up the big banks and get back to sound banking principles we are going to relive this over and over again….Free enterprise has to have the right to fail….Allan Greenspan and his administration have some problems they have to ‘fess up to.” With the current system of megabanks “they get the gain and we get the pain….I’m regulated now by 13 agencies of the US government and I don’t know that I need a 14th.” There’s no one who can read you a riot act like a Southern regional banker

Jun 29 10:38 AM

[Tack:]

Banks are utterly swimming in cash right now, and cash flows keep increasing quarterly, notwithstanding all the chatter about GAAP "paper" adjustments on the balance sheets. The banks keep collecting very real money, while the market and pundits debate the not-very meaningful mark-to-market valuations assigned to debts (that keep performing) and academics debate non-cash "solvency" issues.

Cash flow is the meat and potatoes; paper solvency is an esoteric debate.

Jun 29 11:13 AM

[jswede:]

Casflow.... what's a good ROA? 2%? Maybe they'll hit 3% with all this cheap funding?

Capital.... what are losses on assets? ~30%+ ? Possibly much more?

cashflow is a drop in the ocean compared to losses on assets.

Jun 30 10:25 AM

[Marli:]

Well said. I whole-heartedly agree.

The bank analysts have been wrong because these guys are still using the same old tired Microsoft Excel-driven macros, integrated cash flow statements and valuation models based on annual and quarterly filings, whereas most of the blow-ups and writedowns occur off-balance-sheet.

The assumptions worksheets (which drives their models) are also probably unrealistic and haven't been updated in months. AIG still has $196 BILLION in credit default swaps exposed to European markets, which are in worse shape than the US, while the IMF expects trillions more in writedowns before EOY 2009. The other banks (BAC, C) still have billions of these toxic assets that have yet to be written off. Is this factored into their earnings estimates? Hell no.

Jun 30 10:26 AM

[Andrew Butter:]

Well I just don't trust bank's audits.

If bank's audits were useful then analysts ought to be able to come up with consistent and reasonably reliable opinions. That's the whole point.

Either (a) the analysts don't know what they are doing or (b) the data they get is useless.

The issue is that almost all of a banks profit or loss hinges on an opinion on what is the value today of the assets (on and off the balance sheet)....(they know what the liabilities are at least they ought to).

So what are the analysts using for making assessments these days? Well the reality it's nothing real, it's just opinions.

Until FASB and the regulators mandate a way of valuing assets that is internally consistent and reflects actual reality, figuring out if a bank is a zombie, actually dead or healthy, is impossible.

In July 2003 International Valuation Standards wrote to BIS to say QUOTE: "valuations" (used to assess capital adequacy (and work out the P&L), were fundamentally flawed and bound to be misleading".

Well nothing changed...the valuations are if anything worse.

A while back I wrote that if you want to decide if you invest in a bank, take a photo of the CEO, show it to your dog, if the dog wags his tail, then go for it.

I still think that's by far the most reliable method.

Jun 30 10:54 AM

[frosty:]

"Even more astonishing is that despite the obvious fact that the average analyst estimates are rarely even close to actual results, the market still reacts with shock when a company fails to match the consensus view" -- espcially true of banks but true across the board. The great rally has been fed by results "exceeding analysts expectations" without noting that many, many, many were LOSSES and without noting that many, many, many companies had sales in the range of -15% to -20%.

But banks! You can't really expect anyone to predict earnings when they can make 'em up, at least the big banks with lots of those illiquid assets that they no longer have to mark to market.

Andrew Butter - I like your bank picking strategy!

Jun 30 11:16 AM

[Shadow Banker:]

Trusting Jim

Jun 30 11:30 AM

[Shadow Banker:]

Bank analysts from sell-side firms are the equivalent of Cramer, but just a little less obnoxious.

Jun 30 11:33 AM

[H.J. Huneycutt:]

Not that I don't agree that analysts are normally crap, but when it comes to these megacap financial institutions, I don't think it matters how knowledgeable the analysts are --- they are still going to have an extremely difficult time predicting results within 5% - 10% of the actuals.

There's a reason why I personally prefer to focus on small cap and microcap companies. Megacaps have such sprawling operations, no human being could possibly understand them in any amount of detail. The big banks are even worse than other megacaps (e.g. GE) because they have tons of leverage and lots of non-completely-transpa... loans to boot.

I'd actually be more amazed if an analyst could consistently predict the results of one of these mega financial companies. I don't see how it's even possible short of simply taking management's word and hoping (against all better judgment) that they are both trustworthy and competent.


I also disagree that the incentives for most bankers are aligned with the interests of stockholders. Until we have dramatic corporate structure reform, I don't think that'll ever be the case.


I agree with most of the rest of the stuff you stated in the article. People get too caught up in the quarterlies. The big picture is much more important. Accounting treatments can make results swing back and forth in the short-term anyway.

Jun 30 12:39 PM

[Peter Iwano...:]

i hate sell side analysts. They aren't paid to be right; they are paid to sound smart to their clients.

Jun 30 12:52 PM

[FloridaBoy2:]

B of A had 200 people looking at Merrill's books. It would take that number of analysts or more to decipher the balance sheets of the big banks.

I bought BAC in February when Meredith Whitney was on CNBC dissing all the banks and they were tanking. Thanks Ms. Whitney. Why? For the enterprise value. There is one on every corner and I felt that nationalization was not an issue. In the long run they will prosper.

Citi may prosper too but I decided to pull the trigger on BAC.

In the short run the reported earnings are "optimistic" fiction.

Jun 30 01:05 PM

[Big Al45:]

And if your dog chews up the picture or urinates on it, - then short the bank???


On Jun 30 10:54 AM Andrew Butter wrote:

> Well I just don't trust bank's audits.
> A while back I wrote that if you want to decide if you invest in
> a bank, take a photo of the CEO, show it to your dog, if the dog
> wags his tail, then go for it.
>
> I still think that's by far the most reliable method.

Jun 30 09:20 PM

[Moon Kil Woong:]

Banks and financials have too little disclosure or transparancy, derivatives are impossible to locate or value (apparently they are a national secret that the government has determined shareholders have no rights to know about), accounting allows banks to value or fudge values which combined with leverage makes earnings or loss estimations and reporting silly, suspension of mark-to-market only makes it worse, and the off balance sheet shennaniganism from the dot com 2000 crash is still on the books.

If you want real value don't go looking for it in financials. The government has ruined any concept of real reporting in this critical market sector a long time ago. That's why no one can see the train wreck until you they are burning inside an economic derailment.

Jun 30 10:55 PM

[dcb:]

YOur tax dollars hard at work.
Citi raises card rates on millions

By Francesco Guerrera and Saskia Scholtes in New... and Tom Braithwaite in Washington

Published: June 30 2009 23:59 | Last updated: June 30 2009 23:59

Citigroup has sharply increased interest rates on up to 15m US credit card accounts just months before curbs on such rises come into effect, in a move that could fuel political anger at the treatment of consumers by bailed-out banks.

People close to the situation said that Citi, which is about to cede a 34 per cent stake to the US government as part of its latest rescue, had upped rates on between 13m and 15m credit cards it co-brands with retailers such as Sears.
EDITOR’S CHOICE
Credit card losses hit record 10.4% - Jun-30
In depth: US banks - May-07
Tepid offers for BofA asset manager - Jul-01

Citi’s rate increases emerged on the day the government proposed legislation to create a new regulator with sweeping powers on consumer protection and a week after the bank was attacked by some politicians for raising employees’ salaries.

Holders of co-branded cards who failed to pay their balance in full at the end of the month saw their rates rise by an average 24 per cent – or nearly 3 percentage points – between January and April, according to a Credit Suisse analysis of data from the consultancy Lightspeed Research.

After FT.com broke news of the hike, Citi issued a statement saying: ”We have adjusted pricing and card terms for some customers as part of our regular account reviews. This is an ongoing process to ensure we offer terms, interest rates, credit lines and products based on individual needs and risk profiles. These changes also reflect the dramatically higher cost of doing business in our industry as we work to preserve the broad availability of credit.”

Citi’s move came as the economic downturn caused record defaults among US card users and prompted many issuers to raise rates, both to cushion their losses and pre-empt the new restrictions set to come into effect in February.

However, Citi’s increases have been larger than those of its main rivals, according to Lightspeed, which tracks about 12,000 US credit card accounts.

Carolyn Maloney, Democratic representative for New York, the author of the new rules that will sharply constrain lenders’ ability to raise rates for risky borrowers, criticised Citi’s move. “It’s hard to tell if rate hikes on existing balances being put in place now are the result of prior bad business decisions or getting in under the wire of the new law,” Ms Maloney told the Financial Times.

Copyright The Financial Times Limited 2009

If you want to know why I wanted to nationalize this was it. These scum want each and every last dollar sucked out of the american people and it's governemt before they will be satisfied. The american people still take it up the ass from our government. Iranian's get treated better by their government then we do and they take to the streets.

Jul 01 07:58 AM

[Tack:]

Lending institutions that hold debt paper on their books, rather than sell it, haven't "lost" anything, just because the market has assigned hysterical values to the loans, bearing not the slightest relationship to the real underlying performance. These unrealistic writedowns --which by the way affected actual cash positions not at all-- will subside, then, the lenders will be looking at sizable write-ups to "restore" the values to their balance sheets, that were never lost to begin with.

Meanwhile, the banks (and other lenders) have compensated for these paper losses by raising very real cash. So, they "lose" by writing down paper that they're not selling in the first place, and they correct this by actual, real-money cash raises. Firthermore, bank cash balances ballooned from frightened investors moving money out of the market and into bank deposits. On top of this, the banks are enjoying the largest spreads in history, so the carrying cost of all those supposedly valueless loans is reduced to near zero, and the cash from the vast majority that still pay, as always, just keeps rolling in.

That's why bank balance sheets are currently swimming in cash and cash equivalents. Furthermore, akthough few have seemed to notice, bank cash flows have been increasing for several quarters, all through the writedown hysteria.

At this point the banks have excess liquidity, and if there is any genuine turn in econmic activity and consumer attitudes, a lot of that money will suddenly start to flood into commerce. That's one of the principal reasons why inflation is a decided risk.

Cash positions (real liquidity) and cash flows are, indeed, where the rubber meets the road, as has always been the case.


On Jun 30 10:25 AM jswede wrote:

> Casflow.... what's a good ROA? 2%? Maybe they'll hit 3% with all
> this cheap funding?
>
> Capital.... what are losses on assets? ~30%+ ? Possibly much more?
>
>
> cashflow is a drop in the ocean compared to losses on assets.

Jul 03 07:37 AM