Financials: Why Doesn't Sell-Side Realize the Value?

Oct. 6.09 | About: Fifth Third (FITB)

Take a look at the following, which appears in the valuation section of a sell-side report out last week on Fifth Third Bancorp (NASDAQ:FITB), initiating coverage with a “Market Perform” rating.

[W]e have opted for a price-to-tangible book value methodology, in light of the uncertainties surrounding earnings and true book value. FITB currently trades at 1.1x tangible book value (TBV), a 66% discount to its historical average of 3.1x, and below the current large-cap regional bank peer group average of 1.8x. [Emph. added]

The rating on the stock, remember, is Market Perform. Now, I don’t mean to sound like a crank, but a 66% discount strikes me as a big discount! And yet the analyst (whom I won’t name because, as you’ll see in a minute, I don’t mean to single him out for abuse) doesn’t seem think it’s especially remarkable, or might be a reason to recommend the stock.

This is a great example of what, to me, is the sell-side’s newest, most annoying habit: the refusal of too many analysts to see today’s extreme valuations (at least in financial services) for what they are, and to provide some reasoned judgments about them.

You presumably know what I’m talking about. Historically, the S&P Financials have traded at between 2 and 3 times book value, broadly speaking; they currently trade at 1.1 times. Historically, the typical bank has traded at 10 to 12 times earnings. Now it trades at 4 to 6 times its normalized earnings power. The story’s the same for consumer lenders, investment banks, you name it.

It’s no secret why financials’ valuations are so squashed, of course. The industry has just come through the most harrowing credit crunch in anyone’s lifetime; even with the stocks’ rally since March, valuations are still below their historical ranges.

You’ll have your own view as to whether current valuations are reasonable. On the one hand, the recession seems to be ending, and industry earnings and valuations will shortly revert to their long-term means. Or maybe the economy’s recent strength will only turn out to be temporary, in which case losses at many financial services companies could last for years.

Both views are respectable. What’s not likely to happen, though, is that the industry will stay in its current state of stock-market purgatory forever. It seems nuts to assume that current valuation levels constitute some sort of “new normal.” But that, as the Fifth Third report seems to show, is what too many sell-side analysts lately seem intent on doing. They take current valuations and implicitly seem to think they’ll last more or less forever. It’s crazy.

Look again, for example, at our unnamed analyst’s report on Fifth Third. As I say, his thinking is way too typical of what’s going on up and down the sell-side:

Our valuation range represents 1.1x-1.2x price-to-tangible book value multiple on our 2010 estimate of $9.00. Risks to achieving our valuation range include weakening economic conditions, interest rate volatility, extended weakness in the housing sector, materially increased regulatory requirements or costs, and capital markets performance. [Emph. added]

So the analyst seems to think Fifth Third should trade at 1.1 times tangible book, unless the economy gets worse. No. Prior to the crisis, Fifth Third traded at 3 times stated book. Now it trades at 75% of book. As the recession ebbs, and the company achieves something like it its past levels of profitability, the stock will presumably one day trade at something close to its old valuation.

The only reason it’s not trading there already is that the market (perhaps rightly) is already discounting the “weakening economic conditions, interest rate volatility, extended weakness in the housing sector” that has the analyst so worried. You might argue that the stock isn’t discounting enough in the way of further economic weakness. Either way, economic weakness isn’t a risk to his target; it’s already embedded in the stock’s price.

As I say, this report on Fifth Third is pretty much typical of much of the work the sell side is doing on the banking industry these days. It’s just not very helpful.

Meanwhile, if there were ever a time to stand up and make a valuation call on the banks, this is it. Are you bearish on the economy? Fine, then explain why the sector’s current, extreme valuations aren’t extreme enough. Not bearish? Then tell me why multiples won’t eventually regain their historical form—and why the stocks won’t zoom.

You may be wrong or you may be right. Who knows? But if you’re not willing to go out on a limb now, you’ll never be willing to. This is a moment when analysts can make their careers. Instead, too many analysts’ willful refusal to see a valuation extreme for what it isn’t doing do anybody any good.